One Fundamental Flaw in the Stock Market

When you buy a stock, you are paying one price today for all of its future profits. If their sales or profit margins go up more than expected in the future, the stock rises. It is that simple. And that complicated.

It is not just future profits that you are trying to predict. That's hard enough. A new competitor or a new technology could steal your sales. Tastes could change overnight. Or you might come up with a new process that automates a step that used to be expensive, causing your profits to jump.

You also have to predict the value of those future profits. If you discount next year's profits by 10% and interest rates rise, you need to discount profits by 15%, lowering today's value of future profits. If currencies drop in value, future profits might rise.

There are so many moving variables that can drive predicted future profits up or down that it is no wonder that the market is continuously moving. But the most fundamental problem with all this has to do with margin of error.

You might estimate profits into the future but the further you forecast, the larger your margin of error. This is just a fact. The problem with this, though, is that the margin of error for the whole stock market is probably 5% to 20%, a swing as big - up OR down - as the movement in any given year. Even with really good forecasts, the difference between, say, $8 or $10 for the price of a stock is really just a difference in where you - arbitrarily - choose to land within your margin of error. "Big" market movements can be the equivalent of normal variation.

One fundamental flaw with the market is that we give precise prices to stocks that could more reasonably be given a price range. And because assumptions are continually shifting, so are those prices. This guarantees market volatility.