If some degree of mis-pricing exists in the stock market, it does not persist for long.

Market valuations rest on both logical and psychological factors.

The theory of valuation depends on the projection of a long-term stream of dividends whose growth rate is extraordinarily difficult to estimate.  Thus, fundamental value is never a definite number.  It is a fuzzy band of possible values, and prices can move sharply within this band whenever there is increased uncertainty or confusion.  Moreover, the appropriate risk premiums for common equities are changeable and far from obvious either to investors or to financial economists.  Thus, there is room for the hopes, fears, and favorite fashions of market participants to play a role in the valuation process.  

History provides extraordinary examples of markets in which psychology seemed to dominate the pricing process, as in the tulip-bulb mania in seventeenth century Holland and the Internet bubble at the turn of the twenty-first century.  It is doubtful that the current array of market prices ALWAYS represents the best estimate available of appropriate discounted value.

Nevertheless, the evidence suggest that stock prices display a remarkable degree of efficiency.  Prices adjust so well to important information.  Information contained in past prices or any publicly available fundamental information is rapidly assimilated into market prices.  If some degree of mis-pricing exists, it does not persist for long.

"True value will always out" in the stock market.  To paraphrase Benjamin Graham, ultimately the market is a weighing mechanism, not a voting mechanism.  

A Great Metaphor - The Stock Market can be likened to the Sea.

The stock market is indeed similar to the ocean because, just as a cork floating upon its surface is, the price of a stock is affected by many different influences at once.  And each of those forces can either add to or subtract from the effects of the others.

The broadest influence is, of course, the tide that ebbs and flows regularly and in some places rises 50 feet or more above its low point.

Upon the tide are the broad, rolling waves caused by the various disturbances at the sea bottom.  Then there are the large waves caused by storms and major changes in the atmosphere, and there are the various ripples and patterns caused by the whim of the local breeze that blows this way and that over a few square yards of the surface.

That cork is buoyed by a combination of all of these influences, some rising and some falling, all at the same time.   If you were to try to predict where that cork would be in relation to sea level in the next moment, you'd have a tough time of it.  You can't predict what a storm or even an underground earthquake will do to the cork at any given moment.  And if you add to that the effects of the winds and the little breezes, it's hopeless!

However, you would be able to forecast, in general, where your cork would be over the course of the day, instead of at a particular moment.  This is because the tides are influenced by the position of the moon, by gravity, and by a variety of other factors that are all scientifically predictable - so predictable, in fact, that almanacs are published that forecast the tides for years ahead, right to the minute.

The stock market is also governed by a diverse set of influences.  And just as the sea is, it is predictable over the long term but not over the short term.

Investing: As Easy as Taking a Shower?

By Brian Stoffel 
November 9, 2011 

For the beginning investor, entering the stock market can be a confusing experience. Too often, a newbie dips his or her toe into the water, gets burned, and lets the "pros" take care of money matters from there on out.

It doesn't have to be this way; but first, we need to examine why investing can be such a difficult task.

Peter Senge in his best-seller The Fifth Discipline offers us a simple framework to explain the pitfalls of investing.

It's all about a feedback delayLet's pretend it's the morning, and you've jumped in the shower. Of course, the water temperature isn't going to be perfect right away; you need to adjust the knob. In the most basic sense, your feedback loop would look like this.

Now let's change things up: You have a defective shower. Instead of the water temperature adjusting almost immediately to a turn in the knob, it takes 10 seconds after turning the knob for any noticeable change to occur.

Now the feedback loop looks like this.

That delay is a pretty big deal, especially if you aren't used to dealing with it. Your first time in the shower might go like this: turn the knob to make it mildly hot, not feel a change, and turn the knob to scalding hot. Ten seconds later, while you're burning your skin off, you turn it to mildly cold. Not feeling a change, you adjust it to frigid cold, and then...

Well, you get the idea.

Applied to investingThe inclusion of a delay causes many a self-inflicted wound, and this explains why some beginners run into trouble.

Enticed into the stock market by opportunities for riches, investors may become frustrated when they don't see immediately results from their decisions. This leads them to constantly move money in and out of certain stocks, never allowing time for their thesis to play out.

In reality, an investor's feedback loop looks like this:

How long of a delay are we talking here?Fool founders Tom and David Gardner have always espoused the view that when investing, the average person should have a three-year time limit, minimum. That doesn't mean that you can't sell a stock before the three-year minimum. If it's crystal clear that your original thesis for investing in a company no longer holds true, then it's best to part ways sooner rather than later.

Being "crystal clear," however, isn't as easy as it sounds. Separating a company's performance as a business from its performance as a stock is essential. As Warren Buffett attributed to mentor Ben Graham in a letter to shareholders, "In the short run, the stock market is a voting machine, but in the long run, it's a weighing machine."

