We often hear the term "markets" used in economics and finance, but what are they? Markets are simply a place where people exchange one thing for another. These exchanges can be for anything, between anyone, and happen anywhere. All of the buyers and sellers make up the market. Long ago, we were trading spices for fur. Today, the stock market is where investors trade ownership in companies for money.
How do markets work?
The question used to be, "how many jars of our spices do we trade for a pelt of fur?"
In the stock market, we ask how the price of a particular stock is determined. How many dollars do we trade for a share? Here, our answer depends on:
- Supply - How many shares are investors willing to sell
- Demand - How many shares are investors willing to buy
The supply and demand for ownership in a company are the dynamic forces that determine the market price of a stock.
When the supply of a given good or service increases, the resource becomes less scarce. The market responds by decreasing the price to sell the excess amount. We see this happen at gas stations when oil-producing countries ramp up production.
More oil leads to lower prices for us at the pump.
In the stock market, companies create the initial supply of stock by selling shares to investors, leading to the secondary markets where we trade. To change the supply of shares, companies can perform certain corporate actions. Stock splits will increase the supply of shares and reverse stock splits will reduce it.
While supply can be manipulated, nothing matters if there's no demand.
Intuitively, we are willing to pay more if we really want something, and we'll pay less if we don't want it as much.
The same is true with how we view investments like stocks. If we really want to own a share of Apple stock then we're willing to pay more for it. Therefore, the price of a product or investment will increase if there is greater demand for it. On the other hand, the price will decrease if the demand for it falls.
The price is right
In the stock market, investors who are willing to sell their shares of Apple stock make up the supply for Apple stock. New or existing investors who want to own more shares of Apple become the demand for Apple stock. In one way or another, each seller has a price they would be willing to sell or buy shares of Apple stock.
The prices at which we decide to buy and sell vary for each individual investor and it's true for our everyday life. Is there something a friend or family paid full price for that we would only consider buying if it went on sale?
Price vs. Value
Price is what we pay for something, while value is what we believe it's worth. Value is more subjective, guided by individual tastes, preferences, beliefs, and circumstances. It's more along the lines of what we think the price should be.
When investing, we could figure out what we think a stock is worth by using all kinds of impressively complicated models that include tons of characteristics and predictions about the company. At the same time, another investor will do something else, see things another way, and come up with a completely different value.
While subtle, this distinction is what drives the market dynamics of supply and demand that cause prices to change. We experience this difference when we decide something is "overpriced" and decide not to purchase it. At this point, we believe its value is less than its price so "it isn't worth it." However, if the price falls and we choose to buy it, we decided that its value is now the same or higher than its new price.
Creating a market
A transaction occurs when the price someone is willing to sell matches the price someone is willing to buy.
The headline stock price we usually see quoted by the markets or our brokers is the price the last transaction occurred.
Increasing market price:
- More investors in the market wanting to buy Apple stock, an increase in demand
- The new investors outbid each other for available shares, pushing up the market price
Decreasing market price:
- More investors in the market wanting to sell Apple stock, an increase in supply
- The sellers undercut each other to offload shares, pushing down the market price
Whichever method you decide to use for deciding whether to buy an investment, be wary of the impulsive side of human nature that plays a role in supply and demand dynamics.
Fads are a form of emotional trading that causes demand to rise and prices to skyrocket, which are followed by selloffs and collapses in demand. These bubbles have happened throughout history including the dot-com bubble in the early 2000s, as well as meme stocks (GME and AMC) and meme cryptocurrencies (Dogecoin and Shiba Inu coin) more recently. Avoid getting caught up in bubbles by comparing what you think it's worth to the market price.