The stock price, the great mystery

In principle, getting rich by speculating on the stock market is quite simple. The only thing you have to do is what all good merchants do, namely: buy low and sell high.

Suppose we want to invest in stocks. The choice of stocks we can buy is enormous. At the London Stock Exchange alone we can buy and sell securities of nearly 2,500 different companies. On the New York Stock Exchange we can choose from more than 8,000 securities. And of course we can also invest on the stock exchanges of Frankfurt or Paris, Tokyo or Hong Kong.
So we really have a choice – and that’s exactly why things get complicated: Which stock should we buy?

Prices of traded stocks vary constantly. If we want to follow the simple principle of buying cheap and selling high, a multitude of simple and banal questions arises:

Which of all these shares is now cheap? And which is expensive? After the price of this particular stock has fallen for weeks running, will it continue to fall? In other words: Will this stock that seems good value today not be even cheaper tomorrow? So should we buy now? Or would we do better to wait? And now that the price of this stock has fallen so much, will it start to rise again soon? And now that the price of this other stock has risen for several weeks, will it continue to go up? Can we expect further price increases if we buy now, or is it already too late? …

Similar questions arise when we hold stocks and want to sell them.
Even if these questions seem relatively banal: The answers are not; quite the contrary. When searching for the right answer, you should never forget two basic principles.

Two basic principles always to keep in mind

1. On a Stock Exchange, the price of a share is established according to the law of supply and demand: If many investors want to buy a stock but only few investors are willing to sell, the price of the stock will go up, buyers being willing to pay a higher price to encourage the holders of the stocks to sell. Conversely, if many investors want to sell a stock that only few investors are willing to buy, its price will drop, sellers being willing to accept a lower price to encourage potential investors to buy.
2. Experienced investors do not take their decision to buy or sell a stock based on its past performance, but on the basis of their opinion about how its price will evolve in the future.

These views diverge, thankfully. To make an institution such as a stock exchange work, it is even crucial that there are diametrically opposed views. Indeed, every time a person buys a stock, there needs to be another one that sells. The person who buys necessarily believes the share price will go up, otherwise he or she would not buy. On the other hand, the person who sells necessarily believes the share price will go down, otherwise he or she would not sell (And both are convinced that they are right.)

This explains the old market saying: On Stock Exchanges, you don’t trade securities, you trade opinions.

Since a share represents ownership of a company, its price should reflect the value of the company. For this reason, financial institutions, asset managers and investment advisers have developed sophisticated techniques to analyze a company and its business model, the markets in which it operates, the development of its competitors, its ability to develop new products and services and to generate profits, etc. In a next step, they compare their estimation of the fair value of the company with its stock price and try to deduce whether the stock is cheap or not.

A stock price therefore largely depends on how investors assess the future development of the respective company.

Decisions to buy or sell on the stock exchange may therefore be due to very careful consideration, but they can also be completely irrational. This is the case, for example when you buy because “all the others” are buying, or if you sell because all the others are selling. This inspired a critic to say that the price of a stock has nothing to do with its value, but with the fear or greed of investors. (Like all stock exchange wisdoms this may not be entirely correct, but it is certainly not entirely wrong either.)

Whatever the motivation of the investor might be, any transaction on a stock exchange contains a more or less important element of speculation.