Lesson 2

How the Stock Market Works

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.

As you can imagine, numbers are key when it comes to stock market movements, which could be anything from profitability, unemployment statistics or consumption.

With that said qualitative information can also be important, such as employee satisfaction, the quality of the relationships with business partnership or customer satisfaction.

Short term stock market movements are typically driven by speculation, mostly though the fear or excitement of what possibly could happen. Speculative information is not factual and is spread through gossip or rumours.

Significant market movements, on the other hand, are more so driven by facts i.e. increasing sales figures.

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

Country-specific information

Information that relates to a country can have a big impact upon stock market returns. It can sometimes be the case that country-specific information affects every stock in a stock market, though it’s not always the case as we will explore later.

Country-specific information is mostly related to the wider economy. Examples include GDP, unemployment figures, trade deals, interest rates, tax rates or inflation.

A key example would be the UK’s decision to leave the European Union back in June 2016, which had an immediate impact upon the stock market.

At that time the stock market in London decreased by around 20%. The reason that this happened is that the UK’s economy became vulnerable to uncertain trading conditions that could have a significant impact upon the economy.

Even if WTO terms are implemented under a no-deal situation, the UK economy would shrink by at least 20% (or more) to compensate for increased costs of trade.

For that reason, the stock market initially dropped sharply. A few months later, the stock market in London recovered as nothing had changed officially.

As for what will happen next, it is uncertain and the stock market continues to move upwards and downwards in response to speculative investor sentiment.

Nonetheless, it gives you some idea about how country-specific factors can affect a stock market.

Sector-specific information

Sector-specific information is information that can affect every stock in a particular sector.

Examples include changes to the law, tax incentives, changing consumer demand or changes in the economic cycle.

A key example would be when American president, Donald Trump, announced that he would force pharmaceutical companies to charge less for their medicines.

Donald Trump enacted his intention through an executive order back in June 2020 and several companies operating in the pharmaceutical industry dropped significantly in response.

American giant, Pfizer, for example, decreased by around 15% between June 2020 and November 2020.

This provides some insight into how sector-specific information can impact upon the stock prices of a particular sector.

Company-specific information

Information that specifically relates to a particular company is arguable the easiest information-type to understand.

If a company announces record profits, the stock prices usually goes up. If a company announces a new, exiting product range, the stock will likely go up.

Any information that relates to the economics of a business can affect it’s stock price.

Company-specific information only affects one company, there’s not necessarily any correlation between the activities of that company and the activities of similar companies in the same sector or stock market.

A more obvious example is when things go wrong. When a company goes bust, this is often associated with just that company and not other companies.

It could be the case that the company has been mismanaged or that the company has failed to be innovative enough to maintain market share.

An example in the UK would be a company called Sirius Minerals, who were recently acquired by Anglo American after failing to secure funding to carry on with their project.