Greed? Random Movement? Value? What Drives Markets?
Successful investors tend to follow a disciplined approach to the market. If the market isn’t trending in their favor, then they call the market irrational. Frustrated investors think the markets are unpredictable, at least until their portfolio has gone up or until one of their investments turns out particularly well. Then they, too, will point to their brilliant, time-tested market strategies. If you take a step back and actually listen to short-term market chatter, I wouldn’t blame you if it started to sound to you just like radio static.
The expectation that smart analysis can beat the markets has waxed and waned over the past several decades. Boiled down to their cores, there are four different schools of thought. Some believe markets move primarily because of the behavior of crowds. Strategies used to exploit those allegedly predictable behaviors used to fall under the umbrella of technical analysis, but that has since been eclipsed by the more modern-sounding “behavioral finance”.
There are others who believe markets are simply random. In the late 1970’s, a book called A Random Walk Down Wall Street became wildly popular. It portrayed market movement as random, but biased towards drifting upwards, like a very tipsy diner trying to walk back home. The idea of markets appearing to act randomly wasn’t new in the ‘70’s; that idea has floated around since the late 1800’s. There is a body of academic evidence that pure randomness doesn’t satisfactorily describe the market.
Most of the famous stock investors in recent history (Warren Buffett in particular) have been value investors: they look for investments they believe are undervalued by the market. After the rest of the market recognizes the disparity and bids the price up, the value investor moves on to the next underpriced opportunity. The challenge in value investing is to be right more often than the rest of the market, and, unfortunately, most investors—professionals and individuals alike—have found it very difficult to do, so don’t be too dazzled by business media personalities. There always have been and always will be stock gurus such as Warren Buffett, Peter Lynch, Jim Kramer and so forth. The financial media needs people to talk to and fill up time between ads. Eventually, those hot hands cool only to be replaced by the next wave of talking heads.
All of these beliefs have been in and out of vogue over the years. If markets were purely rational, it’s unlikely investment bubbles such as the late 1990s’ Internet stocks, real estate in 2007, and, quite possibly, today’s Bitcoin frenzy would occur. If markets are completely random, then they would only rarely approach rational values. They might, but only through random movement.
After my years in the market, I tend to see the market as, if not random, at least almost unpredictable over the very short term—minutes, hours, days. Over the intermediate term, which can run from several days to close to a decade, the market is subject to irrational swings of fear and greed. But, as we get closer to serious, patient investing, prices will approach trends in real value. So, there are two timeframes I’m most interested in: those when the market seems to have lost its mind over the medium term, and the longer term that filters out short term noise and rewards solid products and strong management.
Director of Private Wealth Management.- Financial Advisor
Robert W. Baird- Sarasota, FL
