“One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.” — William Feather
Stock prices can seem to rise and fall at random, but there’s a method to the madness. Sort of.
When a privately-held company first decides to take its stock public, it goes through a process to determine a price for its initial public offering (IPO). Typically, the company asks an investment bank or group of banks to evaluate the company based on its financial health, earnings prospects, comparable value to current stocks in similar industries, and estimated demand. A finite number of shares are issued at a set price. After the SEC gives its approval, trading can begin. Once the stock begins trading publicly, market forces take over. In general, supply and demand determines whether the price of an individual stock goes up or down.
If more people want to buy the stock, the price of the stock goes up, because a limited amount of shares are available. The reverse is also true. Generally, an important factor in a stock’s price is the long-term earning potential of the company, including the growth rate of any dividends. Companies expected to earn large profits in the future are attractive; their prices rise because lots of people want to own these stocks. Companies with poor prospects are likely to be unloved by investors, and because few people want to own such stocks, their prices fall. But there’s more to it.
In reality, stock prices fluctuate based on multiple factors no analyst can consistently understand or predict. The overall economic outlook is one influencing factor, as well as the movement of interest rates. Rising interest rates tend to make stock prices go down, because higher rates are associated with slowing economic activity and lower corporate profits. Investors may then also be tempted to move out of stocks and into both Treasury and corporate bonds, since bonds then offer a comparable rate of return with lower volatility. When interest rates fall, stock prices tend to go up—money is cheaper to borrow and interest-bearing bonds become less attractive to investors.
Momentum can sometimes distort the relationship between stock earnings and prices. Rising prices attract more buyers, and increasing demand can drive even higher prices. Traders may add to the upward price movement by buying shares with the expectation that they will sell them in the future at even higher prices. When stock prices on the whole are rising, we call it a ‘bull’ market. The reverse, when large numbers of investors get nervous and start to sell their shares, driving prices down generally, is called a ‘bear’ market.
Most economic theories assume that people make rational decisions when investing. However, the study of behavioral finance has shown us that this is not always the case. Investors frequently make decisions to buy or sell a stock based on emotion, which may or may not turn out to be justified. In the short term, the relationship between a stock’s earnings and its price can make little sense. The future is unpredictable, and so is the direction of the stock market when taking a short-term perspective. Making investment decisions based on fear or greed usually result in selling a stock at its low or buying at its high—just the opposite of what we should do.
Instead of making investment decisions based on emotions or gut feelings, many investors decide in advance upon what criteria a stock must meet to guide buying or selling decisions, such as dividend yield and growth rate, price to earnings ratio, payout ratio, and length of time dividends have been paid. Using these kinds of rules can help investors avoid emotional investment decisions. Another option for taking emotions out of the investment process is to use a stock market investing service. One of the only services in the US that will custom build you a portfolio of individual stocks rather than funds created by a third-party is Emperor Investments.
To conclude, while the price of an individual stock can be difficult to predict, the good news is that the stock market as whole tends to go up over time. Making an investment plan and sticking to it is the best way to weather corrections and market volatility.
Martha Brown Menard, PhD, is a research scientist, financial coach, and dividend income investor. She takes a smart beta approach to building her own portfolio, and likes seeing her income stream grow.