Economics is a murky topic for many people, but it is really a very simple subject.
Nearly every economic situation can be distilled down to one simple concept – supply and demand.
Or, offer and bid
Or, perceived value verses actual value.
Related to this general template are the price movements of our stock market.
Or any stock market.
You may have heard the the goal in making investments is to buy low and sell high.
Another simple maxim of economics.
But to many (most?) the rise and fall of stock prices is without logic.
Even to many who have some understanding of economics.
I am here to help.
Rather than think of the entire stock market and the millions of transactions that take place every minute or hour of each business day, imagine the behavior of just one share of stock of just one company.
A company has issued this one share of stock in the hope that someone will buy it.
When someone buys this share of stock they, in essence, loan to the company the price of that share of stock for some period of time.
The period of time is determined by the buyer.
It may be a short time – sometimes as short as a few hours, or a long time – years, or decades.
The company, for its part, will use the money received by the sale of this share of stock to invest in the operation of the company.
The hope is that, when invested wisely, this money will help the company grow and become more profitable.
When the company becomes more profitable the value of that share of stock will increase.
When the value of that share of stock increases, the owner may be enticed to sell his share of stock and make a profit from the sale (vs the amount he paid for it).
If the owner of this share of stock DOES sell it, the company can sell it again to someone else.
But since this share of stock is now worth more, the next person who buys it will pay a higher price than the first person who bought it.
Thus, the person who buys this share of stock, will, in effect, be loaning more money to the company than the previous purchaser.
Now, back away from this simple example and take a larger view of the stock market.
Think of it just like a supermarket.
A supermarket sells many kinds of food, fruit, vegetables, soup, meat, milk, etc.
In the same way, the stock market sells stock of many kinds of companies.
The shoppers in the stock market are called investors.
There are two types of investors – long-term and short-term.
Long-term investors buy stocks and hold them for months or years.
Short-term investors buy stocks and only hold them for a few hours or days or weeks.
So why does the average price of stocks go up or down?
Two reasons – investors believe that the price of stocks will go up in the future (near or far term), or they will go down (near or far term)
Remember buy low sell high.
Lets assume you have some money and you want to invest it somewhere where it will grow at a faster rate than a regular savings account in a bank.
You look at the general market situation and decide that stocks will likely increase in value in the next year.
You do not know how much but you think they will go up.
So you buy as many stocks as you can afford.
But you are not the only person who views the general economy this way and you are not the only person buying stock for this reason.
As you and others buy up shares of stock, fewer shares of stock remain for purchase.
The fewer shares left to buy the more valuable they become.
So the price for each share goes up.
Supply vs demand.
Lets say you want one share of stock of company A.
And lets say a guy next to you wants that same share of stock of company A.
You offer one dollar to the agent selling the share of stock.
You offer this much because you believe that this share of stock will be worth more than this in a year or so (your investment time window).
The guy next to you offers a dollar and ten cents for this share of stock.
Now you have to decide if you believe that that share of stock will be worth more than a dollar and ten cents in a year or so, or not.
If you believe that it will, then you offer a dollar and twenty cents for the share of stock.
If you do not believe that the value of this share of stock will be worth more than a dollar and twenty cents in a year or so, then you let the other guy have the share of stock.
This is how the price of shares of stock go up.
They are bid up by buyers (investors) competing with each other in the market.
The reverse is also true.
Lets say you already own a share of stock of company A.
But you believe that the future market conditions are such that company A will not be able to sell as many of its products next year as it did last year.
This will cause the value of your share of stock in company A to go down.
Rather than hang on to your share of stock in company A until the market improves, you decide to sell it.
But there are other people who hold a share of stock from company A and they want to sell their shares also.
They are standing in line behind you.
You offer to sell your share of stock in company A to the agent in the stock market for a dollar.
But the agent has already bought back other shares of stock in company A and finds that he cannot re-sell them for a dollar.
So he offers to buy your share of stock in company A for 90 cents.
The offer is good for only one minute.
You see the value of your share of stock in company A dropping as you stand there thinking about his offer.
You decide it is better to sell now at this price than to wait longer and have to sell your share in company A for even less.
You make the sale and as you are walking away you overhear the agent offer 80 cents to the guy who was in line behind you.
There are two reasons why you would want to buy or sell stocks at any given time – you believe the price will go up or it will go down in the future, or other buyers and sellers believe so.
There are two reasons why the price of a stock will go up or down.
Either market conditions are such that the business of a company will do better or worse, or, OTHER STOCK BUYERS believe that the value of a share of stock will go up or down.
Even if YOU do not believe that the value of the stock shares of a particular company will go up or down, if other buyers and sellers think so, the price of shares of stock will move according to what they do.
So if other buyers bid up the price of a share of stock, your share of that same stock will increase in value, too.
If they sell their shares of stock, bidding the price of the stock down, your shares of that stock will go down with them.
Thus, sometimes you buy simply because others are buying and sell only because others are selling.
Many short-term investors like to buy and sell shares of stock “on the margin”.
Basically, they study the price movements of the shares of stock of certain companies or industries.
They know from experience that certain shares increase or decrease in value by a certain percentage then they stop moving that direction and reverse.
So, for example, the price of a share of stock in company X tends to go up 15 percent over three months, then it stops and starts to go down.
So you buy a share of stock in company X when it is low and hold it until it gains about 14 percent, then you sell it and take your profit.
I does not matter if the stock goes up a couple more percentage points after that, you have made your “safe” money on this cycle.
You may invest your money in another stock that is in an increasing cycle while you wait for the value of the stock of company X to drop back to its expected low point.
When the value of the stock of company X hits its expected low point you buy some more shares and ride its value back up to its expected high point again.
Then you sell it again.
And so on.
Remember – supply and demand.
Price always follows demand.
When there is less demand than supply, the price drops.
When there is more demand than supply, the price rises.