Is stock market a voting or weighing machine?

As I read the book “The Intelligent Investor”, I noticed the author of the book, the legendary father of Value Investing Benjamin Graham had once said in the book: “In the short run, the market is a voting machine, but in the long term it is a weighing machine”.

In the short run, Graham said stocks were a “voting machine” driven by investor sentiment. So the theory of supply and demand will function as “voting machine”. Our basic knowledge on economics tells us that the price of goods and services moves when supply and demand are not in equilibrium. Below are few examples of stating how the law of supply and demand will work:-

1) The higher the price, the higher the supply (positive relationship in between price and supply);

2) The higher the price, the lower the demand (inverse relationship in between price and demand);

3) The price is going up due to more demand than supply; and

4) The price is going down due to more supply than demand.

For stocks in the short-run, demand of stocks is affected by transaction cost, liquidity, level of interest rates and the perception towards the stock’s price movement trend, and most of these factors are beyond the control of the retail investors. Moreover, rumours that circulate in the market and the psyche of investors will cause the demand varied more drastically. Whereby, supply of stocks is largely driven by the same dynamics but with the reverse effect. 

However there is one difference in between demand and supply. Demand for a stock can be infinite, but short-run supply is limited by the number of shares in issue. If the majority number of shares in issue is being hold by company founders, substantial shareholders, institutional investors and/or long term investors, it will even scale up the scarcity of short term supply. Thus, given the such imbalance, it should not be too surprised to see stock prices can go sky limit up within a day, or appreciate few hundred percent in a matter of days, despite the lack of any change in the fundamentals of company.

Players of the short term investing comprise mainly two groups – traders and speculators. A trading strategy has worked for some groups, e.g. arbitrageurs, day traders and hedge funds, but that is only in more developed markets. Even then, returns are highly volatile, and the risks taken could be very high. Speculators on the other hand, seem to be in the stock market primarily derived from the chase, not much different in another way of gambling. The reason for buying into an over-priced stock is not important, as there seems only be able to be justified for an assumption of a greater fool out there who will buy it from him at an even higher price.

On the other hand, in the long-run, stocks were a “weighing machine” and stock prices will be driven by the potential of the underlying business of the stock to generate a value higher than what it costs the investor to purchase it. There are list of famous proponents of long term investing, such as Benjamin Graham, Warren Buffet, Peter Lynch, John Templeton. They share the common investing philosophy that short term stock price movements are unpredictable because of the large number of factors that come into play in the market. Taking a short term approach to investing is an exercise in futility due to great price fluctuation, as you could end up buying high and selling low. But business conditions and trends should hold steadier and be easier to identify.

Therefore there are few good points of taking a longer term approach, as investors will have the luxury of being able to ignore short term price fluctuations and investment cycles, minimise transaction costs and enjoy the benefits of compound returns. According to this school of thought, the only thing that matters is the company’s ability to generate earnings and dividend policy. As Benjamin Graham advised, "Investing in a stock market is most intelligent when it is most business-like". To advocate the long term approach, it is most appropriate to think of the investment process as a means of buying into the underlying business. As we should rather say we are “shareowners” instead of “shareholders”, or we would treating buying into stocks as serious term as “investing” (投资股票) rather than “playing stocks” (玩股票) or “goreng saham” (炒股票).

Which way would you like to go on becoming a “voting machine” or “weighing machine”? Make up your own decision before you decide to invest.