The rational way to value stocks is on the basis of future earnings and current interest rates. However, it is widely accepted that rationality is not the only influencer of stock prices.
Human tendencies being what they are, people sometimes allow fear and greed to direct their investment decision-making. Unlike rationality, fear and greed can (and often do) lead to incorrect judgments regarding the long-term attractiveness of particular stocks – or even the stock market as a whole.
What causes stock prices to sway so violently to and fro? I would suggest that it is not the mere existence of the three factors, but rather the changing degrees of influence that rationality, fear, and greed each exerts upon market participants at any given time.
When economies are changing and the future is uncertain, fear dominates and stock prices move lower. By contrast, during times when all seems well in the world, risks weigh less on investors’ minds – greed takes over and stock prices move higher.
Most of the time, consensus opinion is somewhere in between the two extremes of fear and greed. I like to think of rationality as the midpoint between fear and greed, since a proper perspective always incorporates both risks and rewards.
When it comes to investment choices, nothing hurts the investor more than relying on fear and greed to guide behavior. Rationality, especially when applied to a good valuation method, is the key to investing success.