How the Stock Market Works

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Jon Rowe

Jon Rowe

Investment Advisor, Associate with the CISI

October 23rd 2020    5 min read

Whenever you hear about the stock market, you probably hear stories of people making lots of money in a short period of time or of people losing their lifesavings.

Those extreme stories are usually the catalyst for people to do one of two things: either to give it a go themselves to try to replicate any success stories or to actively avoid investing at all costs.

Regardless of your opinion, investing is increasingly becoming important due to low interest rates, which have made the savings of millions of people worth less and less as each year goes by.

The reason is obviously that inflation has been growing at a faster rate than interest rates, which means that people’s savings are going down in value.

One question that you may have wondered is, how on earth does this stock market thing work? This article will try to answer that question in a way that is as easy to understand as possible.

How does the stock market work?

The mechanics of the stock market are quite easy to understand. The prices go up and down based on supply and demand.

If lots and lots of people want to buy a stock, the price will go up and up. Likewise, if less and less people want to buy a stock, the price will go down and down.

If a stock doesn’t move much and looks more like a straight-line, it’s because there is a similar number of people that want to buy and sell.

For example, if 50 people want to sell $50,000 worth of stock and there are 50 buyers that want to buy $50,000 worth of the same stock, the price will stay the same.

Of course in real life this rarely happens. Even if there are an equal number of buys and sells, the stock price tends to change a little. 

What drives the demand for a stock?

Simply put, information is what typically drives the demand (or lack of demand) for a stock.

The information can be specific to that particular company, specific to a particular sector or more generalised to the whole market.

In terms of information that is specific to a company, an example would be when the stock price of a company goes up after the CEO announces record profits.

With regard to information that is related to a whole industry, an example would be when the stock price of all the companies in a whole sector go up after a law changes to benefit their business.

With reference to information that affects the whole market, an example would be when trade deals break down between the home country and a country that is a significant trading partner.

Despite all that, there is a phenomenon in the stock market called the ‘neglected stock effect’, which is when a stock price goes down because there is no new information. The stock is then neglected by investors.  

How do you know if it is a good time to buy or not?

Sometimes it can be difficult to know when it is a good time to buy or not because anything can happen and new new information can enter the market at any time.

It is absolutely possible to make money in the short term but most investors are not able to do this consistently.

Therefore, it is better to take a long term perspective and to try and buy stock at a reasonable valuation.

There are many ways to value a stock but the most common method is to use a ratio called the price-to-earnings ratio (P/E for short). 

This ration essentially compares the price that you pay for a stock with the earnings of a company. So if you buy a stock at $20 and the company makes $1 per share in earnings, the P/E ratio would be 20. You are essentially paying 20 times the earnings of the company.

A P/E ratio of 20 is consider to be a standard but it changes from one industry to another. For instance, it is considered normal to buy technology stocks at slightly higher P/E ratios because they have the ability to grow at faster rates.

You can easily find P/E ratios on Google, Yahoo finance or the Financial Times and it is an easy way to see if you should buy a stock or not.

Notice: The value of your investments can go down as well as up and you may get back less than you originally invested. This article does not represent personalised investment advice and past performance is not a guide to future performance, some investments need to be held for the long term. If in doubt, contact a local financial advisor for assistance.

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