Last Updated on 17 November, 2020 by Samuelsson
The concept of stock investments is something that most people are familiar with. Bringing great profit potential for both short term traders and long term investors, they naturally attract a lot of attention. But why do stocks go up and down?
Stocks go up and down because of the fluctuations in supply and demand. If more investors want to buy a stock, that’s a sign of high demand which eventually drives the prices higher. Similarly, if more investors want to sell, that’s a sign of high supply, which drives prices lower.
So, what factors affect demand and supply and make stocks go up and down? Well, let’s first find out what a stock is!
What Is a Stock?
A stock is an investment in a company and every time you buy a stock you buy a share of a company. The stocks of a company are listed on an exchange, to raise capital in order to grow their business and increase their company’s value. Investors can buy and sell these stocks in their respective exchanges like ASX, NASDAQ, and NYSE.
Common Stocks and Preferred Stocks
There are mainly two types of stocks:
Common stock – Common stocks reflect the individual’s ownership in a company and an investor could claim on a portion of profits, which are called dividends. Investors get one vote per share to elect the board members, that can take part in the major decisions made by management.
Preferred stock – Preferred stock also reflects some degree of ownership in a company but investors do not have the same voting rights as the common stockholders have. However, preferred shares investors enjoy the privilege of getting a guaranteed fixed dividend before the common stockholders. This is different than with common stocks, where you receive variable dividends that are never guaranteed and are subject to the policy of the company. Even in the case of liquidation, preferred stockholders get priority over the common shareholders.
What Causes the Stock Market to “go up and down”.
Any price movement can be said to be the difference between what providers are supplying and what buyers are demanding.
If there are more buyers than sellers (more demand), buyers continue to bid better prices for the stocks to attract sellers to sell their stocks.
On the flip side, a larger number of sellers than buyers (more supply) causes the supply to become larger than the demand, which causes the price of the stock to go down.
Individually, the performance of the security instruments like stocks or bonds is also dependent on the performance of the issuing entity like corporate or government. The general perception among investors is that there is less risk if the product is issued by the Government. This is one of the reasons why bonds are usually more preferred by investors who are risk-averse.
Stocks are tagged with a certain amount of risk as there are several factors that contribute to their pricing. For instance, Tesla Inc (NASDAQ: TSLA) stock lost over 33.4% in the first half of 2019 due to several concerns like rising financial losses, slower production of Model 3, concerns over delisting and becoming a private company, and competition/threat from Amazon.
More Things That Impact the Price of Stocks
General factors that impact the demand for stocks are economic data, interest rates, and corporate results. Economic data reflects information about the state of the economy. If the economy is growing better than expected, it would drive demand for different things related to different industries and the stocks will grow in anticipation of better earnings. Companies’ profits, sales, margins, and outlooks also have a major impact on demand for individual shares.
Companies can decrease their own supply of shares through stock buybacks or delisting. Some ways to increase the supply are initial public offerings, spinoffs or issuing of new shares.
Other factors which make an impact on the pricing of stock are:
- Outrage, Wars, Trade wars, etc
- Concerns over inflation or deflation
- Government fiscal and monetary policy that affects interest rates
- Technological changes
- Natural disasters or extreme weather fluctuations like earthquakes, drought, flood, etc.
- Corporate or government performance data
- Lack of performance/ below par performance by the company
- Management issues
How Can You Profit From Trading Markets That “Go Up and Down”
Depending on what type of trading or investing you are into, you will go about differently to profit from markets that go up and down. In fact, all forms of trading are premised on the fact that markets move up and down. Here are the most common types of traders:
Swing traders hold on to their positions for a period of one day to a few weeks. The most common way of swing trading is to follow a trading strategy that most often is based on technical analysis alone, or supplemented with fundamental analysis.
Short Term or Intraday Traders – Daytraders
These traders use different methods like arbitrage opportunities to exploit price gaps caused by bid-ask spreads and order flows. Daytrading is also included in this category.
Position traders don’t trade very actively. Instead, they hold their positions for several months in order to catch the larger trends and swings in the markets. Position traders may use technical analysis as well as fundamental analysis when entering their positions and are generally not that concerned with minor corrections and pullbacks in the markets. Instead, they look to catch the larger swings in stocks or whatever security they are trading.
Long Term Investing
Long term investors hold their positions for several years, sometimes even for decades, and try to capture the long term upward drive of equities. Therefore, long term investors typically don’t care for bear markets or other types of market corrections.
Over the long term, common stocks, through capital growth, give greater returns than almost every other types of investment available. However, this higher return generally comes at a cost since common stocks investments hold quite a lot of risk. Moreover, if a company goes bankrupt and liquidates, the common shareholders will not get any money until the creditors, bondholders, and preferred shareholders are paid off.
For instance, Amazon.com, Inc. (NASDAQ: AMZN) stock which got listed in 1997, made many investors rich. Amazon stock got listed for $1.73 in 1997. In 2019 the stock was trading at over $ 1911.3. This is a growth of over 110380% since 1997 or a CAGR of over 38%.
Profiting From Economic Crises and Market Bubbles
A bubble occurs when prices are very high with weak fundamentals that cannot support such high evaluations. We recently saw a large economic crisis in the USA between 2007 and 2008. This led to a correction throughout the global markets. Subprime mortgages, inflated real estate prices, and overvalued assets led to a crash of indices and stocks during this period.
Below is the Dow Jones Industrial Average chart with the highlighted dip during the economic crisis period:
Value-based long term investors see this as an entry opportunity as stocks are available at attractive prices. On the contrary, Investors need to note that their will always be a certain set of stocks who do not necessarily fall as much as others during bad times. These stocks are often referred to as “blue chips” and are known for being more stable with less volatility – both in good and bad times.
Warren Buffet and Long Term Growth
Warren Buffet, one of the world’s most popular value-based long term investor, believes in long term investing to reap returns from stock investments.
“Nobody buys a farm based on whether they think it’s going to rain next year. They buy it because they think it’s a good investment over 10 or 20 years.”
– Warren Buffett
Similarly, investors need to evaluate the company’s potential, management ethics, as well as industry dynamics before they make a decision to buy or sell a stock.
At the same time, picking a multi-bagger stock and knowing when to exit is a real challenge that needs time and experience to master.
If you enjoyed this article you might also like our other articles answering common questions traders have!