A few choice examples...To illustrate the importance of understanding this delay, I went back and looked at some well-known companies and how they've performed since three years ago, in November 2008. Here's a look:

Company	3-Year Return	Change at Lowest Close vs. Starting Price
Whole Foods (Nasdaq: WFM  )	612%	(15%)
Sirius XM (Nasdaq: SIRI  )	530%	(78%)
Green Mountain Coffee (Nasdaq:GMCR  )	1,200%	0%
Rosetta Stone (NYSE: RST  )	(72%)*	(72%)

Source: Yahoo! Finance. *Since going public in April 2009.

All four of these examples reveal a slightly different lesson for investors in how they should approach the market with a long-term time horizon.

When the Great Recession hit, investors behaved as if the organic food movement were dead. Adding to the negative sentiment, competition was coming from all sides: Even Wal-Mart (NYSE: WMT  ) began offering some organic food. Investors with a three-year horizon, however, realized that eventually, our economy would recover. And if they were following the broader move toward organic food, they knew the trend was undeniable.

Sirius XM, on the other hand, seemed to be on the brink of bankruptcy in early 2009. Believers in the company, however, were confident that the company wasn't going to be going anywhere, anytime soon. When they were bailed out by Liberty Media (Nasdaq: LCAPA  ) , life (and cash) was injected back into the company.

I included Green Mountain (maker of the ubiquitous Keurig coffeemakers) to show that there's really no telling how long a delay will be. Sometimes it will be a year, sometimes just one day. In this case, Green Mountain climbed immediately. The bigger point is that three years isgenerally long enough for any delay to work its way out of a system.

Finally, Rosetta Stone is an excellent example of the fact that it is OK to sell a stock before three years if your investment thesis changes dramatically. Just last month, I sold my sharesin this company because of the constant turnover in the executive suite.  

http://www.fool.com/investing/beginning/2011/11/09/investing-as-easy-as-taking-a-shower.aspx

Key Points about Risks

Risk unequivocally exist in investing in any stock  ...

... but important to distinguish between volatility in stock price and business risk ...

... and my point is that none are large or imminent enough to explain why shares are so cheap.

Market price fluctuations have only one significant meaning for the true investor.

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity 

• to buy wisely when prices fall sharply and 
• to sell wisely when they advance a great deal. 

At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Explanations for the Erratic Price Behaviour of some of the Most Successful and Impressive Enterprises

Growth Stock Paradox: The more successful the company, the greater are likely to be the fluctuations in the price of its shares.

The argument made above should explain the often erratic price behavior of our most successful and impressive enterprises. 

• Our favorite example is the monarch of them all—International Business Machines. The price of its shares fell from 607 to 300 in seven months in 1962–63; after two splits its price fell from 387 to 219 in 1970. 
• Similarly, Xerox—an even more impressive earnings gainer in recent decades—fell from 171 to 87 in 1962–63, and from 116 to 65 in 1970. 

These striking losses 

• did not indicate any doubt about the future long-term growth of IBM or Xerox; 
• they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.

Every investor who owns common stocks must expect to see them fluctuate in value over the years.

Market Fluctuations of the Investor’s Portfolio

Every investor who owns common stocks must expect to see them fluctuate in value over the years. 

The behavior of the DJIA since our last edition was written in 1964 probably reflects pretty well what has happened to the stock portfolio of a conservative investor who limited his stock holdings to those of large, prominent, and conservatively financed corporations.

• The overall value advanced from an average level of about 890 to a high of 995 in 1966 (and 985 again in 1968), fell to 631 in 1970, and made an almost full recovery to 940 in early 1971. 
• (Since the individual issues set their high and low marks at different times, the fluctuations in the Dow Jones group as a whole are less severe than those in the separate components.) 
• We have traced through the price fluctuations of other types of diversified and conservative common-stock portfolios and we find that the overall results are not likely to be markedly different from the above. 
• In general, the shares of second-line companies* fluctuate more widely than the major ones, but this does not necessarily mean that a group of well established but smaller companies will make a poorer showing over a fairly long period. 

In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.†




* Today’s equivalent of what Graham calls “second-line companies” would be any of the thousands of stocks not included in the Standard & Poor’s 500-stock index. A regularly revised list of the 500 stocks in the S & P index is available at www.standardandpoors.com.

† Note carefully what Graham is saying here. It is not just possible, but probable, that most of the stocks you own will gain at least 50% from their lowest price and lose at least 33% from their highest price—regardless of which stocks you own or whether the market as a whole goes up or down. 

• If you can’t live with that—or you think your portfolio is somehow magically exempt from it—then you are not yet entitled to call yourself an investor. 
• (Graham refers to a 33% decline as the “equivalent one-third” because a 50% gain takes a $10 stock to $15. From $15, a 33% loss [or $5 drop] takes it right back to $10, where it started.

Ref:  Intelligent Investor by Benjamin Graham