What really drives share prices

My 'High Yield Portfolio' (or HYP) strategy is all about income. I try to convince readers of my newsletter, The Dividend Letter, that we should not care about share prices. That the only way to build real wealth is to maintain a healthy and well-diversified stream of dividends over time.

But I know that in practice a lot of my readers do follow the prices of their shares. So I wrote this piece to tackle an important question for them: what exactly moves a share price?

I want to deliver my thoughts, obtained both through long experience and a lot of reading over the years from people who have studied the matter. I wrote this to help my readers and I think it could help you, too.

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In my opinion, the prices of big cap shares in the short term counted in days or weeks are random. But in the long term, counted in years, share prices are driven by the profits of the companies. That's just an opinion I've developed over decades in the markets.

As a result my belief is that that there can be no knowing how prices will move in the short term. That's why I refuse to get caught up in stock picking as so many of my colleagues do. I prefer to adopt my policy of strategic ignorance' (more on that in a moment).

In the long term, however, I believe share prices are more likely to rise than fall. I'll explain my reasons.

The great majority of the shares of big caps are held by the institutions. On any day there will be some selling and some buying by these holders and because they deal in large chunks of shares, these will be in large enough quantity to have some small effect on the price.

Normally these institutions will all have different reasons for wanting to buy or sell the share and the net result of these transactions creates the random short-term move in the share price that you observe.

Sometimes by chance there will be a greater than usual preponderance of sellers or buyers and the price may move down or up by more than it normally does. But it is still just a random move based on demand.

There are sometimes exceptions to this, such as a bid, when results are much better or worse than the market was expecting, and so on. But the vast majority of price changes are simply random.

Why most financial news is utter nonsense

It's a feature of human nature that people think there has to be reason for every move, especially those moves that are not average. And a whole industry exists to supply it. Financial websites, newspapers and share forums all hum with activity and explain every move. Almost all of it is utter nonsense. Few understand this.

You can almost be certain that every time a share does anything even mildly unusual, like going up or down slightly more than the market on a day or going the opposite way, someone on a message board will ask why. And someone desperate to find an answer, no matter how spurious or obscure, will provide one. The real answer in most cases should be "there is no reason, other than more buyers than sellers", in the case of a rise, for example.

In the long term though, the situation is different because share prices and dividends are likely to rise. The reason is simple: inflation.

Inflation has the general effect of increasing profits and dividends too. And because in the long run profits are the driver of share prices, those share prices have a good chance of rising and their dividends a good chance of increasing.

This is a generalisation. There will always be companies that do badly over time, simply because business is a risky activity and inflation alone is no guarantee of rising profits. It's only one factor affecting profits amongst a load of other factors. Similarly there will be some companies that do better than mere inflation. So you cannot apply this thinking to any individual business. But overall, across the market, the trend is that inflation will drive up share prices.

Note though, that this relationship is not always in lock step. There can be long periods when shares are out of line with inflation, either ahead of it or behind. Now is a good example of the latter because the FTSE100 index remains lower than it was in 2000, despite quite a dose of inflation since then.

Similarly by choosing a shorter period, I could show that the current index has beaten inflation. But in the end the connection between inflation and share prices does tend to reassert itself.

So what can be learned from this?

First: it's almost impossible for short-term traders in total to make money from repeatedly trading big caps because their price moves are mainly random. This is especially true for private investors.

It's worse than a 50/50 play because on top of that randomness, the house -ie the brokers and bookies -have an edge in the form of commissions and spreads. It's a little like roulette where overall, players cannot win because of the house's edge.

But having said that, even in a betting game in which the odds are stacked in the house's favour, a handful of players can come out ahead by chance. The mistake made by the rest is to think that they can be one of them, in the belief that those chance winners did it by some skill or system. The proof of the pudding is that very few short-term trading private investors make a decent return over time.

Second: long-term investment stands a much better chance of scoring because the share price moves over time are not random: they have a reason to be driven up long term. Admittedly, as I've said, it is not always a very solid reason as evidenced over the last 12 years, but at least there is some kind of trend driver present. The same cannot be said for attempts to profit from random, short-term moves.

And finally: long-term investment HYP-style brings with it the real reason to be here at all, the opportunity to achieve rising dividends for the same reason as rising prices.

In my HYP strategy, prices are irrelevant or at best secondary. My readers and I are looking for income from dividends, not capital gain. But if you achieve rising dividends on top of rising prices, then you have a perfect storm.

As I mentioned earlier, I adopt a policy of strategic ignorance. What I mean by that is that I don't take the slightest notice of any perceived long-term trends that many consider important in share selection. I studiously ignore anything which tries to inform me of a stock's long-term future.

Why? Because nobody can forecast the future! I don't 'futurise'. Instead I concentrate on what you can know.

And if you're looking to make a good long-term return on your money and above all an income from it then you should consider trying my HYP strategy.

An exclusive from income specialist Stephen Bland

"You really don't need to worry which way the market goes"

Here's a PROVEN way to make money whether it goes up, down or sideways!

Forecasts are not a reliable indicator of future results. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Please seek independent financial advice if necessary. Fleet Street Publications Ltd. Customer Services: 0207 633 3600.