Markets rise and fall as people buy and sell things – not for unforeseen and random reasons. Understanding how markets work will help you make smart decisions, and keep you from following the herd into a bad investment.
To an outsider, the movements of the stock market and other financial markets seem mysterious. Academics call this unpredictability “random”, as in the probability of a game of chance. They use big words like “Monte Carlo Simulator” or “Random Number Generator” but the idea is exactly the same as the proverbial “roll of the dice.”
This might sound good to a professor in his ivory tower or to the outsider unfamiliar with the actual workings of the financial markets but to the experienced investment analyst, it’s ridiculous. Think of how investors were worried in late 2015 over the prospect of the U.S. Federal Reserve, tightening monetary policy. This is a human factor affecting the market. It is not random; the Fed either tightens monetary policy for some time or loosens it for some time.
This is why markets “trend”, or tend to go in the same direction once a trend has been established. This should not be the case with a random “up or down” movement. The professors, in their make-believe world of efficient markets, make the assumption of randomness. In a mathematical sense the model doesn’t apply or poorly “fit the data.” That’s why we keep hearing about events occurring regularly every few years that should be happening in a statistical sense “once in a thousand years.” There’s a reason for this. Unlike nature, human behavior changes over time and makes the assumption of the random nature of the financial markets questionable in practice.
It’s not only professors who make this assumption of random financial markets. It is the major theory behind the pricing of the derivatives and options markets. Despite much evidence to the contrary, there is a huge reason why people close their eyes to reality of the markets; there are a lot of profits being made by financial institutions that prop up this mathematical fiction. Like a casino, they don’t care what the game being played is, as long as the house takes their cut.
Now that we have rejected conventional financial theory, what actually makes the financial markets go up and down? The answer is easy, people buying and selling things. It has to do with the difference between sellers wanting to sell something and buyers wanting to buy it. Basic economics tells us that prices rise and fall in markets to “clear them.” When everyone wants to buy stocks in a hot market, then prices rise, when everyone decides to sell then prices fall until buyers emerge.
In illiquid markets, those with most indecisive people on the sidelines, the difference between buyers’ and sellers’ opinions of value grows. This is called the “bid-ask spread” and is widest for the most illiquid assets such as high-yield bonds or smaller capitalization stocks. When the bid evaporates, sellers have to “hit the bid” to exit their position and the bid is usually well down from the previous trade. The opposite happens when price spike up. Aggressive buyers “lift the offering” and prices rise sharply as sellers hold out for higher prices.
As with any human activity, it is very difficult to predict what people will do. Think of all the people trying to predict the outcome of sporting events. Not many actually get it right and sporting events are a much simpler human activity to analyze than the complex financial markets. A game with a couple of teams and possibly 20 players on each team is much less complicated than the financial markets with literally millions of people participating.
Predicting how human beings will react to specific events like a sports match is hard enough. Predicting how they will react en masse gets into the realm of crowd psychology. What makes one army stay and fight against incredible odds but another flee in terror? John Maynard Keynes, the eminent economist, attributed the propensity of markets to move up and down to “Animal Spirits” of speculators. Alan Greenspan, the former Chair of the Federal Reserve, used the term “Irrational Exuberance” to describe overly optimistic investor behavior in the lead up to the dot.com stock boom and bust in the 1990s.
The one thing we know for sure is that any forecast or prediction is likely to be wrong. That is why the best investors like Warren Buffet concentrate on a long-term strategy of picking the right investments for their portfolios. Things will go up and down, but good investments will maintain their value despite the ups and downs of the market.