The share price moves around because of changes in the market and something called a random walk. Yes, the share price walks around like we do. Read on for a more detailed explanation why stocks go up and down.
The change in the market is new information about a company or something going on in the world. It could be good or bad performance, a natural disaster, Donald Trump being diagnosed with coronavirus or something else.
Individuals and funds buy stock for one reason only: to make money. I can probably speculate all day about the overall benefits of the stock market. However, if we drill down to the fundamental benefit of investing we always arrive at profits.
What is an exchange: how are shares traded
The exchange is a marketplace. I’d say much busier than the local Christmas market. To be fair it’s more like haggling over the price of a house. You make an offer, the seller rejects it, then you make another one until both of you either agree on a price or move on.
The London Stock Exchange is the same, you want to buy the imaginary New to trading PLC stock for £1 per share and send a bid. However, my ask (a.k.a. offer) is £1.05. If it’s just me and you we’d both start changing the price until we agree on £1.02 or £1.03.
It is pretty similar to haggling over the price of a bracelet on the beach. You only miss on the angry face of the seller when they hear your low ball offer of £1.
The effect of time and information
You may be investing because you want to buy a house or a car so you’d be looking at a few years. A friend may be investing for retirement. However, a speculator or a day trader may be investing to earn something in the next few minutes or a few days.
We all have a different time horizon and different goals. This is why shares are bought and sold all the time and one of the reasons why stocks go up and down.
How time affects you
Every day this time period either starts or ends for someone. Consequently, a lot of people have bought shares at different prices. One person has bought Amazon for $7 in 1998 while someone else bought it for $3,175 last week or anything in between.
You won’t be too fussed about selling 1,000 shares for $3,170 or $3,180 each if you bought them for $7. You’re already a millionaire and $10,000 won’t change that.
Others may be speculating on the price and a small change will make a big difference. This is why day trading is harder compared to long term investing a.k.a. buy and hold.
A day trader would be ecstatic to collect 5% on a stock within a few hours. In the Amazon example this adds up to $158,750. For a £10 stock it will be 50 pence a share. You on the other hand will be gutted if you only made 5% for 22 years.
The take home message is that the time horizon sets different profit expectations which result in different target stock prices for the parties involved. We’ve cleared how time affects you, now let’s see how it affects the share price.
How time and information affect the share price
When you invest you buy the future, not the present or the past. It is really important to always remember this.
Just because a company did well in the past doesn’t mean that it will do well in the future. Things change and the winners of today easily become the losers of tomorrow.
So why do we use historical information?
It helps us to create a story and decide what our expectations are. Most finance professionals use something called a model to build a picture of the future. The information which is available is in the past so there is nothing else to build a model on.
The picture of the future is often distorted in one way or another. No one knows what will happen so we can only assume. Did anyone see a global pandemic coming in 2020?
Regardless of the uncertainty sometimes you look at a company and you find out that it is making money, people like the product, it’s coming up with new stuff. Then you think ok, if everything else remains stable there is no reason why it won’t continue to make money. You end up making a decision on the best available information at the time.
Some investments end up losing money but you have to be fair to yourself. None of us know how events will unfold and it is easy to beat yourself up over a decision. But you have to remember you did not have the information at the time of purchase.
We agree to disagree
People think in a variety of ways so it is easy to see that the above method will deliver different results. The implication is that investors will have different price targets for the same stock. It is perfectly fine for you and I to think that the same stock is worth either £10 or £15.
Inconsistency in perception
The larger the gap between everyone’s perceptions of price the bigger the volatility of a stock. This means that the stock will move in a wider range the bigger the disagreement. If everyone agrees the stock will move in a narrower range. You can read more about volatility here if you are interested.
In simple terms think about Tesla. It traded between $330 and $450 last month. Coca Cola on the other hand was between $48 and $51. The market seems to be in agreement about the price of Coca Cola so it has lower volatility than Tesla.
There is an expectation that Tesla stock will move more than Coca Cola in the future. But when is that future? We don’t know. Everyone has a different time horizon so the definition of future varies from person to person.
Why stocks go up and down in the long term
Profit and growth are the drivers of long term share price increases or decreases. Following the analogy from How stocks and shares work if the pizza is getting bigger the share price will go up, if it shrinks it will go down.
But it’s not just that, there are also our expectations. We buy the future so we expect that the pizza will get even bigger. Or maybe the pizza shrank but we think that the company will turn around and it will become bigger. This can happen if there are good growth prospects.
The market thinks that Tesla has bigger growth prospects than Coca Cola. And it is clear to see that it is not wrong. Electric vehicles and batteries are on the rise, while sugary drinks are in decline. Even the managers at Coca Cola see this so they are promoting the sugar free product lines.
Can the market be wrong? Yes, indeed it can. We don’t know what will happen so sometimes we invest in companies that fail. It’s a fact of life.
Why stocks go up and down in the short term
Remember when we were haggling over the price of New to trading PLC shares. The market is vast so it won’t be just me and you trading the stock. There will be thousands if not millions of other bids and offers. Our bets were at £1 and £1.05 but others may disagree.
We already established the differences in perception. Therefore, others may place their bets in a range of £0.80 – £1.20. Some of these orders stay dormant until the price action reaches them.
Let’s assume that there will be bids at £0.99, £1 and £1.01 and offers at £1.04, £1.05 and £1.06. No one is in agreement so no transactions occur. However, someone somewhere wants to buy or sell right now.
As a result either the bids will go up or the offers will go down. This also depends on the amount of bids and offers. If there are more offers the price will go down and vice versa.
This is called a random walk. It is difficult to say what is the driving force of second by second changes in the price so we can assume that it is random. It means that stocks go up and down in the same way pollen moves in water. You can find the basics on Wikipedia.
What about emotions, it can’t be all mechanical
Psychology is a big issue in investing and economics in general. Unfortunately we are not always rational when it comes to buying and selling stock. This sometimes leads to losses or poor timing of a trade.
Emotions affect the decisions of retail investors. Examples are selling long term holdings during a market crash or closing winners too soon.
Even when you know the tricks our mind plays on us you are still susceptible to them.
The psychological aspect is difficult to measure for practical purposes. We can’t really say what is the effect of emotions in pound sterling value.
We established that the primary reasons why stocks go up and down are:
- The time horizon of an investment
- The estimated future company performance
- Agreement or disagreement on the future prospects of a company
- Expectations of the investors
- Random fluctuation in the short term
- The overall state of the economy
At this point you may think, well that’s not very helpful. It seems like I can’t really know what will happen in the future. Don’t worry you’re not alone!
Even top financial analysts are only right about 40-60% of the time. It’s not that far off from a coin toss.
You need to know that the overall market has a positive drift. This means that the market goes up on 53% of the trading days and it goes down on 47% of the days.
So if you invest in a market tracking fund and just wait chances are you will make some money. Don’t forget that you will get dividends too and thus increase the performance of your investment.