What Drives The Movement In Stock Prices?

Warren Buffet does not care about the daily ups and downs of stock prices.  He invests in firms that are likely to grow and be profitable over the long term.  He has been successful with this strategy but the typical money manager has to worry about the short term fluctuations in market prices.  That is because many of their clients will shift their funds to hot money manager who made the right guess about the short term swing in prices.  Consequently, money managers play a game that has been described as a beauty contest by a famous economist.  That game is aptly described in this article; it differs dramatically from the way the game is supposed to work according to the efficient market hypothesis which is believed to be the best explanation of the movement in stock prices by financial economists.  The EMH assumes that the price is always right because every investor has all of the information needed to make an investment decision.  The quote below provides a short description of the beauty contest that offers a behavioral of the investment game.

Keynes’s beauty-contest analogy remains an apt description of what money managers do. Many investors call themselves “value managers,” meaning they try to buy stocks that are cheap. Others call themselves “growth managers,” meaning they try to buy stocks that will grow quickly. But of course no one is seeking to buy stocks that are expensive or stocks of companies that will shrink. So what these managers are really trying to do is buy stocks that will go up in value—or, in other words, stocks that they think other investors will later decide should be worth more.

Buying a stock that the market does not fully appreciate today is fine, as long as the rest of the market comes around to your point of view sooner rather than later. Remember another of Keynes’s famous lines, “In the long run we are all dead.” The typical long run for a portfolio manager is no more than a few years, often just a few months! So to beat the market, a money manager has to have a theory about how other investors will change their minds. In other words, their approach has to be behavioral.