demand > supply = higher prices

demand > supply = higher prices

The general assumption about markets is that they fairly price assets and that they are a true reflection of the success of those assets in generating returns on capital. However, these two functions of the markets are not the same thing. What is more, they are frequently not in alignment with one another. Why is this so?

The short answer is that the demand for investments very frequently far exceeds the supply of investments. And as you know, when demand exceeds supply, prices rise. That is, there are many more actual and prospective investors in markets than there are assets to purchase. This imbalance of a much greater preponderance of “buyers” to “sellers” leads to rising asset prices.

In a perfect world each participant in investment markets has an effective objective, analytical method for determining the appropriate price to pay for an investment. However, it is an imperfect world. Most people purchase investments without much regard to the price that they are paying.

Multiple generations of investors have been taught and told repeatedly that if they are going to save for their retirement, that stocks and real estate are their best bet. The irony is that stocks and real estate are actually more complicated to understand than bonds. Yet, I am certain that if 100 people on the street were quizzed about stocks, real estate, and bonds that the majority of people would not be able to tell you much about bonds. So what’s the point?

The point is that most investors in stock and real estate markets make their decisions without actually considering whether these markets actually can provide value and long-term return. Unfortunately, value is assumed to exist from the beginning and people only purchase their investments based on relative values within a given market. That is people have already made a decision to invest in either the stock market or real estate market and then they look for value within that market.

Additionally, people invest in stocks and real estate because these markets have sex appeal. And because people are more inclined to gossip about stocks and real estate, too. People make many purchasing decisions in life based on excitement, not based on soberness. Yes? The result is that market levels are frequently out of synch with the actual values of investments. When this occurs, in bubbles and in bear markets, it is time to make investment decisions.

In bubbles, prices are much higher than values and this is a time to sell investments. In bear markets, values are much higher than prices and this is a time to buy investments. So the question is: how can I tell how much to pay for an asset? As it turns out, this is not a tough question to answer, but it does involve some time spent on your part to learn how to do it. But the rewards are well worth it because even the overwhelming majority of professional investors do not bother to price their investments and confirm whether or not the price paid is a true reflection of value. There are several good books about investment valuation and in a future post I will share some of these titles with you.

For now, just know that when markets are talked about in terms of excitement, either euphoria or fear, then it is a strong sign that assets prices are not in accord with true, objective value.

I sincerely hope that you are continuing to enjoy the blog!

Jason