How do stock market prices change? The two most common reasons are surprisingly random
For many investors there’s no greater mystery than why stock market prices change.
A vast number of factors can affect the price of any stock you buy. That’s why investors have a natural impulse to look for some sort of investing shortcut or formula that can cut the effort that goes into investing decisions. (Ideally, we all prefer a formula that fits on a T-shirt.)
I spent a lot of time researching investment formulas in my 20s and 30s. I learned they can be a great marketing tool for advisors and financial institutions. But, for investors, they expand costs and/or risk more consistently than profit.
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How do stock market prices change? Random elements occur
News reports will often claim that the stock market went up or down because of some particular fact or news item. These reports may seem to carry an official air. More often, they are after-the-fact rationalizations or guesses. In fact, when analyzing daily stock-market movements, the only thing you can say with anything like certainty is that buying on that day overwhelmed selling on that day, or vice-versa.
Investors’ attention and sentiments shift unpredictably, from moment to moment and day to day. That’s why stock prices constantly fluctuate. It’s also why nobody can predict stock-price changes with any regularity, much less precision. Of course, investors and advisors keep trying.
How do stock market prices change? Random events often occur in bunches
A coin flip is a random event. So is any guess about how the coin will land. But in a series of coin flips, a random series of heads-or-tails guesses can match up with the way the coin lands, and make the successful guesser look like a psychic. Eventually, however, the guesses and the flips will diverge, and their randomness will once again become clear.
Investment formulas are a little like that. But rather than rely on an obvious random event like a coin flip, most formulas start with a seemingly reasonable proposition about bargains in the stock market. The formula may depend on value factors such as a low stock price, a low P/E ratio, a high dividend yield, or a low ratio of stock price to book value. Or it may be based on foreign-exchange rates, long- and short-term interest rates, or price-change statistics.
Formula promoters often use “back-testing” to support their position. They check historical records to see how the formula would have worked in the past. Often they tinker with the formula and back-test different versions of it, over a variety of historical periods, and only tell investors about the results of the tests that generated a profit.
Investment professionals sometimes refer to this formula-creation process as, “first-you-shoot-the-arrow, then-you-draw-the-target-around-it.”
The problem is that the formula can only work in the future if there’s some consistency in the relationship between the elements in the formula and the outcomes of the trades. You can spot that consistency when you study the past, but it may be due to a unique series of coincidences. You can’t predict how long (or if) anything similar will appear in the future.
How do stock market prices change? It’s important to recognize investment trends
It pays to keep in mind that the stock market anticipates things, and no trend lasts forever. Stocks put on lengthy downturns due to business and economic problems. The downturns go into reverse long before the problems get solved.
Remember, a highly dramatized story is far more entertaining, and more absorbing, than a straight explanation of facts. But don’t let entertainment value, or your degree of absorption in the story, warp your judgment.
How do stock market prices change? Regardless of the reason, don’t sell too soon
Selling too soon is one mistake that many investors make. They may sell off good investments in anticipation of a market downturn. Or in times of market pessimism, investors may be tempted to sell all of their stocks, regardless of quality, in hopes of getting back in at lower prices.
Selling to sidestep a market downturn rarely works out as neatly or as profitably as sellers hope. First, some stocks hold steady or rise during a downturn—these are often the strongest stocks in the subsequent upturn. And sometimes the downturn ends much more quickly than you expected, and you wind up buying back in months or even years later, at much higher prices.
Other times, the market moves up, the seller buys back in, and the real downturn begins.
At TSI Network, we encourage investors to find and hold (or buy and watch carefully) shares in well-established companies, especially ones that pay dividends. Market downturns will always occur from time to time, but over the long term, keeping your purchases—including those made with either market and limit orders—to a minimum will greatly increase your profits.
How have you used investing formulas successfully in your career?
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