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Understanding the Stock Market: Firm Foundation vs. Castle in the Air Theories

I’ll be the first to admit it. I am not an expert in the stock market. In fact, my understanding of the stock market is somewhat limited. Especially compared to my knowledge of real estate.

Why is my understanding of the stock market so limited?

It’s a fair question. Especially since I talk a lot about how and why I invest in the stock market and why I so strongly believe that it is the right way to do so.

The answer though is pretty straightforward.

I just don’t need to be an expert in the stock market to successfully invest in it. In fact, I worry that a lot of people become worse stock market investors as their understanding of it grows. I’ve seen it happen.

understanding stock market

So I learned a much as I needed to invest successfully in the stock market. Things like:

And I generally ignore the rest. I chose to spend my time actively learning about and investing in real estate.

In fairness, this is all anyone really needs to do to be a successful stock market investor. Especially if you are a physician who just wants to set their finances for success and then ignore them. If that is the case, here are the basics and this is the formula for financial freedom…it’s that simple.

But, I started to feel an itch

Don’t worry. It wasn’t the itch to start investing in individual stocks or actively manage my investments.

I started to feel the itch of curiosity. I wanted to increase my understanding of the stock market. Learning what not to do can be as helpful and interesting as learning what to actually do.

So I started reading a lot more about the stock market. And I’ve found it really interesting.

I’m careful not to fall into confirmation bias. My goal is not to just find people who think like me to confirm what I believe. That happens too much in the world today. So I look for opinions and information from all sources and stock market beliefs.

So far, this has only helped to give me a more firm belief in my written investment plan.

Regardless, think it will be fun to share some of what I have learned with all of you. And I’ll plan to do just this in a series of regularly irregular posts coming up!

Understanding the stock market (even though it can’t really be understood…can it?)

The first concepts that I’d like to discuss surrounding the stock market are two theories that I find fascinating. Intuitively, they both make sense.

And even though I didn’t know them by name, I think I’ve always sensed their presence in the personal finance world.

They are the firm foundation and the castle in the air theories.

Let’s dig in.

Firm foundation theory of the stock market

The firm foundation theory of anything really, but in this case we are talking about stocks, says that each investment has an intrinsic value.

Because it has an intrinsic value, investment decisions can be made based on the current price of the investment compared to its intrinsic value.

This means:

  • If the current price is lower than the intrinsic value, you should buy it
  • If the current price is higher than the intrinsic value, you should sell it

In the world of the stock market, the intrinsic value of a stock is generally argued to be based on the growth, earnings, and/or dividend yield of the stock. It can also be argued to be based on factors like the growth of the industry of the stock and similar factors.

The practice of determining this intrinsic value is called fundamental stock analysis.

What do I think of the firm foundation theory?

Ready for my unsolicited hot take on the firm foundation theory of the stock market? I think it makes sense. I mean, what rational person would argue that it doesn’t? Does everything not have an intrinsic value?

Ah, but therein lies the rub!

Everything may have an intrinsic value. However, that intrinsic value may be different to different people.

But, even more importantly, an intrinsic value means absolutely nothing if we do not have an accurate way to measure that intrinsic value!

And that is our reality. We have no reliable measuring stick. Study after study shows the fundamental analysis does not work. At least not better than a passive investing strategy with broad, low cost index funds.

Which brings us to…

Castle in the air theory of the stock market

The castle in the air theory instead focuses on behavior and psychology in assessing and understanding the stock market.

This theory argues that intrinsic value can’t be measured. And even better, it just doesn’t matter.

All that matters is what other people think about a certain investment or stock. It does not matter what price you buy a stock at, so long as you can find someone else to buy it for more money.

In this case, the name of the game becomes guessing what other people think about the stocks you want to buy.

Ah, but those other investors know that you are thinking about what they think about the stocks. So the actual name of the game is to guess what other investors are thinking that other investors are thinking. And so on and so on (and my brain is hurting…)

Basically, as long as you can find a sucker to pay more than you paid, you win. And that is why you are building castles in the air. And they can disappear just as quickly.

The practice of analyzing this psychology is called technical analysis.

What do I think of the castle in the air theory of understanding the stock market?

Guess what? I think it makes a lot of sense.

And why wouldn’t it? Behavior and psychology play a HUGE role in finance. So why wouldn’t this include the stock market? It’s impossible for stock investors to be coldly rational and not let emotion be involved.

But again we run into a sticky point…

How can we measure this behavioral component of the stock market, regardless of its absolute or partial impact?

…We can’t.

So no matter how right or wrong this theory is, it just doesn’t matter. Remember, luck is real and it is part of investing. And the reason is that the actions of the stock market are part of billions or micro actions, related and unrelated, that take place every day. We can’t predict them. Not even the “experts.”

Related Post:
Examining the Role of Luck in Personal Finance

And it’s not just me saying this. Study after study has also showed that technical analysis (which attempts to measure the castle in the air-ness of the stock market) can not reliably outperform a simple passive investing strategy.

What does this all mean?!

I did warn you. I told you that you didn’t actually need any of this information to be a successful investor in the stock market.

Watch Jordan’s Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here!

I told you that contrary to common sense, a deeper understanding of the stock market would not make you a better investor. In fact, in the wrong hands making the wrong conclusions, it could even make you a worse investor!

So, my recommendation is the you file all of this away as curious and interesting information never to be put into action. Or you just plain forget all about it. Nothing to see here. Just look away.

And just keep investing for the long term using a simple passive strategy with low cost, broadly diversified index fundsaccording to your asset allocationrebalancing once a yearfollowing your written financial plan

(Hint…if you need any guidance investing this way, just visit any of the links above!)

What do you think? Are you a firm foundation believer or a castle in the air subscriber? How do you invest in the stock market? Did understanding it better help? Let me know in the comments below!

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    Jordan Frey MD, a plastic surgeon in Buffalo, NY, is one of the fastest-growing physician finance bloggers in the world. See how he went from financially clueless to increasing his net worth by $1M in 1 year and how you can do the same! Feel free to send Jordan a message at [email protected].

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