Financial markets don’t just move on their own. Prices of assets on exchanges, such as stock exchanges, change because investors are buying and selling them. An increase in the price of a given asset reflects an excess of demand for that asset over supply – or, put another way, if there’s more buyers than sellers of a given asset, it’s price will go up. The opposite is also true. If pressure from buyers of an asset equals pressure from sellers of an asset, then the price will stay relatively static.
Let’s pick apart the reasons why an asset’s price might have pressure to move up or down.
Consider the example of the stock of a high-end car manufacturer. When the economy is doing well, unemployment is low, and wages are rising, you’d expect there might be more demand for luxury cars. Investors might collectively decide to buy the stock of all luxury carmakers merely on that basis, pushing the stock of our carmaker up. In addition, imagine the financial press is reporting that our particular carmaker is seeing record footfall in its showrooms. On that basis, investors might choose to tilt their investments towards this carmaker, more so than others. A few months later, our carmaker publicly releases its semi-annual results, confirming that it has had a record 6 months. Investors go wild and buy the stock some more, drastically pushing up its price.
These all seem like reasonable reasons to buy a stock. The economic backdrop is supportive, our particular carmaker is outperforming its peers, and the good performance is being reflected in the official numbers. We call these types of reasons for movements in the price of a stock, or any other asset, ‘fundamentally-driven’ changes. Investors, collectively, are taking in information about the stock, and reflecting that information in their decisions to buy or sell the stock. The information was positive, so investors collectively bought the stock.
It is important to note, however, that even though the information seemed fairly black-and-white in this example, it still had to go though a human brain (or many human brains) to eventually end up in the price of a stock. So financial markets are controlled by people. Ok, there are some automated investment strategies that are placing trades in markets without human intervention, but these are all designed by humans and they are all subject to control by humans. Most have fail-safes or emergency release valves that require regular human intervention, and so – at least in our opinion – they are still subject to human interference.
If financial markets are controlled by people, it must be the case that financial markets are emotional. All humans have emotion, and a collective bunch of humans participating in a given market will collectively have emotions too. So, financial markets move not just on the basis of hard facts, but also on the basis of emotion.
It is difficult to separate the fundamental element of a change in the price of an asset from the emotional, behavioural, or sentimental element. Investment strategies attempt to do exactly this, and ‘contrarian’ styles of investment will often seek to buy an asset that the investor thinks is not being appreciated enough by the rest of the market, and sell an asset that they believe the market is too enthusiastic about. They’ll undertake ‘fundamental’ analysis in order to make their assessments. The degree to which an asset’s price reflects its fundamental (also known as intrinsic) value gives the fundamental investor some idea of their target price for the asset.
Although everyday investors don’t necessarily need to undertake the kind of detailed fundamental analysis that professional investors are doing, it is still important to have some understanding of the fact that ‘price’ doesn’t necessarily equal ‘value’. You know that to be true in other parts of your life, even without undertaking detailed analysis. Our guiding principle, then, is to keep your emotions in check, and try to avoid being a behavioural investor, even if you’re not the perfect fundamental investor.
To the pound 