How to protect yourself from the volatility of the stock markets
From the time markets open until trading closes, stock prices are in constant fluctuation.
Everything from a breakout news story to a shareholder meeting can impact a stock’s price. A lot of times, it has to do with supply and demand, such as we saw during the infamous GameStop surge, when a collective of small individual traders drove share prices up. While some lucky traders were able to sell the stock at its peak and profit, many traders hoping to make a quick buck instead lost money when the price eventually fell back down.
Nobody can predict every element that goes into stock price fluctuations, though many try. That’s what a hedge fund trader’s entire job is all about: trying to pool money together to maximize returns on investments, all while predicting — or influencing, some say — what the market does.
The everyday investor isn’t going to spend all day watching charts go up and down. That’s why we at NextAdvisor support a more passive investing approach and recommend that investors buy and hold index funds, including mutual funds and ETFs, which encapsulate broad compositions of securities stretching across industries and markets, rather than individual stocks.
One benefit of investing in index funds is that you can start building wealth even if you don’t have a lot of technical knowledge about the stock market. But for investors interested in adding individual stocks to their portfolio, it can be helpful to have a basic understanding of how to research stocks and monitor stock prices. That starts by paying attention to the news cycle, market conditions — and even your gut.
Here’s what you need to know.
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What affects stock price?
High demand for a stock drives the stock price higher, but what causes that high demand in the first place? It’s all about how investors feel:
- Market sentiment toward the stock.
- Market sentiment toward the industry.
- Market sentiment toward the stock market.
- Confidence in the economy.
Nearly any and all daily happenings can influence stock prices. The market, after all, is a reflection of how companies and industries are valued in our society. Being the fickle creatures that we are as human beings, our ideas of value change all the time.
- Anything from a public relations crisis to breaking company news could impact a stock’s price. When investors, particularly at the hedge-fund level, sense cause for concern, we can watch that drama play out on the stock market. The same happens with factors like the Federal Reserve’s interest rate policies, geopolitical events like wars and boycotts, and even factors like innovation and technology, such as the hype we see around cryptocurrency right now.“Many of these factors can be chalked up to ‘noise’ and increase daily price volatility,” says Jim Plumb, vice president and senior analyst at Illinois advisory firm, RMB Capital.But one factor influences share prices more than any other: Profit.“In the long run, stock prices converge toward the present value of future cash flows generated by the underlying business. Ultimately, these fundamental factors will have the greatest influence on stock prices,” says Plumb.
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The big picture is what matters
Long-term investors, like those of us at The Motley Fool, don’t much care about the short-term developments that push stock prices up and down each trading day. When you have years or even decades to let your money grow, analyst reports and earnings beats are often fleeting and irrelevant. What matters is where a company will be five, 10, or 20 years from now.
In the long term, the value of a stock is ultimately tied to the future cash flows generated by the company. Investors who believe a company will be able to increase its earnings in the long run or who believe a stock is undervalued may be willing to pay a higher price for the stock today, regardless of short-term developments. This creates a pool of demand undeterred by day-to-day news, which can push the stock price higher or prevent big declines.
While a lot of ink is spilled about daily fluctuations in stock prices, and while many people try to profit from those short-term moves, long-term investors should be laser-focused on a company’s potential to increase its profits over many years. Ultimately, rising profits push stock prices higher.
Solution
Fundamental Factors
The two most fundamental factors boil down to profitability and the valuation ratio, says Juan Pablo Villamarin, CFA and senior investment analyst at Intercontinental Wealth Advisors.
“Profit is the ultimate result of many sub-factors — revenue potential, management competency (like governance, skills), and cost management,” Villamarin says. “Although slightly more abstract, the valuation ratio is the relationship between a certain financial metric (like earnings, revenue, cash flows) and the market value of the entity.”
The most famous metric is the price-to-earnings — or P/E — ratio. A P/E ratio is the ratio of a company’s share price to its earnings per share. Investors use these ratios to compare the performances of similar companies against one company’s records, both historical and projected earnings.
Technical Factors
Technical factors are things that change the supply and demand of the stock that won’t fundamentally alter the prospects of generating cash, Plumb says.
“Take a stock split for example,” he says. “If company XYZ was trading at $100 per share with a total enterprise value of $100 million and offered a 2-1 stock split, the shares would now trade at $50 but the total enterprise value would not change since twice as many shares are now available,” he explains.
Even though it’s a stock split, Plumb says some investors are enticed by the lowered price, even though the business fundamentals didn’t change.
Technical factors can also include the time of day or specific days of the week a trade takes place compared to other days and times, says Villamarin. In addition, the price movement of one stock compared to the movement of another stock in the same industry or business sector can also influence the stock price.
“These technical factors may be important because they give insight into the supply and demand dynamics of the stock,” Villamarin says. “Some factors may reflect and predict the future demand for a stock,” he says.
Trends — both historically from the company and an industry as a whole — are considered technical factors.
News
If you’ve ever seen a company’s stock price go up or down following an earnings call, it’s because of the news.
“The trick is to decipher news that can have an impact on fundamental factors versus noise that can alter the short term supply and demand of a stock,” Plumb says. “News that changes the probability of a company’s ability to generate future cash flows can have a major impact on prices, especially if the impact is significantly different than current expectations.”
Quarterly earnings reports can cause the stock market to both dip and rise, although the effects aren’t always straightforward due to the myriad of factors involved in determining stock prices. In January 2021, for example, Apple shares fell in price despite the company reporting record quarterly profits.
