Volatility in the stock markets means the extreme wide day-to-day
changes in the prices of shares. But instead of quantifying volatility,
we look at it its source and the reason for its existence. The aim is
not to protect from volatility, an impossible task, but to prepare
investors for the turbulence of equity markets.
Information :
The amount of
information available on listed companies today and the spread of this
information have never been so great before. Prior to mid-1990’s, the
relative inaccessibility of information ensured that stocks of even
large established companies were out of sync with their fundamentals.
That gave insiders a chance to profit from such market inefficiency.
Today with proliferation of television and internet media, stock prices
are covered by the minute so that movement in share prices becomes news
by itself. So, a small piece of positive or negative information can
lead to large changes in the stock price.
Investor reaction :
Volatility in a
stock price precedes the flow of information. But how various investors
in the stock market react to this information is often more important.
Robert J Shiller, a renowned professor of economics at Yale University
attributes excess volatility to investor reactions that emerge from
their psychological or sociological beliefs, than those coming from
good economic sense. According to him, substantial price changes can be
explained by a collective change of mind by the investing public which
can only be explained by its thoughts and beliefs on future events,
that is its psychology.
Investor type :
Investors react
differently to the same information. John M Dalton in his book ‘How the
stock market works’ says that risk averse investors might sell as the
market becomes bearish, while more speculative investors might sell
short to gain high profits. Long term ‘buy and hold’ investors on the
other hand might interpret a market downturn as a chance to indeed buy
low and hold to sell high. All this creates inefficiencies in the
market, which arbitrageurs in turn exploit to make a living.
Unique
preferences of each market participant also add to volatility. Foreign
investors for instance are keener to exit from stocks if the rupee is
expected to slip against the dollar. In the process of converting their
rupees to dollars, volatility in the foreign exchange market is
transferred to the stock market. Institutional investors are known to
either buy or sell large quantities of shares any company at a point of
time. This by itself can create an unusual swing in price.
Difference
of opinion among people who believe in fundamentals and technical
analysis also leads to volatility. The former construction valuation
models using dividend streams or earnings-based models to arrive at
investment decisions. Shiller, however, proved that fluctuations in
prices are far too big to be accounted by changes in expected earnings
or dividends alone. This takes us to the next point
Market expectations :
Stock prices
behave in relation to investor expectations about their future. So even
a slight change in information used to form those expectations can
drastically the market’s assessment about their worth. And since new
information is pouring in every day, it is constantly affecting stock
prices. On the brighter side, investors can profit from a high element
of earnings surprise that these shares carry. Shiller’s book,
‘Irrational Exuberance’, on the relative overvaluation of the stock
markets in the US, provides another view. According to him, millions of
individual investors may be investing in stocks because they have seen
the success that others have had, and so their choice to do so is
rational, but they may not actually performing any real analysis or
adding to the collective knowledge of stocks and their pricing. This
logic could apply to Indian stock markets too with investors betting on
the next big stock. So, expect volatility. Stay focused with stocks
that clearly meet your objectives. Recognize that emotional reactions
to short-term market movements can hurt your long-term investment
goals. Also, don’t have unrealistic return expectations. |