Why Stock Prices Go Up and Down

Posted By: Advisor Analyzer Team

The markets are filled with a variety of participants. Much like any aspect of life the markets are filled with people who make things better and those who make it worse. While there are revolving theories and explanations as to why market prices fluctuate so often, investor behavior is undoubtedly a contributing factor. For some participants, investing is a commitment and they remain steadfast behind their decisions. Other investors buy and sell so frequently they could moonlight as a part time ebay business. Below are some of the more common types of investors and traders that make every day in the markets, a new and different experience.

Holder

The holder, as the name so accurately implies, is in a perpetual state of acceptance and committed to inaction. Holders often purchase an investment and continue to add to the position as necessary. They rarely sell or rebalance their portfolio to a target allocation and feel the markets will dictate the weighting of each holding. When markets are down, they remain passively inactive and which leaves them susceptible to “un-open envelope syndrome” (A phenomena where investors ignore their monthly portfolio statements when the markets are down). Due to their infrequent selling behavior, holders generally have a very small impact on daily trading price fluctuations and consequently are a small contributing source of market inefficiencies.

Rebalancers

While holders are the poster child for market inaction, rebalancers are the worker ants of the investment community. All too often, rebalancers adjust their portfolio allocation by trading positions after major market moves. They prefer to maintain a disciplined approach by maintaining a policy portfolio structure that is to be followed religiously. Deviations from this target weighting scheme are corrected and rebalanced accordingly. As a result they are often referred to as formulaic rebalancers.

 

Rebalancers have a smoothing impact on market price fluctuation. When prices decline, they increase their allocation to that position, supporting prices from further depreciation. Conversely, as prices rise, they sell the position to trim down the weighting in their policy portfolio. However, like holders, rebalancers rarely take on new positions or portfolio allocations. Rather, they continue to contribute or reduce their existing positions as markets fluctuate up and down.

Valuators

Valuators are a diverse bunch with different sub categories of investors in each. They are very flexible in their investment philosophy, buying and selling on a case by case basis. They are able to trade bi-directionally by taking both long and short positions to capitalize on potential investment opportunities. They are generally split into two categories, and depending on market conditions, valuators may either smooth or exacerbate price fluctuations.

 

Contrarian: The contrarian valuator believes large moves in one direction will ultimately reverse. They believe abnormal price fluctuations up or down are the result of market participant overreaction, and endeavor to capitalize on market price reversions. When prices move down, contrarians view the markets as cheap, and begin purchasing these shares. As prices rise, they view investments as rich and begin trimming or shorting these positions. Therefore, trading behavior of contrarian valuators tend to have a smoothing effect on market prices.

 

Momentum: Momentum investors are the diametrical opposites of their contrarian associates. Momentum valuators believe price deviations will persist or even shift further from the mean. Generally they follow the overall trends of the market; shorting or selling their existing positions as prices fall, and buying or adding to their allocation when prices rise. Like pouring fuel on a fire, this trading strategy often results in exaggerated price movements in one direction. While this may put a smile on many investors’ faces when prices rise beyond forecasts, the probability and size of subsequent price declines become significantly increased. After all, the further you stretch a rubber band, the harder it snaps back or breaks.

Conclusion

Stock prices will continue to fluctuate as long as there are different buyers and sellers (or at least until the markets reach true efficiency). Understanding the different trading behavior of investors can help us recognize potential reasons behind a price move, and assess the likelihood it will persist or revert back to the norm. Besides, while there have been many reasons proposed for these price deviations, when all’s said, it’s as simple as more buyers than sellers or vice versa.