Because the stock market is an auction made up of buyers and sellers (including individuals, corporations, mutual funds, and more) of shares of publicly traded companies, fluctuations in stock prices is nothing out of the ordinary. In fact, the price of companys stock can vary drastically from one day to the next. Before adding shares of stock to your portfolio, it is important to understand what causes stock market fluctuations and its risks. Giordano Trabucchi / EyeEm / Getty Images
Ask anyone about the stock market and it s clear that almostPeveryone can agree on one thing: the prices of stock fluctuatePfrequently, increasing and decreasing in market quotation sometimes by shocking amounts in a single trading day. PWhy do stock prices fluctuate? PWho or what is causing them? PThose are great questions and most often asked by novice investors. PTo help you understand, I m going to give you a basic overview of some of the forces that cause this volatility. PSome of this will be a bit of an oversimplification but by the time you re done reading it, you ll know a lot more than the general public about the way the stock market works and how stock prices are set. First, realize that the secondary stock market (as opposed to the primary stock market in which companies issue in exchange for cash) is an auction. PThat means there are buyers and sellers lining up on either side of a potential trade, one party wanting to sell its ownership, one party wanting to buy ownership.
PWhen the two agree upon a price, the trade is matched and that becomes the new market quotation. PThese buyers and sellers can be individuals, corporations, institutions, governments, orP Pthat are managing money for private clients,P,P,Por pension plans. PIn many cases, you won t have any idea who is on the other side of the trade. Because the stock market functions like an auction, when there are more buyers than there are sellers, the price has to adapt or no trades are made. PThis tends to drive the price upwards, increasing the market quotation at which investors can sell their shares, enticing investors who had previously not been interested in selling to sell. POn the other hand, when sellers outnumber buyers, there is a rush to dump stock and whoever is willing to take the lowest bid sets the price resulting in a race-to-the-bottom. PThis can be a problem, particularly during periods like the collapse of 2007-2009 because firms such as Lehman Brothers were forced to dump anything and everything they could to try and raise cash, flooding the market with securities that were worth far more to a long-term buyer than the price at which Lehman was willing to sell. There are a myriad of factors that can cause the relationship between buyers and sellers to change. PInP, I broke out four such examples after. We talked about. We talked about the commodity nature of stocks.
We talked about. We talked about. PI built upon this in an article calledP Acquiring Undervalued Stock for Your Portfolio by Buying on Bad News. In some cases, stock prices fluctuate because a requisite percentage of money flows in the market at any given time aren t taking a. PAn illustration I used was the equity valuation assigned to renowned jeweler Tiffany Company. PThe volatility of Tiffany s share price years ago when I originally wrote this article was entirely unwarranted by the long-term value of the firm. PFirst, pushed the price far beyond what any conservative buyer would want to pay and when it looked like the world might struggle for a bit, dumped it, driving it down below what the same conservative investors might want to pay. PThis volatility can cause the journey to be rough but that is the reason it is important to have a diversified portfolio and focus on the. To learn more about this topic, readP. In and, analysts use techniques to model behavior of, in particular share prices on, and prices. This practice has its basis in the presumption that investors act and without biases, and that at any moment they estimate the of an asset based on future expectations. Under these conditions, all existing information affects the price, which changes only when new information comes out. By definition, new information appears randomly and influences the asset price randomly. Empirical studies have demonstrated that prices do not completely follow random walks.
Low (around 0. 05) exist in the short term, and slightly stronger correlations over the longer term. Their sign and the strength depend on a variety of factors. Researchers have found that some of the biggest price deviations from random walks result from seasonal and temporal patterns. In particular, returns in January significantly exceed those in other months ( ) and on Mondays stock prices go down more than on any other day. Observers have noted these effects in many different markets for more than half a century, but without succeeding in giving a completely satisfactory explanation for their persistence. uses most of the anomalies to extract information on future price movements from historical data. But some economists, for example, argue that most of these patterns occur accidentally, rather than as a result of irrational or inefficient behavior of investors: the huge amount of data available to researchers for analysis allegedly causes the fluctuations. Another school of thought, attributes non-randomness to investors\’ cognitive and emotional biases. This can be contrasted with. When viewed over long periods, the share price is related to expectations of future earnings and dividends of the firm. Over short periods, especially for younger or smaller firms, the relationship between share price and dividends can be quite unmatched.