Tags: alternatives | buy | sell | assets

Einstein Was Right: It’s All Relative

Wednesday, 03 Apr 2013 07:37 AM

By Patrick Watson

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In an alternate universe, Albert Einstein might well have been a great stock trader. He would know that financial markets are priced not on their own merits, but “relative” to each other.

What happens when you buy a share of stock? Someone else out there in the vast sea of investors simultaneously has to sell. You, the buyer, obviously think the price is headed up. The present owner is rational, too. He must expect lower future prices. You can’t both be right. Either he’s crazy for selling, or you are crazy for buying.

Reality is more complicated. Every transaction is a decision to buy one asset and sell its alternative. Right now you hold cash. You want to own stock instead. When you decide to buy the stock, you’re also deciding to sell the cash. The other guy is doing the opposite: selling stock and buying cash.

You can’t avoid owning something. The most you can do is trade it. Even if all you get is an IOU from a bankrupt seller, you still got something. Even if all you give up is a smile, you still paid somehow. That’s why we call it a “trade.” Both parties give, both parties receive.

Now what does all this theoretical physics have to do with stocks? I’m getting there.

Ever find yourself wondering why anyone would buy that when it is so obviously overpriced? You’re asking the wrong question. Ask yourself this: “What’s the alternative?”

Currencies are a good example. Why would any foreigner want to own any U.S. dollar asset? I don’t have to tick through all the reasons the greenback should be toast. You’ve heard them all before. Yet the dollar is still the planet’s reserve currency — not because it is great, but because all the alternatives are even worse.

The same applies to stocks. Whether you think the Dow Jones Industrial Average is undervalued or overvalued, your conclusion is relative to the alternatives. When you buy U.S. stocks, you’re not buying the Nikkei, or the FTSE, or gold, or wheat, or T-bonds or whatever. When you sell stocks, you have to do something with the proceeds. The decision to stay in cash, if that’s what you do, is a decision against everything else.

You can’t buy unless you sell, and you can’t sell unless you buy. Remember this and you’ll be almost as smart as Einstein.

© 2014 Moneynews. All rights reserved.

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