In the stock market, good analysis does not guarantee a good investment. Even when they correctly anticipate how a company will evolve, investors can lose money. In financial markets, being right is not enough; you have to be right at the right time.
The stock market is unforgiving. And paradoxically, that is part of its appeal. Investors can spend hours poring over annual reports, dissecting companies’ financial statements or scrutinizing charts to identify trends and determine the best entry and exit points. Despite all these efforts, even the most experienced investors get things wrong. If the stock market punishes those who are wrong, it is sometimes even harsher on those who are right.
Imagine an investor capable of predicting a company’s bankruptcy with certainty. Convinced by his analysis, he decides to short the stock to profit from its decline. Yet, against all expectations, the share price continues to rise. Losses mount until a margin call forces him to liquidate his position. A few weeks later, the company goes bankrupt. The investor was right, but he lost money.
This situation illustrates one of finance’s most famous sayings, generally attributed to John Maynard Keynes: “The market can stay irrational longer than you can stay solvent.”
In the stock market, being right too early is sometimes the same as being wrong.
If seasoned analysts, despite being capable of producing rigorous analysis, fail to anticipate market movements, it is not necessarily because their reasoning is wrong. It is often because their scenario does not play out when they expected it to.
The reason lies in part in a particular feature of financial markets: share prices reflect not only companies’ prospects, but also investors’ expectations about those prospects. And above all, the way those expectations evolve.
When the stock market becomes a beauty contest
A little economics never hurts, especially when John Maynard Keynes enters the financial markets with metaphors. In Chapter 12 of his General Theory of Employment, Interest and Money, published in 1936, the economist used the image of a beauty contest. The comparison became famous, illustrating quite accurately some of the forces driving investor psychology.
His insight is simple. In financial markets, a stock’s price depends not only on its fundamental value. It also reflects, and sometimes primarily reflects, investors’ perception of that value.
A company’s growth prospects, expected earnings and the outlook for its industry naturally influence its valuation. But these factors are not enough. What also matters is how other investors interpret them.
To illustrate this mechanism, Keynes drew on beauty contests organized by newspapers of his time. Readers had to select the six most beautiful faces from a hundred photographs. The winner was not the person who chose the most attractive candidates according to his or her own preferences, but the one whose selection came closest to the choice of all participants.
In other words, to win, participants did not have to choose the most beautiful candidates, but to guess which ones others would consider the most beautiful, and therefore come as close as possible to the consensus. A rational participant therefore does not seek to express personal preferences. He or she tries to anticipate those of others. And because every participant may follow the same reasoning, the game consists of guessing what others think others will choose.
For Keynes, the stock market partly operates according to this logic. In the short term, a stock’s price depends less on its intrinsic value than on investors’ collective expectations. This phenomenon is particularly visible in the most speculative stocks, whose prices can fluctuate considerably without any equivalent change in their fundamentals.
Back to the future: expectations dictate prices
Therefore, being right about a company’s prospects does not guarantee making money in the stock market. A company may show excellent financial health, report sharply higher earnings and still see its stock fall.
Portuguese group Galp Energia, one of Europe’s leading oil and gas companies, offers an illustration today. Its stock is down nearly 10% despite solid profitability and the publication of adjusted net income up 68% to €682m.
Investors appear more concerned about the failure of negotiations with Spanish group Moeve, which sought to bring together their refining, chemicals and fuel distribution operations.
They had apparently priced in some of the profits expected from the deal. Its abandonment is prompting them to revise their outlook and potentially the stock’s valuation. Strong financial results are not enough to offset this disappointment.
For a buyer convinced of Galp’s long-term potential, the situation may seem absurd. His fundamental analysis may remain perfectly valid. Yet if he bought the stock just before the announcement, he could suffer an unrealized loss of nearly 10% on his very first session as a holder. He was not necessarily wrong about the company. He may simply have been wrong about when to invest.
A matter of timing
This apparent contradiction can be explained by the behavior of economic agents. In financial markets, everyone seeks to anticipate the moves of others in order to buy before a rise or sell before a decline. The goal is not only to identify promising companies, but to take a position before their potential is fully recognized by the market.
It is not enough to predict what will happen, you must also anticipate when the market will price in the information. The entry point then becomes an essential performance variable. Two investors can share exactly the same analysis of a company and achieve radically different results depending on when they buy its stock.
This does not mean investors should abandon fundamental analysis in favor of speculation. On the contrary, understanding a company’s economic and financial prospects remains essential. But this analysis must be accompanied by consideration of the expectations already priced into the stock.
In the stock market, a good company does not necessarily make a good stock. It all depends on the price paid, the expectations already priced in and the company’s ability to exceed them. Investors must therefore ask not only what will happen, but also what others think will happen. This question of timing is particularly important for traders seeking to realize capital gains quickly and who sometimes use derivatives or leveraged products.
