Why does a stock go up or down?
AI's response in regular print | Beverly Hills, CFP®, Joe O'Boyle's in italics
“Why does a stock’s price go up or down and why does the stock price change every second/millisecond?”
A stock's price goes up when the demand (buyers) for the stock is greater than the supply (sellers), leading to higher bid prices.
Similarly, a stock's price goes down when the supply (sellers) exceeds demand (buyers), causing sellers to lower their ask prices to attract buyers.
A variety of factors such as company earnings, news about the company or its industry, or broader economic factors can influence the supply and demand dynamic and make a stock more or less attractive.
So, why does the stock price change every second or even millisecond? This is largely due to the way modern financial markets operate.
Continuous Trading: Stock markets are essentially continuous auction markets, where buyers and sellers constantly place orders to buy or sell. The stock price at any given moment reflects the highest price a buyer is willing to pay (the bid) and the lowest price a seller is willing to accept (the ask). As new orders come in, they can immediately affect the stock price by changing the highest bid or lowest ask price.
Bid: The bid price is the highest price that a buyer (the bidder) is willing to pay for a given stock.
Ask: The ask price is the lowest price that a seller (the asker) is willing to accept for a given stock.
When Bid Prices Rise: When there are more buyers than sellers, the buyers may compete against each other to get their orders filled, thereby raising their bid prices. This increased demand compared to supply drives the stock price up.
When Ask Prices Fall: Conversely, if there are more sellers than buyers, sellers may lower their asking prices to attract a buyer. This increased supply compared to demand can cause the stock price to fall.
A trade occurs when a bid price matches an ask price. The difference between the bid price and the ask price is known as the "bid-ask spread." In liquid markets with many buyers and sellers, the spread is typically small. For less liquid stocks, the spread can be larger, reflecting the increased risk of buying or selling those stocks.
This mechanism happens continuously during trading hours, leading to fluctuations in the stock price throughout the day. It's worth noting, however, that while this explains the mechanics of price changes, it doesn't account for the reasons behind changes in demand and supply, which can be influenced by a wide range of factors including corporate news, market sentiment, economic indicators, and more.
High-Frequency Trading: In recent years, high-frequency trading (HFT) has become more prevalent. HFT is a type of algorithmic trading characterized by high speeds, high turnover rates, and high order-to-trade ratios. These HFT algorithms are capable of making trades in fractions of a second, reacting to market data or placing new orders as soon as they detect an opportunity.
Market News and Data: News about a company or its industry, economic data, and even social media buzz can move the market quickly. Traders and their algorithms are constantly watching for this information and can react almost instantly.
Global Trading: Trading now takes place on a global scale, with buyers and sellers active in different time zones. This ensures that there are almost always active traders, which contributes to continuous price changes.
It’s important to understand that the fundamental value of a company doesn't change every second or millisecond, but the price of its stock changes due to the dynamic nature of financial markets and the continuous flow of orders and information. Consequently, from time to time, large dislocations in stock prices may create wonderful long-term opportunities for investors.
“Why does a stock go up day-to-day versus over the long term?
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” — Benjamin Graham
In the short-term, a stock's price can be influenced by many factors such as news events, market sentiment, and trading volumes. In other words, it's more about the popularity of the stock among investors, much like a voting machine. Benjamin Graham, the "father of value investing” and mentor to Warren Buffett, coined this analogy. In the short-term, the stock market behaves like a voting machine, tallying up which firms are popular and unpopular.
But in the long-term, a stock's price is primarily driven by the company's earnings and profitability – or the fundamental health of the business. So, over time, the stock market works more like a weighing machine, assessing the substance of a company.
To illustrate, let's take an example: Suppose a company announces an exciting new product. The stock price might spike up in the short term due to increased demand driven by the positive news. This is the market acting like a "voting machine," where investors' enthusiasm about the new product drives up the price.
Over the long term, however, what matters is whether the new product actually translates into increased earnings for the company. If the product is a hit and significantly boosts the company's profits, then the stock price may stay elevated or increase further – this is the market acting as a "weighing machine," reflecting the company's improved financial performance.
The difference is that short-term price movements are often influenced by investor sentiment and can be more volatile, while long-term price movements are more tied to a company's fundamental financial health. This is why many investment professionals advise a long-term perspective when investing in stocks.
According to legendary investor, Peter Lynch, “There are reasons for stocks to go up. It’s a magic number, easy to remember. Coca-Cola is earning 30 times per share what they earned 32 years ago. The stock has gone up thirtyfold. Bethlehem Steel is earning less than they did 30 years ago. The stock is half its price of 30 years ago. Stocks are not lottery tickets. There’s a company behind every stock. If a company does well, the stock does well. It’s not that complicated.”
“How can Benjamin Graham’s idea of “Mr. Market” help investors to better understand the stock market?”
Benjamin Graham introduced the allegory of "Mr. Market" to explain the mood swings of the stock market in his book, "The Intelligent Investor”.
“Mr. Market” is an imaginary investor who is driven by panic, euphoria, and apathy on any given day, without regard to fundamentals. Each day, Mr. Market offers to buy your shares or sell you his shares of stock at a specific price. His prices are determined by his mood rather than the inherent value of the shares of stock. If he is euphoric, his offer price is high, but when he is panicked, he wants to sell at a low price. The key point is that you as an investor are free to either agree with his quoted price and trade with him or ignore him completely. Mr. Market is always there when you want to trade.
To provide an example, consider a company whose shares are trading on the stock market. Let's call it “Company X”. After thorough analysis, you, as an investor, determine that the fair value of Company X is $50 per share based on its earnings, assets, and growth prospects.
One day, Mr. Market, in a state of panic due to some short-term negative news, offers to sell Company X's shares at $30 each. According to Graham's philosophy, this is a great opportunity. Since you've done your homework and believe the fair value of the shares to be $50, you can choose to buy from Mr. Market at his depressed price of $30, confident that over time, the price is likely to move toward its fair value.
Conversely, if Mr. Market becomes overly optimistic and offers to buy your shares of Company X for $70 each, much more than you believe they're worth, you might choose to sell.
The key takeaway from Graham's Mr. Market allegory is not to be swayed by market price fluctuations and to always base decisions on thorough analysis of a company's fundamentals such as a company's earnings, assets, and dividends. This way, investors can take advantage of Mr. Market's mood swings rather than falling prey to them.
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About OpenAI’s ChatGPT tool:
GPT (short for "Generative Pre-training Transformer") is a type of language model developed by OpenAI that is trained to generate human-like text. ChatGPT is specifically designed for generating text in a conversational style. It is a machine learning model and has been trained on large datasets of real-world conversations in order to learn the patterns and styles of human communication.
Joe O'Boyle is the founder and principal of O'Boyle Wealth Management, a full service financial planning and investment management firm, located in Beverly Hills, California. Joe O’Boyle was named to InvestmentNews 40 under 40 class of 2016, and has a catalog of financial planning and investing articles on Money.com & U.S. News. Disclosure information.