Why Do Stock Prices Fluctuate?
Understanding the Forces That Cause Stock Prices to Fluctuate
Ask anyone about the stock market and it's clear that almost everyone can agree on one thing: the prices of stock fluctuate frequently, increasing and decreasing in market quotation sometimes by shocking amounts in a single trading day. Why do stock prices fluctuate? Who or what is causing them? Those are great questions and most often asked by novice investors. To help you understand, I'm going to give you a basic overview of some of the forces that cause this volatility.
Some of this will be a bit of an oversimplification but by the time you're done reading it, you'll know a lot more than the general public about the way the stock market works and how stock prices are set.
First, realize that the secondary stock market (as opposed to the primary stock market in which companies issue stocks and bonds in exchange for cash) is an auction. That means there are buyers and sellers lining up on either side of a potential trade, one party wanting to sell its ownership, one party wanting to buy ownership. When the two agree upon a price, the trade is matched and that becomes the new market quotation. These buyers and sellers can be individuals, corporations, institutions, governments, or asset management companies that are managing money for private clients, mutual funds, index funds, or pension plans. In many cases, you won't have any idea who is on the other side of the trade.
Because the stock market functions like an auction, when there are more buyers than there are sellers, the price has to adapt or no trades are made. This tends to drive the price upwards, increasing the market quotation at which investors can sell their shares, enticing investors who had previously not been interested in selling to sell.
On the other hand, when sellers outnumber buyers, there is a rush to dump stock and whoever is willing to take the lowest bid sets the price resulting in a race-to-the-bottom. This can be a problem, particularly during periods like the collapse of 2007-2009 because firms such as Lehman Brothers were forced to dump anything and everything they could to try and raise cash, flooding the market with securities that were worth far more to a long-term buyer than the price at which Lehman was willing to sell.
There are a myriad of factors that can cause the relationship between buyers and sellers to change. In Investing Lesson 2: Why Stocks Become Overvalued or Undervalued, I broke out four such examples after introducing you to Wall Street and how it works.
- We talked about the struggle between investors and speculators.
- We talked about the commodity nature of stocks.
- We talked about how life can cause individuals to react and buy or sell shares based upon their specific situation at a specific time.
- We talked about temporary problems in the business that cause the stock to become unattractive to investors who either fear the pain will never end or who are unable to see through to the core economic engine and value it appropriately. I built upon this in an article called Acquiring Undervalued Stock for Your Portfolio by Buying on Bad News.
In some cases, stock prices fluctuate because a requisite percentage of money flows in the market at any given time aren't taking a long-term view of an enterprise. An illustration I used was the equity valuation assigned to renowned jeweler Tiffany & Company. The volatility of Tiffany's share price years ago when I originally wrote this article was entirely unwarranted by the long-term value of the firm. First, hedge funds pushed the price far beyond what any conservative buyer would want to pay and when it looked like the world might struggle for a bit, dumped it, driving it down below what the same conservative investors might want to pay. This volatility can cause the journey to be rough but that is the reason it is important to have a diversified portfolio and focus on the look-through earnings.
To learn more about this topic, read The Beginner's Guide to Investing in Stocks.