Stock Trading Information Blog

The stock market has been observed to display high volatility or fluctuation in the stock prices in short term as compared to long-term fluctuations. In a short duration, the stocks are capable of providing a high return on investment as well as higher losses, but on a long-term horizon, maybe one year or two year or more, their behavior displays a remarkable degree of predictability.

In the short run, the stock price is affected by a lot of factors unrelated to the stock itself.

The most important reason for such predictability in the long run prices is that the positive impact of the various unrelated factors is balanced by the negative impacts these unrelated factors may cause on the stock price movements, thus reflecting in the long run a return that is very close to the true expected return based on the company’s fundamental strength, growth potential, etc.

This is an area which is hotly debated though in the finance literature.

There are some researchers, who argue that the price earning ratio is the most common indicator of the expectation of return from an investment in the stock, and they have done some studies linking this ratio with the changing demographic structure of a population, thereby concluding that since it is possible to predict the demographic structure in a population, it is possible to predict the stock prices as well on the long run.

There is one view, according to which the forecasting power of any forward looking model diminishes as we stretch the time horizon. It basically implies that it is possible to forecast tomorrow’s or the day after tomorrow’s wheat prices with a reasonable accuracy, but it is not possible to forecast the wheat prices one year from now, as there are so many uncertainties involved in such a forecast.

There may be a severe drought in the coming year that we do not know at present which may severely affect the wheat production and therefore its price in the coming year. Similarly, a lot can happen to the company in one year or two years from now, which is very difficult to judge.

There may be a change in the government policy, which may favor or work against its interest severely affecting the company’s profitability. A lot can happen to the sector or the economy as a whole, the competitors may decide to do something that may have big influence on the performance of the company.

This is one issue on which the finance literature is full of empirical studies, though there is still no consensus. Broadly, we can say that the indices representing the overall markets, for example Dow Jones or S&P 500 have demonstrated a remarkable degree of predictability, offering most of the time a return in the range of 8-10%.

We can also say that the stock markets in general have given a return greater than what the bond or fixed income security market has given. But at the level of individual stocks, it is difficult to say whether the level of predictability is good in the short run or in the long run?

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