In a democracy, the majority rules, right? Not when it comes to stock pricing.
On any given day, the price of a stock is set by those who actually show up to the market to buy or sell shares. The data that comes in the Wall Street Journal, the numbers that crawl across the bottom of the screen on CNBC, are the results of market participant actions.
If you look at statistics on trade volume and open interest (how many shares of a given stock exist), you will find that it is not at all unusual for only about 1% of a company’s stock to be bought or sold on any given day. Or to state that differently, 99% of the owners of the shares don’t bother to show up at the market that day. However, because of the way the market dynamic works, it isn’t the 99% who get to decide what shares are worth, but the 1%. In the modern world, a high percentage of that 1% may be traders with no long-term interest in the stock’s value; but rather an interest in how much of a move in the current price they can ride to quick profits.
So the people who care the most are the ones that stay home and get no say in the value; and the ones who do determine the value are going to be a small group, some percentage of which are only interested in the fluctuation and not the stock/company at all? Yep.
Market theory concludes that this is OK, because if the vocal 1% gets things too far out of whack the silent 99% will start to rise from the couch and enter orders of their own to true things back up. Practice often matches theory, too; this does happen. Sometimes.
But there isn’t anything in place which forces the rest of the shareholders to vote, nor is there any compulsion that the traders and other 1-percent-ers act with any kind of rationality.
In the real world, this dynamic usually rears its head at the worst possible time: in a crisis. The hallmark of a crisis is that a market gets imbalanced at a time when the data is not coming in fast enough to give a clear sense of exactly what is happening.
So what do those on the sidelines do in the face of uncertainty? Usually nothing. They wait. Which means they don’t become market participants. It means they don’t vote. It means they don’t counteract the moves of the 1%. It means that the assumed checks and balances don’t get deployed. The 1% that got the ball rolling in the wrong direction are the only ones actually on the scene, and they often act in ways which accelerate the problem rather than fix it.
And that, ladies and gentlemen, is how markets crash.
So the message here is this: any asset which trades on a public exchange (that’s stocks, for sure; but also things like commodities and currencies) has an inherent risk factor which off-exchange assets (such as a rental house, or a private mortgage/note) don’t have. Exchanges create a force multiplier that allows a relative few to dictate the valuations which impact the majority; and allows them to change those valuations rapidly without actually transacting a very meaningful exchange of asset volume.
That’s not to say that market forces don’t impact off-exchange assets. But it is generally the case that rapid swings and meltdowns are much more rare, simply because the connective mechanisms (that are what make exchanges work in the first place), aren’t there.
Most investors have never thought about this aspect of markets. Those who have often decide that the exposure to risk is simply unnecessary, especially when they have options for good yielding investments in asset classes with less susceptibility to rapid price changes.