The Conceptual Foundations of Investing

5FUNDAMENTAL ANALYSIS AND VALUATION

There are two fundamentally different approaches to active investing. One is to buy securities that you believe are well-priced relative to the future cash flows you expect to receive as an owner. If your belief is correct and if you hold the security long enough, either the cash you receive will justify the purchase and/or eventually the market will come to appreciate the value of the security, giving you the opportunity to sell at a price that produces a superior return. The second approach is to buy a security with the intent of reselling it in the relatively near future at a higher price. Much technical analysis is based on the second approach. Charts are analyzed with the goal of identifying when prices will rise or fall so as to profit from the price movement. Security cash flow is largely irrelevant. The goal is to buy today what you think someone will pay more for tomorrow.

The effort to buy assets you think someone will pay more for tomorrow is not something we address in this book. It falls more into the realm of psychology than finance. Therefore, we do not see it as a fundamental concept of investing. There is, however, one aspect of the buy low/sell high approach that is worth addressing before we leave the topic and that is the possibility of bubbles.

BUBBLES

If a sufficient number of traders employ the buy low/sell high strategy, it is possible for price increases to become self-fulfilling. Investors buy today because prices ...