In a perfect world, every stock price would precisely reflect exactly how much a company is worth. More precisely, if you added up all of a company's stock, you would get a value that perfectly matched how much it is fundamentally worth.
In real life, however, this is not the case. Why do stock prices change? That is a question that does not have a simple answer.
Some companies that are not noticed on the stock market suddenly explode one day and increase their values tenfold. Other companies have no noticeable change in operations, but experience a sudden hit to their stock price for no real reason. And others still, experience tons of volatility and are driven by seemingly random forces. Take Gamestop for example:
GameStop, for those who don't know, was a struggling company whose stock price was hovering around $20 – $40 for a long time. However, within the span week, it shot up all the way to $470, and then back down to $126 in an even shorter time span.
There was no change in GameStop‘s operations. No big announcement. No sudden release of anything. So it can't be the fundamentals of a company, earnings announcements, or management improvements. So then what truly influences a company's share price?
Importance of Price
It's important for anyone who wants to invest to know how their investment vehicle determines price. If you're investing in real estate, you're going to look at house comps, square footage, number of rooms, etc. If you're investing in treasury bills or bonds, you're going to look at inflation rates and interest. Stocks are the same way.
However, stocks are one of the more volatile investment types, which means that even if you know HOW price is determined, you may not be able to actually PREDICT the price. Nevertheless, it's still important to know if you want to enter the markets anytime soon.
Supply and Demand
Like almost everything else in the world, the price of a company's stock follows the very simple rule of supply and demand. Unlike almost everything else in the world, the price of a stock is an almost instantaneous reflection of supply and demand.
Let's say you have a diamond ring you want to sell. It's a very pretty ring and you're hoping to sell it for $10,000. You go to the mall to ask around and see if anyone wants to buy it.
You approach someone and ask them if they are willing to buy your diamond ring to which you're met with “ha, no way. Some other guy is selling the exact same diamond ring for $9500. Why would I buy yours when I can buy his?” Frustrated, you too decide to lower your price to $9500 to match your “competitor.” This is supply at play. An increase in supply decreases the price of your ring.
You go home unable to sell your ring and decide to try again the next day. At the mall (the next day), you don't need to approach anyone because tons of people swarm you. “Oh my goodness what a pretty diamond ring!!” “Wowww, I want to buy it.” “No wait, I want to buy it!” “I'll give you $11,000 for it!” “NO don't sell to him, I'll give you $13,000 for it!” This is demand at play. An increase in demand will likewise increase the price of your ring.
The Stock Market
This is how stock markets work. The more people want a stock, the higher the price. The less people want a stock, the lower the price. But a major difference is that the reflection of supply and demand is global and it's near-instantaneous for the stock market.
Let's go back to the diamond ring example. If there was a person in Zimbabwe who had the exact same ring and was selling it for $9500, it probably wouldn't impact your price. At least not instantly. Over time, if he posted it on eBay or Amazon, maybe you would come to notice it, and maybe you would lower your price to match his. Even then, people probably don't want the inconvenience of shipping fees and whatnot, so will be willing to pay you a premium (higher price) just for being closer.
None of that matters in the stock market because everything is online and digital. If I'm trying to sell my stock, it doesn't matter if you're in Zimbabwe or China or Canada. I'll sell it to whoever gives me the highest price. This means that every nuance of supply and demand is almost instantly priced into the stock market. The price of a stock is simply a reflection of the lowest cost that sellers are willing to sell the stock for which buyers are willing to pay for.
What Might Impact This
It's impossible to know what everyone is thinking at every point in time, so it's impossible to predict with 100% certainty where a stock price will go. That being said, there are a few major things that have historically INFLUENCED the price of a stock. Here they are:
Positive and negative news have a big impact on supply and demand.
Let's return to the diamond example once more. You're attempting to sell the diamond and are excited because you found someone who is willing to pay $15,000 for it. Then one day, the person just stops texting you altogether and the deal falls apart. You're confused as to why when you catch a glimpse of the news.
The front page headline reads “Beware of Diamond Ring Fraud Running Rampant in (insert your town name).” All of a sudden, nobody is interested in your diamond ring anymore. You can't do anything but lower the price back down.
Company stocks are the same way. A single piece of good or bad news could cause a stock to rise or drop by several percentage points. This could be news of a new CEO, news of an acquisition, news of plans for expansion. Literally anything can move the markets.
I can't believe I'm saying this, but yes memes have the power to drastically alter supply and demand. An engaging meme with a wide audience has arguably the same (or more) power than mainstream news. This is because it can reach just as many people, yet memers typically are much more committed to a cause.
Don't believe me? Just look at the GameStop stock chart. One large meme, combined with a little bit of hatred for Wall Street, gets you this incredible rally:
I honestly can't remember the last time a piece of news impacted a stock to such proportions. In today's “internet age” it's worth noting the impact that memes can have on stocks and on businesses in general.
Finally, we have trusty old fundamentals. These include a company's earnings, their management team, and the competitive advantages that they possess.
Even though news and memes have the ability to sway a stock's price in the short-term, fundamentals will win out in the long run. Eventually, after all the hype and fear goes away, what you're left with to determine a company's value is its fundamentals.
For those of you who just want to make a quick buck by hopping on a train and then hopping off a train, fundamentals don't matter. But for anyone else who cares about long-term investing, company fundamentals are one of the best things to look at when deciding what to buy and what not to buy.
This is because no matter how delusional a market seems now, eventually people will wake up to a certain company's underlying operations and position. This revelation will generate the appropriate supply and demand for the stock, and all will be normalized.
Only Invest in What You Understand
Generally speaking, it's wise to only invest in what you understand. If not, then only invest what you're willing to lose.
Some good questions to ask yourself might be:
- How does this company make money?
- Does this company have an advantage over its competitors?
- Is the company's industry growing?
- How sustainable is the company (can it sustain a pandemic or worse)?
- Who runs the company and do I trust them?
If you're satisfied with the answers to those questions, then the company you're looking at might be a good pick for the long-term. If not, try elsewhere.
Why do stock prices change? Simple. Supply and demand. The more people want a stock, the higher the price will go. The fewer people want a stock, the lower the price will go. The tricky part is to pinpoint exactly how much supply and demand there is. There are a few things that have historically proven to impact a stock's price:
- Memes (now a historical factor)
If you're investing for the short term, you'll want to rely on short-term events that could drive a stock's price up or down. On the contrary, if you're holding for a long time, you'll want to make sure that the company's fundamentals are sound and that you believe in it. Happy investing 🙂
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Jeff is a current Harvard student and author of the blog Financial Pupil who is passionate about learning, living, and sharing all things personal finance-related. He has experience working in the financial industry and enjoys the pursuit of financial freedom. Outside of blogging, he loves to cook, read, and golf in his spare time.