This was the headline in yesterday’s news:
“North Korea’s weekend bomb test unsettled markets on Monday with Australia, Japan and South Korea all finishing the day lower.”
So why does what happened in North Korea affect markets?
The reason the stock market fell yesterday is because people think there is more risk in the world than there was before North Korea detonated their nuclear bomb. But why is an increase in “risk” bad for stocks?
First, what is risk?
Risk just means uncertainty. That’s all. Uncertainty of an outcome. If we proposed a game where you had a 70% chance of doubling your money vs another where you had a 30% chance, which game would you be more willing to risk your money to play? The 70% one of course, because there is more certainty in the outcome. More probability of you winning. Less risk of you losing.
The stock market works EXACTLY THE SAME WAY. No matter what anyone tells you, investing in the stock market is akin to gambling. It’s educated gambling, but it’s gambling nonetheless. There is no certainty, no matter how sure the person is who gave you the stock tip, that it will go up. It could go down. It could even go to zero.
So what you pay for a stock today really just represents the cost of your bet. The potential future price of the stock is the payoff of your bet and the probability of that payoff happening, is the risk you’re taking. So, the more likely the payoff, the lower the risk and the more you’re willing to pay for the bet. In terms of the stock market, the more certain you are about the future price of a stock, the more you will be prepared to pay for it today. The less certain you are, the less you will be prepared to pay.
North Korea and da bomb – da bad news
So when North Korea goes out and detonates a bomb, it gets everyone spooked. No one knows what will happen next. It could lead to more sanctions, a trade war or worse a conflict. The key point though, is that we don’t know. There are many potential outcomes. Some of them are rather benign, others severely frightening.
This uncertainty makes it hard to accurately predict the future price of stocks. It doesn’t change their potential future price, it just makes it harder to estimate it. And if you are less certain, you are willing to pay less. And if you’re paying less, prices will fall.
And that’s what happened in the market yesterday. The risk of all your bets increased.
Anyway, that’s 5 minutes. Hope it helped.