Why do stock prices change?

Stock prices change because of changes in supply and demand.

But first let’s get a highly simplified understanding of a stock. For a more complete understanding, you are better of picking up a copy of the book, or attending the live program.

What is a stock?

A stock is nothing but a certificate of part ownership in a business.

So if a company worth 10,000, released 1000 shares worth 10/- each, and you bought 250 of shares, you’d be a 25% stock holder.

So why do stock prices change?

Because depending on the faith that a business’s stock holders have on the business, they may decide to buy more shares, refuse to sell their shares, or may decide to sell their shares.

The more optimistic they are about the business, the more their tendency to buy more stock and hold. The more pessimistic they are, the more is the tendency to sell the stocks soon.

But since they are a limited number of stocks to begin with, if more people want to buy a stock, a seller would be in a position to ask for a better price. Similarly, if all the stock holders are in a selling spree, there are way too many sellers, but were few who are interested in buying said stocks. This affects the stock price change negatively and the price drops.

Stock price change is primarily driven by market sentiment

And it could be driven by both internal and external factors. This slide from the program lists a few such reasons.

There’s a popular story on stocks which very well explains the behavior of the short term stock markets. And at a time when markets are showing high volatility(as they often do), I thought you’d find this story interesting too.

So here goes.

It was autumn, and members of a Native American tribe ask their New Chief if the winter was going to be cold or mild. Since he was a Chief in our modern day society, he couldn’t tell what the weather was going to be like. Nevertheless, to be on the safe side, he replies to his tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared.

But also being a practical leader, after several days he gets an idea. He goes to the phone booth, calls the National Weather Service and asks,

Is the coming winter going to be cold?

The weather man responds.

It looks like this winter is going to be quite cold indeed.

So the Chief goes back to his people and tells them to collect even more wood. A week later, he calls the National Weather Service again.

Is it going to be a very cold winter?

The man at National Weather Service again replies,

Yes. It’s definitely going to be a very cold winter.

The Chief again goes back to his people and orders them to collect every scrap of wood that they could find. Two weeks later, he calls the National Weather Service again.

Are you absolutely sure that the winter is going to be very cold?

The weatherman replies,

Absolutely. It’s going to be one of the coldest winters ever.

To which the Chief finally asks,

How can you be so sure?

And the weatherman replies,

Well, the tribes are collecting wood like crazy.

This is pretty much the only reason why stock prices change

A critical point new equity investors need to understand is that when you buy the stock of a company, you are becoming a part owner of the business. You haven’t just bought a piece of paper which is supposed to just go up in value overtime. But what you’ve bought is a piece of all the company owns and represents. It’s brands, its hard working people’s aspirations, its infrastructure… And good businesses take time to grow and increase their profits.

On a day to day basis, despite the company’s stock price going up and down, nothing fundamental about the business changes. Factories still run as they would, people work as hard as they were in the days before. As awareness towards equity investing grows, you can only expect even more disconnect between a company’s stock price and its fundamentals.

Stock prices change a lot on some days because investors often react to every market news

But as long you own stocks of companies which are fundamentally good to begin with, you should just stop listening to all the noise and get some peace.

In a way, these market corrections are often necessary to give new investors a much needed wake up call. Several who do understand equities as an asset class, tend to panic and liquidate their mutual funds or discontinue their SIPs. While it is clearly a bad idea to do that for SIPs, study after study has even shown that liquidating your investments too, is one of worst things an investor could do.

So what do you do when markets start to correct?

By by its very inherent nature, Equity is a volatile asset class. At times, even after a full year of investing, your portfolio could show zero or negative returns. There have even been times in Indian stock market history where investments took 6 years to recover from their losses.

So seasoned equity investors, only concern themselves with the long term. They completely ignore this day-to-day market noise. While it drives most new investors mad, it doesn’t affect the peace of a long term investor much.

Equities aren’t supposed to be an asset class which go up, week after week. As an investor, if you aren’t able to understand and make peace with this, it may be best to avoid them an as asset class all together, and invest in safer, less volatile investments like FDs and Debt mutual funds. These low risk investments will almost always appear green anytime you look at them. But since they’re low risk investments, your returns would also be low(around 8-10% at best).

As an example, here’s an updated chart I created yesterday based on actual data between 1998 and 2018. This denotes the number by which your investment would’ve multiplied by, over this 20 year period.

Even the worst performing mutual fund gave 28X returns, compared to FD which gave 4X returns. But, remember that we had several minor and at least one major market crash during this period. In 2008, people’s equity investments were literally cut down in half as the markets crashed by almost 50%.

And despite of all that volatility, equities still managed to give the type of returns which you see in the chart above, with even an average performing mutual fund, providing a 50X return. Several mutual funds, including the ones listed in the chart, were in the RED for years together at a stretch, during the recovery from 2008 crash.

The most important trait you need to be build as a long term investor, is patience.

Happy Moneyplanting.

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