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Given the extremely large number and variety of available securities, investors need a rational basis to select among them. Without rational selection criteria and a good understanding of which factors are more or less likely to increase risk-adjusted returns, investors will make decisions based on false assumptions.
The Skilled Investor has concluded that all forms of active management that cannot be cost justified should be driven out of personal investment strategies. Individuals need to choose a comfortable, low cost, low tax, risk-adjusted market investment strategy and let it run over time. Maintenance should be minimal and low cost, and the urge to chase “beat the market” mirages should be heavily restrained. Investors’ strategies should focus on broad-based, market-oriented securities that can be acquired economically and held inexpensively for an extended period.
Markets blend the speculative, future-oriented value assessments of a wide variety of investors of differing outlooks and opinions. The current price of a security represents the market’s risk-adjusted consensus about its potential future value, given the various advantages and disadvantages that all investors see in holding or selling that security.
Three key concepts are important to consider when deciding on a rational basis for choosing investments.
First, the current price of a security represents the market’s consensus about its potential future value, given the various advantages and disadvantages that all investors see in holding or selling that security. As such, the current security price is a weighted average valuation forecast of events that might or might not occur. Market prices are the best available assessment of forward-looking, risk-adjusted fair market value.
Through the market price, a wide array of investors with differing predictions and varying concerns essentially “vote” on the expected or likely future value of a security through the current price. Investors’ evaluations of the value of securities may vary widely. What one person might see as a great bargain, another might consider grossly overpriced.
Second, securities prices represent the current valuation consensus on a risk-adjusted basis.
Risk refers to the expected size and likelihood of future up or down price variations or volatility. As such, not only do prices reflect expected returns, they also reflect the panoply of concerns, optimism, risks, and euphoria about how a wide range of factors might affect the price in the future.
Third, [...]