The stock market is driven by supply and demand. The number of shares of stock dictates the supply and the number of shares that investors want to buy dictates the demand. It's important to understand the for every share that is purchased, there is someone on the other end selling that share (or vice versa). The stock market is really just a big, automated superstore where everyone goes to buy and sell their stock. The main players in the stock market are the exchanges. Exchanges are where the sellers are matched with buyers to both facilitate trading and to help set the price of the shares. The primary exchanges are the Nasdaq, the New York Stock Exchange (NYSE), all of the ECNs (electronic communication networks) and a few other regional exchanges like the American Stock Exchange and the Pacific Stock Exchange. Years ago, all of the trading was done through the traditional exchanges (like the NYSE, American and Pacific Exchanges) but now almost all of the trading is done through the Nasdaq, which uses ECNs and thousands of other firms with access to the Nasdaq to facilitate trading.
The stock market is really just like any other marketplace - it facilitates the exchange of goods between interested parties and works to reduce distribution costs and set prices.
How stocks are valued.
Stocks have two types of valuations. One is a value created using some type of cash flow, sales or fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for a particular share of stock and by how much other investors are willing to sell a stock for (in other words, by supply and demand). Both of these values change over time as investors change the way they analyze stocks and as they become more or less confident in the future of stocks. Let me discuss both types of valuations.
First, the fundamental valuation. This is the valuation that people use to justify stock prices. The most common example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio. This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices.
The other way stocks are valued is based on supply and demand. The more people that want to buy the stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower the price will be. This form of valuation is very hard to understand or predict, and is often drives the short-term stock market trends.
It’s all about risk and return, and because your money is at more risk in the stock market than if you park it in a savings or CD (by the way, the money you invest in a CD is probably reinvested by the company offering the CD), the potential return is higher. It’s true that the gyrations in the stock market can cause both large losses and large gains, but if your investment time horizon is long enough, these short-term fluctuations will result in relatively high returns. It is generally accepted, that the average long term return from investing in stocks is 10-12%. This is much higher than the average CD or savings rate of 4-6%.
Why the stock market gets out of whack with reality.
Over the long term, the stock market is driven by underlying economic, financial and global growth. But in the short run, the market is driven by simple greed and fear, which are dictated by human emotions. During periods of prosperity, the stock market often rises faster than underlying earnings. During tough economic times, political uncertainty, and low consumer confidence, the stock market often performs worse than the underlying fundamentals predict.
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