Stocks go up like a balloon, down like a rocket

At the moment things are pretty good, with the Dow Jones close to a record high and, although it may not seem it, the volatility is at an almost record low.

You might notice the rapid spike in volatility when Lehman Brothers went bust and the US market dropped sharply in 2008. This introduced the stockmarket concept that markets go ''up the stairs and down the escalator''.

If you think about it, the stockmarket only crashes. I don't remember it going up 25 per cent in a day.

I don't remember any headlines saying, ''Stock market boom, stock brokers retire as Dow gains 1000 points in a day''.

The reason, of course, is a possibly fabricated hypothesis that losses have three times the emotional impact of a gain. In other words, we fear a loss three times more than we want a gain. This would tend to suggest that share prices will take three times as long to rise as they do to fall.

The GFC was the obvious example. Four years' worth of investing, nurturing, hoping, praying, luck and good intentions were destroyed in 16 months. Stocks go up like a balloon and down like a rocket. It is easier to lose confidence than it is to build it. Another adage: ''It takes five minutes to be fearful, but you can't get confident in five minutes.''

The reason is that it takes a lot longer to build trust than it does to lose it. And as we all know, when we are betrayed we get at least three times as upset. That's why, despite it being almost six years since the GFC, we have yet to recover the highs and are still 21 per cent below our peak.

It's why the majority of long-term investors will tell you that despite the rally in the market in the past 18 months they still ''don't trust it''.

But the beauty of the three-to-one ratio is that clearly the ''value'' of a stock doesn't move in the same way, just the share price. Did the value of the bank sector really drop 56 per cent in the GFC? Of course not. The emotional components that were driving share prices at the time (fear and betrayal) were not a reflection of value.

A value investor will sell this as an opportunity to you. If everyone is running around with their hair on fire, painting targets on the pavement outside their office buildings, then there is opportunity about. You don't need to be smart to spot value at the extremes they will tell you, although if I dare you to start pompously spouting about ''value'' in hindsight to someone who took an emotional beating in 2008, you're likely to get a swift response.

But extremes aside, the reality is that the emotional component of a share price, rather than being wrong, is a much more important and common driver of share prices than value and it is a bit unrealistic to focus on value alone when sentiment-driven prices can persist for long periods.

At the same time, value calculations, even if correct, can take years to manifest themselves again in the share price. That makes ''value'' investing a game of patience during which you have to hope that the value calculation you did when you bought the stock hasn't changed - which it almost certainly has.

You should ''value'' all the value investment products and methods, but I do think that while they focus on intrinsic value, their real worth is in doing the work to allow the identification of ''good stocks.'' The intrinsic value calculations and how they relate to the current share price are a bit secondary.

Good stocks tend to do better in a bull market and a bear market, so the work involved in valuing a company is an essential part of having an edge. But you will still need timing because the concept of there being an ''exact'' value for a stock is a bit too idealistic.

By the way, the bottom line of the three-to-one theory is that there's no rush to buy. You can take your time, but when it comes to selling, you'd better be quick.

Marcus Padley is the author of the stockmarket newsletter Marcus Today. For a free trial go to marcustoday.com.au.