Question

Risk and Return

Please respond to the following:

• Determine whether stock prices are affected more by long-term or short-term performance. Provide one example of the effect that supports your claim.

Answer 1

Stock prices rise and fall in both the short and long term.

However, in short term, the stock prices tend to be more volatile leading to considerable fluctuations.

In the long term, the stock prices smooth themselves out and the effect of volatility minimizes.

The reasons behind the fluctuations of stock prices are the market forces; demand and supply.

For example: New Information

Any kind of information regarding the world, national, economic, or corporate that directly or indirectly affect the company, leads to a change in the price level of its stock.

For instance, a positive news, let's say, a very high earnings growth of a company in a specific quarter can lead to a drastic increase in the stock price.

This is because when the news of an earnings surprise becomes public, the investors' expectations increase regarding the growth prospects of the company.

This in turn leads to increase in the demand for stock of the company in comparison to its supply, thereby increasing the overall price of the stock.

In contrast to this, in the longer run when a company reaches its sustainable level of normal earnings i.e. the level of revenue a company can generate over a longer period of time with its core business activities, the stock prices smooth out and the effect of volatility minimizes.

This is because in long term, the expectations of investors are formed based on the true earnings potential of the company.

More such factors that determine higher volatility of stock prices in short term are macro-economic factors, changes in risk factors/composition etc.

Hope this helps!

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