The Effects of Free Market on Investing

If you ask me, properly determining the value of an investment is the single most important aspect of investing. Many investors may argue that diversification is most important, but diversification will not help if the majority of investments are overvalued. In theory, the risk of loss along with the reward (expected increase in value or expected cash flow) should be what determines the value of an investment. However, in reality there is a third component that determines value: the law of supply and demand. According to the law of supply and demand, when demand increases (demand curve shifts to the right) the price will increase accordingly.

The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The graph depicts an increase in demand from D1 to D2, along with a consequent increase in price and quantity Q sold of the product.

All to often, would-be investors use demand to determine the value of an investment rather than arriving to a price by properly assessing risk and reward. This mob mentality leads to an unjustified increase in the value of an investment. Ultimately the market will realize the investment has been overpriced, a lot of selling takes place, and the price falls to a more reasonable level. On occasion, the free market will underestimate the value of an investment. The price remains below the intrinsic value until either the market slowly comes to realize its underestimation, or some event takes place that exposes the market has underestimated the value of the investment. This would lead one to the conclusion that it is better to underestimate the value of an investment than to overestimate it.

If you can’t already tell, I’m a big fan of value investing. Value investing is “the strategy of selecting stocks that trade for less than their intrinsic value.” Of course, the real challenge lies in properly determining the intrinsic value of an investment. I believe you should never let demand be a part of the equation. Some investors actually do the opposite, allowing trends in investment volume to determine their investments. However, I would label such individuals speculators rather than investors. If you are unable to determine the intrinsic value (or a conservative estimate) of an investment, you probably should not invest in it.

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