Financial Management: Principles and Applications, 13/e

7.4 What Determines Stock Prices?

Our review of financial market history tells us that stock and bond returns are subject to substantial fluctuations. As an investor, how should you use this information to form your portfolio? Should you invest all of your retirement account in stocks because historically stocks have performed very well? Or should you be timing the market, buying stocks when the returns look good and buying bonds when the stock market is looking rather weak? Note that this is exactly the question the great-grandfather faced in the example we used to introduce this chapter.

To answer these questions, one must first understand that stock prices tend to go up when there is good news about future profits, and they go down when there ...