The price of a stock equals the future expectations the market has from the stock, says conventional finance theory. But it’s never too obvious as to what the future is. And that leads to stock market bubbles.
Future is uncertain and predicting how a company will perform in the days to come is such a difficult task. Chances are that the actual scenario might turn out to be quite different from what the expectations are. A particular sector, which is deemed to be hot as of now, may not perform in the future. But for the time it is deemed to be hot as a lot of money will flow into the stocks in that sector, leading to increased valuations. Later, the investors will realise, in retrospect, was not really justified in the first place.
James Surowiecki in his book The Wisdom of Crowds says, “The problem with the stock market is that there never is a point at which you can say that it’s over, never a point at which you will definitely be proved right or wrong. This is one reason why a company’s stock price can easily soar far past any reasonable valuation, because people can always convince themselves that something in the future will happen to make the company worth it. And it’s the same reason why you can make money in the stock market even when you’re wrong: even if the market does eventually get the price right, it can be wrong for a long time, because there is no objective means to demonstrate it’s wrong”.
The stock market might eventually get it right but till that time there is a bubble in place that keeps bloating as more and more investors chase the same set of stocks. But what makes investors invest in the same set of stocks? The answer is in Robert Shiller’s all-time classic Irrational Exeberance. He says, “A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times.”
If a person wants to invest, the chances are that he will look around to see what his acquaintances, neighbours or relatives are doing with their monies..
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