Things happening in the world at large can also affect stock prices. Amid the COVID-19 pandemic, the stock market as a whole has taken a few major drops. The first was in March 2020 and the most recent was this summer as the Delta variant surged around the country, causing traders to worry about market recovery.
Market Sentiment
Market sentiment, or investor sentiment, is the investor outlook regarding a particular stock’s performance in the market. Sentiment drives demand, which also influences supply.
“It’s used to describe the expectations of the market regarding portions of metrics of the financial market,” Villamarin says. “Market sentiment matters profoundly because, at the end of the day, supply and demand forces are critical for the medium term movement of asset prices. Psychology is critical for market dynamics.”
There are several theories that try to explain how market sentiment can drive the supply and demand of stocks:
The Behavioral Financial Theory: This theory looks at psychological factors when analyzing financial markets. Some investors act on emotion and in some cases, overconfidence in a particular security or asset. These reactions can cause biased investing decisions, potentially hurting your investment.
The Animal Spirit Theory: This theory assumes that people act on instinct in situations of uncertainty, the same way animals are said to operate. In turn, actions — like making moves on the stock market — are also driven by instinct. When the market is good, investors will buy. When the market is bad, investors will sell. Even if the instinct isn’t necessarily right, it’s a driving force in decision-making.
“In periods of greed, market participants believe stock prices will continue to move higher and are willing to pay ever-increasing prices for stocks,” Plumb says. “Greed eventually turns to fear as investors begin to realize expectations have become too elevated and begin to sell stocks,” he adds.
Plumb says we can measure market sentiment using the CBOE Volatility Index (VIX), or the “fear index.” The higher the VIX goes, the higher the fear in traders. The lower the VIX, the lesser the fear. When the market is stressed, VIX goes up. The VIX averaged 15.4 in 2019 but reached an almost-record high of 82.69 at the beginning of the COVID-19 pandemic in March 2020, according to Reuters.
Bottom Line
While using your instincts and intuition when investing, it’s easy to let your emotions get the best of you. Keep in mind that even with careful research, investing always carries some inherent risk. It’s a good idea to diversify your portfolio as much as possible, so that you’re spreading out your risk over multiple investments. An easy way to do this is by primarily investing in ETFs and index funds instead of individual stocks.
Index funds and ETFs are great ways to build wealth with relatively low maintenance and low barriers to entry. If you also want to invest in individual stocks, it’s always a good idea to do your research and become well-informed about a stock’s past and potential performance before buying anything.
Ultimately, though the stock market may have its ups and downs in the short term, investing is a great way to build wealth in the long term. Be sure that you’re investing smartly with a strategy that suits your financial goals, and keep your focus on your long-term goals (such as saving for retirement) to avoid making hasty decisions based on short-term panic or the fear of missing out.
Solution
Stocks can be a valuable part of your investment portfolio. Owning stocks in different companies can help you build your savings, protect your money from inflation and taxes, and maximize income from your investments. It’s important to know that there are risks when investing in the stock market. Like any investment, it helps to understand the risk/return relationship and your own tolerance for risk.
Let’s look at three benefits of investing in stocks.
Build. Historically, long-term equity returns have been better than returns from cash or fixed-income investments such as bonds. However, stock prices tend to rise and fall over time. Investors may want to consider a long-term perspective for their equity portfolio because these stock-market fluctuations do tend to smooth out over longer periods of time.
Protect. Taxes and inflation can impact your wealth. Equity investments can give investors better tax treatment over the long term, which can help slow or prevent the negative effects of both taxes and inflation.
Maximize. Some companies pay shareholders dividends1 or special distributions. These payments can provide you with regular investment income and enhance your return, while the favourable tax treatment for Canadian equities can leave more money in your pocket. (Note that dividend payments from companies outside of Canada are taxed differently.)
Different Stocks, Different Benefits
The two main types of equity investments below can each offer investors different benefits.
Common shares
Common shares are the most (you guessed it!) common type of equity investment for Canadian investors. They can offer:
Capital growth. The price of a stock will go up or down over time. When it goes up, shareholders can choose to sell their shares at a profit.
Dividend income. Many companies pay dividends to their shareholders, which can be a source of tax-efficient income for investors.
Voting privileges. The ability to vote means shareholders have some measure of control over who runs the company and how.
Liquidity. Typically, common shares can be bought and sold more quickly and easily than other investments, such as real estate, art or jewellery. This means investors can buy or sell their investment for cash with relative ease.
Advantageous tax treatment. Dividend income and capital gains are taxed at a lower rate than employment income and interest income from bonds or GICs.
Preferred shares
Preferred shares can offer investors the following benefits:
Reliable income stream. Generally, preferred shares come with a fixed dividend amount that must be paid before any dividends are paid to common shareholders.
The Advantages of Dividends
Dividends are a way for companies to distribute a portion of their profits to shareholders. Typically, dividends are paid in cash on a quarterly basis, although not all companies pay dividends. For example, companies that are still growing might choose to reinvest their profits back into their business to help grow it.
For investors, dividends can offer advantages in areas such as:
Returns. Receiving dividend payments on your stock can increase the total return on your investment.
Volatility. Dividends can help lower volatility by helping support the stock price.
Income. Dividends can provide investors with investment income.
Stability. Companies that manage their cash flow effectively tend to maintain consistent or growing dividend payments. Business stability and earnings growth often leads to a higher share price over time.
Higher income. Compared to common shares, preferred shares tend to pay higher dividends. (Note: preferred-share dividends come with the same advantageous tax treatment as dividends on common shares.)
Variety. There are many types of preferred shares, each with different features. For example, some allow for unpaid dividends to accumulate, while others can be converted into common shares.
