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Financial Freedom Is Merely Organized Common Sense
Why Stocks Are Volatile
It is possible to understand why the price of a stock is so volatile. It is because there are always two values for a given stock and they do not arise from the same fundamentals.
Last October, I wrote about 19th century economist Knut Wicksell and his ideas about interest rates. Since then I have been thinking about Wicksell’s comment but in respect to equities instead of interest rates.
Wicksell’s key idea is that there are two interest rates. The “Natural Rate” which is what people and thus the market believes to be the value of money, and the “Financial Rate” which is what people actually charge or pay. Interest is the price of money and when set properly there are just enough borrowers to sop up the money that lenders wish to invest. The idea in economics is that of a “Market Clearing Price” being the one that exactly matches the lenders and the borrowers.
The defining idea is that people buy stocks and bonds for the same reason. The expectation of future cash receipts. To that single extent there is no difference between bonds and stocks. The problem is the differing complexity of their valuation.
Both interest bearing securities and equities are promises about the future. The interest bearing choices make a promise of a return of capital at some future date and a promise of small payments in the interim. The valuation is based on those promises and adjusted for the credit risk of the issuer, and for the purchaser’s expectation about future interest rates compared to the coupon rate. The value is just a complicated arithmetic question.
A stock has the same set of promises but they are fuzzier. There is no security agreement nor are there written promises. The valuation is more artful. What can you know or believe about future profits? Unlike bonds, stocks have no priority charge on income so that factor could be highly variable. Nothing like a coupon. Management skill, competition, government actions, borrowing covenants, innovation and more make future income difficult to know.
In the case of a stock, the “Natural price” is the one that is based entirely on the fundamentals. The price Warren Buffett or Seth Klarman might want to pay. The “Financial Price” is the price that the broker quotes when you ask. It may have little relationship to the natural price because the bidders in the stock price auction all have different ideas about the future cash stream from the company. One likes management another does not. One thinks competitors will overtake, another thinks they will not. Some expect a takeover offer, others do not. The differing ideas about value create noise. Static. Eventually, static cancels out and the signal remains.
For an investor with a long time horizon, the natural price matters and the financial price does not. For a day-trader and some other investors, the financial price is all that matters. The “Bus Theory.” If you see it moving, get on, when it stops, get off.
The variant styles rely on materially different factors. Investors want to know fundamentals, traders want to know how other traders will interpret those fundamentals. Traders compete with other traders, investors do not.
Traders understand people better and they know where and how quickly information moves. Investors don’t care much.
Stocks are volatile because people change their mind and are governed by both enthusiasm and fear. Sometimes on the same day. In the short run stocks are as volatile as people.
There is nothing wrong with either style, but you must know which you are using and develop the skills that are appropriate to that choice.
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Contact: don@moneyfyi.com | Follow Twitter @DonShaughnessy
Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.
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