Market volatility can create anxious moments for even the most disciplined of long-term investors. But people who make it through to their goals are usually the ones who can separate the feeling itself from the urge to act upon it.
Understanding how markets work can make it easier to deal with volatile periods. Here is a layman’s explanation.
It doesn’t matter what you buy, price is a function of supply and demand.
In the case of shares, buyers offer more for the shares (more demand) to entice sellers to get rid of them. Conversely, sellers can ask less for the price of shares (more supply), hoping to entice buyers to purchase.
Retailers do the same. With summer coming on, they need to sell their remaining winter stock. They reduce prices to entice people to buy.
Understanding supply and demand is easy.
What is difficult to comprehend is what makes people like one share and dislike another.
The principal theory is that the price movement of a share indicates what investors feel a company is worth.
And here’s where it gets a little complicated.
The worth of a company reflects not how the company is performing right now, but the returns that investors can expect in the future.
The share market is therefore always looking to the future. Prices change when expectations of the future change. When better news about a company is released, prices will rise. Worse news means prices will fall.
In the digital world, these price changes happen almost instantly. For example, a gold explorer announces it has found a new ore body. Technology can determine very quickly how that will improve future profits and buyers offer more for shares in an instant to reflect the new valuation. By the time you and I read about it in the paper the following day, the news is already reflected in the share price.
The most important factor that affects the demand of shares, and therefore its value, is its future earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, they aren't going to stay in business. Public companies are required to report their earnings twice a year. Analysts watch with rabid attention at these times, which are referred to as earnings or reporting seasons. The reason behind this is that they base their value of a company on their earnings projection. If a company's results surprise (are better than expected), the price jumps up. If a company's results disappoint (are worse than expected), then the price will fall.
Do the analysts always get it right. Absolutely not!!
During the internet bubble from 1995 to 2000, dozens of Internet companies rose to be valued in the billions of dollars without ever making even the smallest profit (some even had no revenue, they were just an idea!!). The market expected huge profits in the future and pushed the price up accordingly. These profits of course never materialised and as we know now, those valuations crashed.
Investors have developed literally hundreds of calculators, ratios and indicators to help them determine what a share should be worth. Some you may have already heard of, such as the P/E ratio, while others are extremely complicated and obscure with names like Chaikin Oscillator or Moving Average Convergence Divergence (MACD).
Whatever method used, if the analysis shows the shares are undervalued, they buy. If the analysis shows the share is overvalued, they sell.
Others believe because that share markets are so efficient, and information translates to prices so quickly, it isn’t possible to pick winners and losers reliably and cost effectively. They believe you are better off to merely capture the average market return at the lowest possible cost. Hence the massive growth in index funds and exchange traded funds.
Something everybody can agree on is that shares are volatile and can change in price extremely rapidly.
So what has caused the recent volatility. Isn’t the US economy in the best shape in decades with unemployment at 40-year lows? Why would it suddenly fall by 10%?
I’m hoping now you know the answer to this.
Can anyone tell me?
Here’s another one. Sometimes during reporting season when a company announces an increase in earnings, the price goes down. Why would that be?
Leave your answers in the comments below.
Now might be a time to read one of my most popular blogs to help your understanding further.
A man, his dog and the sharemarket.
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