Q: Why is the sharemarket so volatile when earnings of companies do not change so quickly?

A: Markets rise and fall. We have seen this before and we will see it again. In 1934, Warren Buffett’s mentor, Benjamin Graham, published Security Analysis, which became a bible for serious sharemarket investors. It encouraged those investing to draw a distinction between investment and speculation. Graham’s three ideas are as follows:

You should look at shares as part ownership of a business.

Market fluctuations provide an opportunity to profit from folly rather than participate in it.

Prepare for a worst case scenario by including a margin of safety in your portfolio.

Speculators lose sight of a key point: the sharemarket facilitates the trade in ownership of companies. When you buy shares, you buy a portion of a company and share in the fortunes of that business. The value of that business should be based on your view of its performance – both now and into the future.

In 2007, Commonwealth Bank paid out $2.56 per share in dividends (fully franked) and the share price high for the year was $62, representing a yield of 5.9 per cent. In 2010, CBA paid out $2.90 in dividends and the share price low was $47, which represented a dividend yield of 8.8 per cent (fully franked).

Why were people happy to pay so much more for the stock four years ago, yet sell the stock now when the dividends paid have grown?

The market is often driven by sentiment, not logic. Building a margin of safety in your portfolio means you prepare for tougher times. Be conservative with earnings outlooks for particular stocks and invest in a range of stocks and diversify your holding into other markets. Invest in accordance with your appetite for risk. Do not place yourself in a position where you are forced to sell quality stocks in a falling market.

This article was published in The Australian on 17 September 2011. A direct link to the article can be found here.

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