Even a casual observer of the share market knows that prices can move significantly and quickly. This 'volatility', as it is called, can make shares seem very risky — and indeed they are if you plan on buying and selling over short periods.
But what's behind all these fluctuations in price? It can seem very confusing to the uninitiated; and indeed there are many so-called 'experts' that seemingly fail to grasp the basic mechanism. But misunderstanding what drives share prices can lead investors into making some serious — and often very costly — mistakes.
The irony is, it's not that complicated. In fact, it's downright simple. But don't think that means it's easy to predict what prices are going to do — it's most certainly not.
A useful analogy is the weather; just because meteorologists understand what factors determine the weather, doesn't mean they can ever hope to accurately predict it more than a few days out. And the same goes for share prices; understanding the drivers of price is one thing, forecasting is something else altogether!
But we are getting ahead of ourselves. To understand share prices, we need to go back to basics…
Greed And Fear
Benjamin Graham, the mentor to billionaire investor Warren Buffett and one of the greatest investors of all time, famously said:
"In the short run, the market is a voting machine but in the long run, it is a weighing machine."
Though it is easy to forget at times, shares represent part ownership in a business. And over time, share prices will reflect the performance of that business. If the shares you own represent a terrible business, you're not likely to see your shares do well — and vice versa. This is what Ben Graham means by a 'weighing machine'.
However, in the short term, which is really anything less than a few years, the price of a share can do all sorts of crazy things that bear no relationship to what is happening with the underlying business. All that matters is what people are prepared to pay — the so-called 'voting' element.
Remember the 'tech-boom' of the late '90's? Shares in companies with absolutely no profits — and often no business model — were going through the roof. Investors were willing to pay anything because they believed that although these businesses weren't making any money, they would be very profitable in the future — and they were voting with their wallets, so to speak.
Similarly, during the depths of the Global Financial Crisis (GFC), people were selling their shares for a fraction of their true worth; fear and panic meant that people wanted out, no matter what.
In both cases, the value of shares became completely divorced from economic reality. It seems ludicrous in hindsight, but this kind of thing happens regularly — and will happen again (and again, and again).
Why? Because the price of a share is determined by what people are prepared to pay at any given time, and people can be emotional, irrational and short sighted. Although common sense will win out eventually, prices can (and do!) all sorts of crazy things in the meantime — and that's a wonderful thing!
Meet Mr Market
Benjamin Graham used the allegory of 'Mr Market' to describe this phenomenon. In his book, The Intelligent Investor, he asks the reader to imagine that they own a business in partnership with a manic-depressive called Mr Market.
Each day, this character knocks at your door and offers to buy your shares, or sell his, at a certain price. On some days, the price will be overly pessimistic, at other times it will be unrealistically optimistic, and on many occasions it will be something more reasonable.
Buffett expanded on this idea in his 1987 letter to shareholders:
"Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful."
The Real Mr Market
Mr Market is a useful idea to help investors come to terms with the daily fluctuations in price. And it's not far from what actually happens in the real world.
The key difference is that instead of one person looking to buy and sell shares, we have many thousands. Some will be day-traders, others will represent large financial institutions and (increasingly) a good deal of trades will be executed by computers!
To come full circle, this is why it's impossible to predict short term prices — to do so would require you to accurately understand the reasoning and intentions of thousands of individuals. Good luck with that!
We can't possibly know what motivations are driving these players, but it is a fundamental mistake to assume that the price being quoted is always the result of a rational, well considered understanding of the business and it's long term prospects. And, just as with Mr Market, we are entirely free to ignore them if they are offering prices that do not make sense.
The Foolish Bottom Line
When asked for a market forecast, the 19th century industrialist John Pierpont Morgan would respond with "it will fluctuate". It's as accurate a forecast as you're ever likely to get — and despite appearances, a valuable one.
A key distinction of successful share market investors is that they understand that the share market is merely a mechanism for exchange. Its fluctuations often have little to no bearing on the qualities of the underlying business, and volatility is there to be taken advantage of.
Trying to work out where prices in the near term is a futile exercise. The thoughtful investor is more concerned with understanding the underlying business, and determining what price they would be happy to pay. If Mr Market gives you an opportunity — you take it! And if not, just ignore him. He'll be back soon enough with a better deal.
And that's what we are all about at Motley Fool Dividend Investor — working out which businesses are worth owning. The types of businesses that we can reasonably expect to keep paying us a handsome, and growing, income stream for many, many years. And when Mr Market is prepared to sell us these businesses at attractive prices, we are more than happy to oblige!
Yes, we have to endure some volatility in the short term, and that can sometimes be a little uncomfortable, but it's a small price to pay for wonderful investment returns!
