Be honest. How often do you check stock prices?
Long-term investors understand that in the short run the stock market is a voting machine, and over the long term, it is a weighing machine. Given enough time, the value of the stocks they own depends on the success of their underlying businesses. If a company prospers, its stock price will rise. If it fails, its stock will fall. Wait long enough, and those outcomes are almost guaranteed.
In the short term though, stock prices change every single day. And no matter how much of a long-term focus you have as an investor, it is easy to get caught up in the events of the day. Stock prices can move despite there being absolutely no news at all related to the company in question. Other times, there is some possible explanation for the rise or fall in stock prices.
Understanding the behaviour of short-term price movements can be useful to long term investors. That is because you can exploit the weakness of short-term traders to pick up stocks of great companies at occasional bargain prices. Below are some common events that may or may not move the market.
- Earnings reports
Although companies communicate from time to time about how their business is doing, most investors focus their attention on the earning season when businesses release their latest quarterly or half-yearly results. It is at this time that investors hear directly from corporate management about the performance of their companies.
Short-term traders are laser-focused on precise expectations. If a company misses earnings expectations, they may beat the stock down. But if expectations are exceeded, they may bid the stock up. In the long run, whether a company makes $0.01 per share more or less than expectations is insignificant to its intrinsic value. Hence, any sharp price movements due to a small bottom line increase or miss should be viewed as speculative at best.
- Macroeconomic and geopolitical events
Sometimes markets will react to the news on macroeconomic and geopolitical events. How much the market moves depends on the potential severity of the event in question and part on the level of uncertainty about the possible outcomes. Market sentiment can be fragile when investors are nervous leading to volatility in stock prices.
The Covid-19 pandemic offers a good example of how news-related moves can reach extremes. At first, when the outbreak seemed confined to Wuhan, China, stock markets in other jurisdictions barely budged. But once the pandemic spread to the rest of the world, markets everywhere started failing dramatically. Fear reached a peak in March, with a 30% drop in the S&P 500, as investors extrapolated a worst-case scenario with economic recovery stretching years into the future.
The doom and gloom did not last long though as governments adapted quickly to control the spread of the virus and allow economies to reopen. The S&P 500 roared past their record highs recently, marking the quickest 6-months recovery from bear-market territory in its history. Indeed, investors have learned that the stock market is at times divorce from the real economy. While economic data is backwards-looking, stocks are instead looking ahead to a much brighter future. Additionally, many investors now realise the effects of the health crisis are not all negative. Some companies have benefited from the Covid-19 pandemic. Case in point the astonishing rally in glove-maker stocks which at the moment shows no sign of abating.
- Market gossip and rumours
Perhaps you have heard of this saying in the stock market: “to buy on rumours and sell on facts”. It promotes the idea of capitalising on market movements by opening a position on a rumour, in anticipation of an announcement that could cause a shift in the market. The short-term trader will then close their position once the news has broken, often at a considerable profit.
Unless you are fortunate enough to own a crystal ball, new investors should avoid investing quickly in a “hot” stock tip, or going all-in on a rumour of earth-shaking earnings. Investing in market gossip and rumours can be dangerous if news goes against you. Further, retail investors are competing with professional firms that not only get information the second it becomes available but also know how to properly analyse and act on that knowledge.
- Herd mentality
Finally, in the absence of any market-moving news, investors can still be vulnerable to emotional tendencies. When the stock market is rising, many investors are fearful of missing out on gains. They ignore the risks and jump onto the coattails of a rising market, expecting to make a quick buck. Conversely, when the stock market is falling, many investors rush to the exit door, pushing stock prices down as they cannot get rid of their shares fast enough.
The market moves that herd mentality brings about are not always tied to business fundamentals or other relevant economic news. You can therefore exploit them if you have a long enough time horizon, either by buying when stocks go inexplicably on sale, or by holding on to your shares even as a booming market goes far beyond your highest expectations.
Focus on the true value of your portfolio
Owning stocks means owning pieces of businesses. The best way to think about a stock’s intrinsic value is the same way you think about the house you own. Over time, your home will rise in value, with some fluctuations depending on the economic health of your community and how many people are looking to buy and sell houses at any given time. While there is no daily market for houses as there is with stocks, it is hard to imagine that the actual value of your home will rise and fall in the same manner as stocks prices. In the same way, we should not expect the actual values of businesses to change all that much on a day-to-day or even month-to-month basis.
That is not to say that all stock market movements are baseless. News events can and do affect the intrinsic value of a business, and in those cases, adjusting stock prices to reflect new information is appropriate. But a huge portion of daily stock price movements is essentially random. If you can accept that, it can take a lot of the pressure of making smart long-term investment decisions in your stock portfolio.