People have always wondered why the stock market fluctuates. The phenomenon has kept many brilliant academic scholars bewildered, which they are still attempting to understand and explain how the market operates. One theory generally accepted (by academics) is the Efficient Market Hypothesis, which simply states that the stock prices will constantly adjusts and reflects exactly how the companies are doing. People either embrace this hypothesis or hate it totally.
I would not say I can explain it better, but I think I can provide a simple explanation where you might gain a little understanding and appreciation. Allow me to begin…
First and foremost, the share price is supposed to convey the value of a company. Hence, it is true that the market has to be efficient so as to reflect the ‘true’ price of the company.
We know that business takes time to grow. It takes years or even decades for one to see the growth. If this is true, it means that share price should not fluctuate in a matter of days as business fundamentals do not change overnight. But why does it fluctuate even within the day?
This brings us to the next point – The market is participated by human players and being humans, they have judgements and emotions. Each investor has a perception on how much the company is valued and how much he/she is willing to pay for the share. Due to differences in their judgements, the share price is affected as some will bid higher and some lower. Human behaviour that influences the market is at its peak during bull and bear runs, where we can witness the ability of humans driving up prices up and down. Bull runs are fuelled by humans’ greed and bear runs are fuelled by humans’ fear.
Hence, we now understand that share price not only reflects company value but also human judgements and emotions (which I refer to them as psychological effects collectively).
With this understanding, let’s take a look at this graph:
The graph tries to show the influences of human psychology and market efficiency over a period of time. The Efficient Market Hypothesis is not totally wrong. It is just a frame of time that we are looking at. If we take a long investment horizon, say 10 years, you would expect the share price to reflect the value of the companies. Profitable companies will show its worth overtime and this is why fundamental investors invest for the long run.
On the other hand, the shorter term (days) we look at, the psychological effects on share prices are more pronounced. Therefore, technical analysts and traders play the market in reaction to mass market psychology. They do not care how well the business is doing.
The lesson to take away – If you invest based on judging the value or growth potential of a business, you have to be patient and allow time to show the ‘true’ value of the company. If you do trading, you have to take into consideration of the market psychology and not what the company sells.
You may also like:
- Warren Buffett – “I’d be a bum on the street with a tin cup if the markets were always efficient.”
- Sir Isaac Newton – "I can calculate the motion of heavenly bodies, but not the madness of people"
- The Complete Turtletrader by Michael Covel
- The Warren Buffett Way – Robert Hagstrom
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