Wednesday, September 24, 2014

Sources of Randomness in Stock Prices

When we follow an individual stock, or a stock market average like the Dow or Nasdaq 100, most of the time most of what we see is random movements. At one extreme the entire market can be seen as random, as espoused in A Random Walk Down Wall Street and elsewhere.

As an approximation that might be true, and so it may not be a bad suggestion that anyone who wants to participate in stocks, but does not want to be hassled by doing their own research and analysis, should just invest in index funds.

Of course we know the real world of corporate profits is not just random. Apple's stock rise is not just the result of randomness, nor is Blackberry's fall. You can make a fortune investing in the right companies when they are small and (hopefully) watching them grow.

Here I want to take a preliminary, non-scientific, look at some of the causes of "random" stock movements caused by buying and selling that are not driven by the anticipation or demonstration of increased or decreased earnings.

I began thinking about this back in the 1980's, when I was starting my own business while still working as a paralegal. I worked in a probate office, and this is what happened on an almost daily basis: stocks were sold. The stocks had typically been accumulated during a lifetime, then the owner had died, and then the estate was tied up in probate for a while. The "kids" -- often they were in their 60s -- had been waiting to inherit most of their lives. The moment it was legally possible the stocks were sold, converted to cash to be distributed.

It was rare to see anyone say, "hey, I'll sell all the stocks but Apple". Or "wait another month, the market is down today, we'll get more money if we wait a month." In fact that never happened that I recall.

So did your stock from $2 a share in an hour today? It could be bad news is circulating you have not heard about; it could be someone manipulating the price; or it could be that Wasp Savemoney, deceased, had a chunk of the company and it was dumped all at once.

Two seasonal times of selling stand out. College funds are also saved over a decade or more, only to be dissolved rather quickly starting with the first Freshman year tuition payment. When taxes are due, leading up to mid-April, so selling or failing to buy will be due to that.

When a house is bought, it may require cashing out stock to make the down. That, again, is timed to the escrow, not the ideal timing for maximizing stock value.

The financial news often accounts for stock market movements with bland terms like "profit taking." If selling is profit taking, is buying profit giving away?

A big factor in selling is portfolio limits. Wise investors do not allow themselves to become too concentrated in any particular stock. This is particularly true of professionally managed money. In my personal portfolio I am not supposed to have more than 10% in any one stock. In a large pension fund or mutual fund the percent might be 5% or even 2%.

So if a stock goes up enough, portfolio rules force managers to do some selling. They might think that the stock will continue to go up; they might have some power to make limited exemptions. But they are certainly not going to buy more of the stock, and at some point they must sell. For the manager this is not random, it is causal, but it appears random to the rest of the market.

If, like me, you manage your own investment portfolio, you want to know what is really going on. Mostly this is at the company level. You want to know factors contributing to next quarter's or next year's or next decade's profits.

But it is oh so much easier to while away the hours watching prices move. Perhaps even trying to outguess the other guessers.

Just keep in mind that people die on a daily basis, and some of them have substantial portfolios, and those almost always get sold and converted to cash. A bad flu sweeping through the more elegant nursing homes in December can cause the market to sink one day the following year.

To see a list of stocks I write about go here: William Meyers stock reports

To pick a stock randomly try my Random Stock Picker

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