Download Topic 4 – Why do share prices fluctuate?

Why diversify?
Reduce risk
Predicting and timing the market is difficult, if not
impossible and therefore sophisticated investors know
that diversifying your investments is crucial. It reduces
risk significantly without sacrificing much from returns.
Risk can come in many forms; inflation, volatility,
collapse in house market, currency movements, shift
in interest rates which can impact different types of
investments. Diversification is the first line of defence
against these risks.
Protect against uncertainty
Nobody knows how our economy
will perform in the future, what
markets will deliver the best or
worst returns, what inflation
will do, or in what direction
interest rates will move. The
only way to protect against
this uncertainty is to diversify
across a range of assets, markets,
sectors and securities. Diversification can be viewed as
an insurance policy against uncertainty.
Guard against inflation
Many people shun diversification into shares and
property altogether and prefer to keep all their savings
in term deposits. This might feel safer, but inflation is
the real enemy here which can decimate the spending
power of your savings over time.
Remove the need to time the market
The price you pay for shares, property, bonds and
currencies has a big impact on your future returns.
However, trying to pick the best time to invest is very
difficult because the future performance of markets
is unpredictable. Therefore it is absolutely critical that
investors not only diversify their investments but
also diversify their market timing by purchasing their
investments in instalments over a period of time.
For more information on asset allocation
and diversification please refer to Topic 9 of
our ‘Overview of Investing’ booklet.
Topic 4 – Why do share prices fluctuate?
Share prices are determined by how well a company is
performing. In general terms, if a company is growing its
profits (and therefore dividends) this will likely result in
an increase in the share price. However, it is important
to remember that there is no automatic link between
a company’s profit and its share price, as this is also
determined by supply and demand in the market place.
If investors get enthusiastic about a particular company
and start purchasing their shares, this can push the share
price up. Conversely if they become nervous about a
company’s performance and sell their shares, the share
price can drop.
Ultimately the supply and demand of a company’s shares
can be influenced by a number of factors:
1
1 The company’s current performance is crucial. If
the company is making a profit and either pays out
dividends or reinvests the dividends into the business
(to enable capital growth), this offers value to the
shareholders. Shareholders are less likely to sell and
more investors are inclined to buy.
3 A range of economic factors affect share prices and
3
how they move including:
a Economic growth – is the economy growing?
b Overall consumer confidence and spending – if
confidence and spending is high, companies are
more likely to produce a profit
c Unemployment – high unemployment has an
impact on consumer spending
d Inflation – if prices of goods and services increase
due to inflation, this may suppress spending
e Currency – an increase in the New Zealand dollar
can benefit companies importing but would
have a negative impact on profits of companies
exporting
f Market conditions – if some markets are volatile
this can affect investor confidence and consumer
spending
g Interest rates – an increase in interest rates
usually cause share prices to weaken
2
2 The company’s future performance will determine its
future value. Any changes to the company’s future
earnings (its ability produce a future profit to pay
dividends and provide capital growth) will affect the
share price, so if forecasts look positive this is likely to
affect the share price positively.
© Craigs Investment Partners 20125