KEY POINTS:
In Tim Harford's book The Undercover Economist, he explains why share prices move the way they do.
One of the most famous dotcoms was the internet bookshop Amazon.com.
Amazon started selling books on the internet in 1995, and in 2003 it sold more than $5 billion worth of merchandise. Amazon's rapid growth and its fight to become profitable is remarkable, but not as remarkable as the price of its shares. In 1997 Amazon shares were first sold to the public at a starting price of $18.
In 1999, Amazon shares soared to more than $100 despite multiple stock-splits designed to increase the number of shares. At the time it was said that Amazon.com was valued at more than all the regular bookshops in the world.
But throughout 2000, Amazon shares slid back toward $18 and beyond. In the summer of 2001 Amazon shares were trading around $8. In 2002, the company was getting good write-ups in the financial press, but shares were still down more than 80 per cent from the peak. Yet since then they have recovered to $40 a share. Which price was the mistake: $100 or $8? Or both?
The answer would be useful, not least because Amazon's rollercoaster performance is common. So can the Undercover Economist say anything about why share prices acted the way they did, and how they might behave in the future?
Economists face a serious problem in trying to say anything sensible about stock prices. Economists work by studying rational behaviour, but the more rational the behaviour of stock market investors, the more erratic the behaviour of the stock market becomes. Here's why. Rational people would buy shares today if it was obvious that they would go up tomorrow, and sell them if it was obvious that they would fall. But this means that any forecast that shares will obviously rise tomorrow will be wrong: shares will rise today instead because people will buy them, and keep buying them until they are no longer so cheap that they will obviously rise tomorrow.
In fact, rational investors should be able to second-guess any predictable movements in the stock market or in the price of any particular share - if it's predictable then, given the money at stake, they will predict it.
But that means that if investors really are rational, there won't be any predictable share movements at all.
All the predictability should be sucked out of the stock market very quickly because all trends will be anticipated. The only thing that is left is unpredictable news. As a result of the fact that only random news moves share prices, those prices, and the indices measuring the stock market as a whole, should fluctuate completely at random. Mathematicians call the behaviour "a random walk" - equally likely on any day to rise as to fall.
More correctly, the stock market should exhibit a "random walk with a trend", meaning that it should on average edge up as the months go past, so that it is competitive compared with other potential investments such as money in a savings account, or property.
If it was expected to edge up by more than that trend, it would already have done so, and similarly if it was expected to edge up by less, or to fall, it would already have underperformed. This is the reason people hold shares at all.
The trend doesn't alter the basic analysis, though, and on any given day the trend is dwarfed by random movements.
This theory should hold even if not every investor is rational.
The ones who are should be enough to force the market into a random walk, providing they are throwing plenty of money into good shares and out of bad ones. Throwing money around shouldn't be too difficult, since presumably the smarter investors make more money.
Should we believe the "random walk" theory? We certainly shouldn't expect it to be absolutely true. If it was, that would be a paradox: perfectly informed investors produce a random market, but a random market doesn't reward anybody for becoming perfectly informed. It wouldn't be worth anybody's while to invest time and effort to analyse the market or uncover new information, if everybody else was doing the same.
On the other hand, a market full of unexploited opportunities would offer big profits to any investor willing to research them, which would then lead to fewer unexploited opportunities. Somewhere in the middle is a balancing point: a nearly random market with enough quirks to reward the informed investors who keep it nearly random.
You can see the same phenomenon at work at the supermarket checkout. Which queue is the quickest? The simple answer is that it's just not worth worrying about.
If it was obvious which queue was the quickest, people would already have joined it, and it wouldn't be the quickest any more. Stand in any queue and don't worry about it. Yet if people really just stood in any queue, then there would be predictable patterns that an expert shopper could exploit; for example, if people start at the entrance and work their way across the store, the shortest queue should be back near the entrance. But if enough experts knew that, it wouldn't be the shortest any more.
The truth is that busy, smart, agile and experienced shoppers are a bit better at calling the fastest queues and can probably average a quicker time than the rest of us. But not by much.
