What Causes Stock Prices to Change
Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall. Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies. That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don’t equate a company’s value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding.
To further complicate things, the price of a stock doesn’t only reflect a company’s current value, it also reflects the growth that investors expect in the future. The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn’t going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Market Analysts watch with rabid attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company’s results surprise (are better than expected), the price jumps up. If a company’s results disappoint (are worse than expected), then the price will fall. Currently its reporting season on the ZSE and prices have dipped slightly because of some disappointing results from the listed counters.
Of course, it’s not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if this were the case! During the early 2000s in Zimbabwe banking counters where highly favoured and sought after. Consequently their prices moved significantly upward. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. divergence.
From experience we know that investors may ‘temporarily’ move financial prices away from their long term aggregate price ‘trends’. (Positive or up trends are referred to as bull markets; negative or down trends are referred to as bear markets) Over-reactions may occur—so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. Economists continue to debate whether financial markets are ‘generally’ efficient.
So, why do stock prices change?
The best answer is that nobody really knows for sure. Some believe that it isn’t possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price extremely rapidly. The important things to grasp about this subject are the following:
- At the most fundamental level, supply and demand in the market determines stock price.
- Price times the number of shares outstanding (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless.
- Theoretically, earnings are what affect investors’ valuation of a company, but there are other indicators that investors use to predict stock price. Remember, it is investors’ sentiments, attitudes and expectations that ultimately affect stock prices.
- There are many theories that try to explain the way stock prices move the way they do. Unfortunately, there is no one theory that can explain everything.
Sometimes the market seems to react irrationally to economic or financial news, even if that news is likely to have no real effect on the fundamental value of securities itself. But this may be more apparent than real, since often such news has been anticipated, and a counterreaction may occur if the news is better (or worse) than expected. Therefore, the stock market may be swayed in either direction by press releases, rumors, euphoria and mass panic; but generally only briefly, as more experienced investors quickly rally to take advantage of even the slightest, momentary hysteria.
Over the short-term, stocks and other securities can be battered or buoyed by any number of fast market-changing events, making the stock market behavior difficult to predict. Emotions can drive prices up and down, people are generally not as rational as they think, and the reasons for buying and selling are generally obscure. Behaviorists argue that investors often behave ‘irrationally’ when making investment decisions thereby incorrectly pricing securities, which causes market inefficiencies, which, in turn, are opportunities to make money.
The stock market, as with any other business, is quite unforgiving of amateurs sometimes. Inexperienced investors rarely get the assistance and support they need. The above discussion demonstrates that though the stock market is an excellent wealth creation tool, it is unpredictable and therefore sufficiently risky. It is therefore important to understand some fundamentals and to simulate before committing one’s money into the market.
Sources: Wikipedia.com and Investopedia.com