Relevance of Temporary Price Fluctuations
In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value.
Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals.
But are temporary price fluctuations really a risk?
- Not in the way that permanent value impairments are and then only for certain investors in specific situations.
- It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals.
- The reality may only become apparent after the fact.
- While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility.
- Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility.
If you are buying sound value at a discount, do short-term price fluctuations matter?
- In the long run they do not matter much; value will ultimately be reflected in the price of a security.
- Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact.
- For example, short-term price declines actually enhance the returns of long-term investors.
There are,however, several eventualities in which near-term price fluctuations do matter to investors.
1. Security holders who need to sell in a hurry are at the mercy of market prices.
- The trick of successful investors is to sell when they want to, not when they have to.
2. Near-term security prices also matter to investors in a troubled company.
- If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds.
3. The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell.
- If you hold cash, you are able to take advantage of such opportunities.
- If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.
- This creates an opportunity cost, the necessity to forego future opportunities that arise
.
- If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.
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