Overview – Why do the prices of stocks change so frequently?
One of the biggest stumbling blocks for new investors is the uncertainty surrounding stock markets. Any intro college course on economics or finance will at some point touch on the efficient market theory, which states that at any given time, all public information on every company is reflected in its stock price. There are a few “forms” of the EMT: semi-strong, strong and weak. To clarify our definition, strong form EMT says that all public and nonpublic (i.e. insider) information is already priced in, whereas weak form holds that prices eventually reflect past public information (stock prices will eventuallymove towards their actual values). Here at IPT, we believe strong (and semi-strong) form EMT to be completely idiotic. Heck, if it were true, a ton of people might as well quit their finance jobs and retire, since there is absolutely nothing to be gained from trying to pick stocks.
However, many people will observe that with no news surrounding a company, and nothing material changing with the company, the stock price can still change. That is why it is important to understand the different reasons why the price of a stock can move–it creates opportunities for those who know where to look (which is a key tenet of Joel Greenblatt’s, as well as many other value investors’ investing philosophy: read our review of Joel’s book here).
In this post, we’ll cover some of the main reasons that a stock might move, delve a little bit into market psychology, and finally, show how to use unpredictability to your advantage.
Reasons a Stock Might Move
At the most fundamental level, stock prices should move based on market dynamics, i.e. supply and demand. When more investors want to buy the stock than to sell it, the price goes up. When more investors want to sell than buy, the price will drop. This is simple and shown in the following Econ 101 chart:The stock price at any given time is the equilibrium between what a buyer is willing to pay and what a seller is willing to accept. What causes these equilibriums to change? Any form of news will almost always affect the stock market. This is because the stock market learns something new that it didn’t expect. Some of them include:
- Articles in the popular press (Wall Street Journal, NYTimes, etc) or local newspapers
- Quarterly or annual SEC filings by the companies themselves (10-k, 10-q, etc.)
- Press releases by the company itself (8-k)
- Analyst upgrade/downgrades at a major investment bank or research firm
- Credit rating changes (by any of the major rating agencies such as S&P or Moody’s)
- Economic forecasts by economists or the Federal Reserve
- Foreign policy of the US or other major world powers
- Politics and election cycles
- Fraud or corporate crime (think Enron)
- Any major corporate event such as bankruptcies, initial public offerings, spinoffs, and so on
As you can see, the list keeps expanding, and could be broken down into subcategories, each of which would be enough to write a book on. The above items can be further separated into company specific, and broad market. It’s pretty easy to see which fall into what category. As you might expect, company specific news will move that specific company more than the overall market, and vice versa. Having a good understanding of at least the main reasons why a stock might move is important, but not the defining feature of a part time investor.
The other side of the coin is equally important to understand, and that is market psychology. While the above items could be characterized as material events that shouldaffect the market price, psychology is a bit harder to characterize. We all know that, as humans, we are subject to panicking and becoming excited; it’s just part of our nature. Unfortunately, this translates to the stock market as well—we only need to look as far as the past few years starting in 2007 to know how true this is. Panics and crashes have been around about as long as public markets have (see the 1600s Tulip maniaWikipedia). No matter how many times we fix a broken economy, we are still subject to emotion, and thereby subject to panics and crashes.
Why should you bother to learn about this? For one, it may save you money. If you could recognize symptoms of an overinflated asset bubble (think real estate in the most recent crash), then you might have the foresight to get out before it pops. However, most people like to see the price of their assets continually going up each year, so they are blind to the fact that it is unsustainable. Removing emotion from any investing equation makes it easier to discern under- and over-valuation, and that is what we’re all about.
A much more in-depth look at trading psychology
A great resource to check out for trading psychology is the free website of Dr. Brett Steenbarger, who has authored a few books on the subject as well. According to his homepage, there are over 3,400 articles on that, and all the ones we have read have been incredibly useful.
Conclusion – What does it all mean? How can you take advantage of it?
The fact that there are so many reasons why a stock might move is incredibly frustrating to some investors. What is the point of investing, you might ask, if there is no way to predict which way the stock market will move every day? As it turns out, we think that there is plenty of reason to invest, even if you can’t predict or analyze the day-to-day or minute-to-minute movements. As part time investors, we believe that despite the daily volatility and unpredictable movements, stocks will trend to their actual values over time (a key tenet of value investors in general). In fact, the volatility is sometimes beneficial, because it creates opportunities for those who know where to look. If you buy an undervalued stock for a longer time frame, it will generally rise in value. That is why investors like Warren Buffett have done so well buying long-term investments.
Stay tuned for an upcoming post on how to identify opportunities in the stock market! We’re pretty excited to write it.