The “true” value of a security is the sum of all cash which will be kicked back to the investor, ever, in the form of dividends, share repurchases, or eventual liquidation–discounted at a rate reflecting the appropriate systematic risk of the future cash flows.
Think about that. Forever is a long time. Model the expected future cash flows from a business some time (as a financial analyst, I did it many times.) A substantial fraction of the discounted value will be in cash flows in the far distant future. So your model is only as good as your predictions of what will happen many years from now.
Then there’s the matter of discounting. The value will be hugely sensitive to the discount rate you choose. The discount rate in turn depends on the risk-free rate (largely under the control of the federal government), the market premium for systematic risk (a nebulous concept subject to change without notice), and the amount of systematic risk in the business being evaluated (also subject to estimation error and change without notice).
Considering the difficulty and uncertainty of security analysis, the wonder isn’t that the market is as volatile as it is, but that it isn’t more volatile.
Is there some way I can find out how the market did on a specific day and an explanation for why? I’d like to know if I’m just imagining that there’s recently been several 200+ gains in the Dow followed the next day by 200+ drops, which is the basis of my OP.
Also, there’s a decent (and somewhat technical) explanation in the Wikipedia article on Volatility (finance).
According to the chart at Cboe Tradable Products, market volatility has been increasing over the past year, i.e. the movements up and down have been larger.
I understand what you’re saying here would agree that’s a good definition from an accountant’s standpoint, but would have started the sentence as “One method to value a security…” Maybe that’s why you put “true” in quotes. I would have said that the true value of a security is the price of the last transaction between a willing seller and a willing buyer.
But that would provide no insight into how that value is determined.
It’s true that many investors–probably, most–don’t perform the fundamental analysis that I described. (I don’t–I’m a passive investor.) Perhaps many trade on emotion, or short-term technical analysis, or the phase of the moon. It’s easy to imagine this emotional trading as accounting for stock market volatility. Most of the earlier posters in this thread made that assumption.
My point was that even if every investor is a hyper-rational fundamental analyst, securities are difficult to evaluate and the valuations are hugely sensitive to small changes in parameters like interest rates and long-run growth. Volatility need not imply irrationality.
There are lots of reasons for increased volatility. Program trading (which has spawned algorithmic trading), increased size of the market players, and herd mentality are some of the largest reasons.
If you are thinking the network and local news reporters, neither they nor the people writing their copy have the slightest clue what they are talking about. Ignore them.
If the case is that simple, wouldn’t the Russell 3000 or the Wilshire Total Market Index be a better choice?
Just to expand on yabob’s point, the S&P 500 is market capitalization weighted, whereas the DJIA is price weighted. That means that IBM (closing 5/8 price 124.92, market cap $171.57B) is more important to the index than MSFT (closing 5/8 price $29.27, market cap $272.60B). A 1% move by IBM on the DJIA has a greater effect than a 1% move from MSFT; on market weighted indices, MSFT’s move would carry more weight.
Can anyone comment on the volatility of the stock market 50 or 100 years ago? I’m reading Reminiscences of a Stock Operator and the author talks about stocks rising 30 or 40 points at a time, with par values of 100. My impression from the book is that wild swings of 50% of market cap were commonplace.
Umm, how about that not every Tom, Dick, and Harry had a computer where they could trade online. If a much smaller group of people decide to trade on a given day, they will move the market more than a larger group.
I would add that anyone interested in how this stuff works should check out the eminently readable “Trading & Exchanges” by Larry Harris. One of the best & most informative books I’ve read on any subject, does a great job of demystifying how markets work without descending into impenetrable jargon or (worse) math.
BTW, two additional considerations in explaining market volatility: Short selling: "the practice of selling securities the seller does not then own, in the hope of repurchasing them later at a lower price. " Derivatives: “financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps.”
However, some say that short selling and derivatives *stabilize * the overall market.
Contradictions (or even, paradoxes) abound in the world of trading and investing. (Just like they do in life.) Economists specializing in financial markets are the “experts”, but they haven’t “figured it out”. Even though some of them have predicted the last 7 out 4 market crashes …
That depends on what you consider ‘common’. There have been four 200 point swings in the last 15 trading sessions. It is certainly becoming more common.
