Participants in the securities market can be divided into two groups:
- Smart Investors – 20% of the market
- Followers – 80% of the market
Smart investors conduct in-depth analysis of organizations and determine their intrinsic value, or more precisely, a range of intrinsic values. Naturally, even the assessments of such investors do not match each other.
Follower investors observe market trends and act accordingly. When smart investors start reacting to information, followers follow and cause the market to deviate from the intrinsic value ranges.
For example, if smart investors start selling shares, followers notice the trend and begin mass selling without understanding where the lower boundary of intrinsic value lies, reducing demand for the shares and causing a devaluation. After this, smart investors re-enter the scene… This also happens when the vector changes direction…
The conclusion from this model is that market fluctuations are a natural process, and because smart investors’ assessments differ from each other, follower investors automatically cause market swings, even if nothing fundamentally changes in reality.
Another important conclusion is that smart investors determine the price levels of stocks in the market. In other words, where the average or median price will be depends on smart investors, while deviations are caused by followers.
Below, the graph shows different types of investors and their approaches:
- Intrinsic – Evaluators of intrinsic value, i.e., smart investors;
- Traders – Investors focused on short-term waves, trying to keep up with new information signals;
- Mechanical Indexers – Investors working with strictly predefined rules, replicating indexes, or investing in indices;
- Mechanical Quants – Investors working based on complex statistical models;
- Closet Indexers – Closet investors, well disguised under the guise of active investors, but in reality, making passive investments in index replications.
Source:
Value: The Four Cornerstones of Corporate Finance by McKinsey & Company Inc., Tim Koller, Richard Dobbs, Bill Huyett