Forex Investment and Currency Trading

There was no outbreak of war, no government upheaval, no business scandal. Yet on October 19, 1987, the Dow Jones Industrial Average went down as if something disastrous had happened. By the end of the day, the Dow had plummeted 22.6 percent, its largest single-day percentage drop in modern market history. Broader markets were hit just about as hard, leaving stunned investors with staggering losses at the closing bell.

But was it really such a catastrophe? Looking back years later, we can see that it took just 16 months for the Dow to regain all the losses of October 19 – and just 8 months for it to rebound to a loss of less than 5 percent. We can also see that the history of the markets is filled with dramatic ups and downs. From that perspective, that day looks less like a disaster and more like an extreme example of business as usual.

If you are going to invest in stocks, you need to know that you’re not seeing a once-in-a-lifetime event every time a stock – or an index – shoots up or down.

Market Speak

When we’re talking about individual stocks or stock markets, volatility refers to increases or declines in value. Stocks have historically been more volatile than other investments – such as bonds or cash – meaning prices move around more. It makes sense. Unlike bonds or cash, stocks don’t come with a guarantee of repayment with interest. They’re worth whatever investors will pay when you want to sell.

Why markets move

One way to think of stock markets is as polling places, where investors gather to size up current profits, future growth potential, possible risks, etc., and se the price at which they’re willing to buy or sell a stock. In essence, the markets hold a never ending election on each stock, with investors casting their votes by buying or selling.

According to this theory, prices of stocks change from day to day, or even from minute to minute, as new information becomes available and investors act accordingly. For example, when Wal-Mart sold less merchandise than expected during the 2004 holiday season, it put future sales forecasts and profits in doubt. As a result, investors collectively adjusted the price of Wal-Mart’s stock downward by about 6 percent over two days of trading.

Fact Versus Fantasy

Sometimes it’s not so much the facts that change but how investors feel about them. For example, online retailer Amazon.com saw its stock rise from $1.50 a share when it was first offered in 1997 to $106.69 (adjusted for stock splits) in December 1999, at the height of the Internet bubble. The price plunged from that peak all the way down to $5.97 in September 2001 following the September 11 terrorist attacks on the World Trade Center and the bursting of the Internet stock bubble, only to rebound again to $33.09 as of June 30, 2005.

During all these ups and downs, Amazon’s stated goal was always to build a profitable online retailing business. A rational investor, who focused on how Amazon was doing against that goal, probably wouldn’t have bought the stock at the height of its popularity in 1999. Despite rapid growth, the company was losing money, to the tune of $882 million by the end of that year. And it was valued at a price that couldn’t be justified by any realistic projection of continued growth.

The Bottom Line

Stock splits refer to the division of company shares. Two-for-one, three-for-one, and three-for-two splits are all relatively common. If you own 100 shares of a stock selling for $50, and it splits 2-1, you’ll end up owing 200 shares of a stock selling for $25 instead. Note that splits have no effect on overall share value. When we compare share prices for companies over long periods, we simply adjust the share price to factor in whatever splits occurred.

If it doesn’t change the value, why do companies split their shares at all? It’s all psychological. Keeping prices down can make shares seem easier to afford to small investors, or even create the illusion of getting something for nothing. By the same principle, reverse splits – in which a company gives investors fewer, more-expensive shares – are sometimes used to make an embarrassingly low stock price appear higher.

On the other hand, that same rational investor might have found Amazon considerably more attractive by late 2001, when the company was still growing, still expanding consumer segment – and much more reasonably priced. Yet that’s when most people were selling.

Ignoring the Crowd

We always know what has happened in the past, but we can only make educated guesses about what will happen in the future. Most investors are great at extending straight lines.

As our Amazon example shows, investors in 2001 knew that Internet stocks in general, and Amazon in particular, had been grossly overvalued and had dramatically fallen in value. But they could only guess about what was next.

Most people did the natural thing and assumed the future was going to be similar to the present. In other words, they overlooked the fact that Amazon was still a viable, growing business and decided instead that Internet stocks, and markets in general, were going to keep falling.

It can be hard to calmly assess your stocks when their day-to-day prices depend in large part on the perceptions of thousands (or millions) of other investors. Yet that’s exactly what you must do. In the long run, the fact t5hat many of these investors act irrationally or don’t do their homework is what gives the truly rational investor an edge.