Stocks by themselves don’t have any value. Their price is based on what investors see in them. Or rather: what they see in their future. If the buyers of a stock think that it has a good future, then the price they are willing to pay for it will go up. Likewise, if people think that a company will face tough times in the future, then the price of its stock will go down. When buying stocks, you therefore shouldn’t think about their prices, but rather about their future. This is what professional investors do.
Today’s price of a stock mirrors how professionals view the stock’s future. You basically get their opinion for free when you look at stock prices. For this reason, buying stocks is in fact rather easy. However, we know that stocks are subject to big fluctuations. Or in other words: The opinions about the future of a company can change quickly. That’s why the stock price alone is a not a very good guide. Just because the price of a stock has gone up does not mean that you should buy it.
Index funds and ETFs see this differently: They weight expensive stocks higher than cheap ones. One example is the Swiss Market Index SMI, which contains the 20 largest companies on the Swiss stock exchange. The more expensive the company, the greater its importance in the SMI. The most expensive companies are currently Nestlé, Novartis and Roche. Prior to the financial crisis, it was the banks.
If you follow this logic, then you’ll have many expensive stocks and few cheap ones. This costs a lot of money and does not necessarily bring in a lot of money. Therefore, you must set the stock price in relation to the company itself: You do this with a price-earnings ratio or a price-to-book ratio. These are called