Wait… That’s How the Stock Market Actually Works?
7 minutes on how prices move, who decides, and how you’ll use this understanding to stop losing.
When I started investing, I had a genius instinct for picking the exact wrong stocks. Yes, I was a proud GE shareholder when their share price tanked by 50%, and I held on tightly to a biopharma company I knew nothing about as their price halved from $8 to $4… then halved again to $2. Now, it wasn’t all bad. Yes, I lost much of the $200 I had originally mustered up, but there were a couple positives to this skill I had developed.
First, I had no problems with the notoriously high short-term capital gains tax that hits Robinhood traders all too often. I would masterfully sell my ‘losers’ right before their rally and hold onto my ‘winners’ juuust long enough to see them fall back to my purchase price. Hah! Take that, government. No taxes!
I also received the healthy dose of market humility that many Robinhooders are only now experiencing with much higher stakes than my original $200 naiveté.
But the most important benefit of my modest (OK, godawful) foray into investing was that I became obsessed with learning how the market actually works. I took a 180° pivot from my pre-law studies and graduated three years later, summa cum laude and top of my class with a degree in finance and economics and experience in the management of a $2 million investment fund. It turns out the real levers of the stock market had been there all along, it just took some (obsessive) research to find them.
So now it’s time to share how stock prices actually change — and how you can use this information to stop picking losers. We’ll first look at IPOs to see how prices are initially set, then untangle price movement post-IPO and see how we can use this wisdom to stop picking ‘young AJ’ stocks and start earning respectable returns.
What’s an IPO, and Who Picks a Stock’s Price?
When Tesla makes a Model 3, they attach a sticker price at which that they’ll sell it to you or I. They try to find a price that matches the value and reliability of the car, and they’ll also do lots of research on what price potential buyers would be willing to actually pay.
The process isn’t actually all that different for stocks. When a company wants to sell shares of their company publicly for the first time, they’ll usually go through through a fancy and highly-regulated process called an initial public offering (IPO). They’ll partner with a big bank to help with the process, submit several filings to a governmental regulator called the SEC, and survey potential investors to see what they might be willing to pay. Right before the bank and the company sell their first shares, they lock in a ‘sticker price’ they think fairly represents the current and future cash-generating power of the company. Too high, and few investors will want to buy in. Too low, and the company misses out on cash. In a well-functioning financial ecosystem, companies will choose an IPO ‘sticker price’ that matches the true value of their present and future cash flows.
How Do Stock Prices Move Post-IPO?
So we bought the Model 3 car at the sticker price, but of course, after a few years, we can turn around and sell the car to someone else at some other price. Around this time, Tesla might announce that these cars are actually polluting explosion hazards. Shoot! There goes our chance of selling for a decent price. On the other hand, Elon Musk might conversely announce that our model is the most reliable car he’s ever built! Let’s sell now for a great price, or wait until even more good news comes out!
Just as our futuristic electric car will change in value, so too will stocks. Stocks actually do one better, and don’t require any one person (or Kelly Blue Book) to give the correct value. The genius of our stock market is that without any one pricing dictator, efficient markets will self-generate the true value of a stock.
What does this actually mean? Well, it means that when lots of smart investors and stock market analysts get together, basic market forces (remember supply and demand?) will find the right price today for present and future profits of a company. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. If more people want to sell a stock than buy it, the price falls. The equilibrium price is right where supply meets demand; where all investors for a given stock are satisfied.
But here we’ve stumbled upon a more difficult question: what makes investors like or dislike a stock? Well, sometimes they love the company’s product, sometimes it’s a great CEO, and other times investors are just plain guessing (like I was on GE). Stock analysts can pair these qualitative (value-based) factors with an arsenal of quantitative (numbers-based) formulas that take in company earnings and future growth and spit out a rough target dollar amount for the stock. You may have also heard of a technique called ratio analysis, where investors compare financial ratios too see how good of deal they think they can get for a company’s earnings. While no one investor is likely to perfectly value the stock, large pools of investors are remarkably good at finding the right price in the long run.
Sometimes, however, stock markets misbehave. Investors might gamble on a stock not because they think the company is worth it, but because they predict a ‘greater fool’ will buy the stock for an even higher price (the ‘greater fool’ game can lead to the often-discussed phenomenon of market bubbles, and eventually sharp corrections). This is why Benjamin Graham, often hailed as the father of value investing, said “[i]n the short-run, the market is a voting machine…but in the long-run, the market is a weighing machine.”
To recap: Stocks are initially set at what the company thinks is a fair IPO, or ‘sticker’ price. Once sold, the responsibility is then turned over to the hundreds of thousands of investors that either want to buy (demand) or sell (supply) until the stock reaches the equilibrium price. Markets are generally accepted to behave well, or efficiently, but can occasionally get out of whack when investors go hunting for ‘greater fools’ rather than buying or selling based on the true value of present and future cash-flows.
How to Stop Losing
So how can we know which way will a stock move? Here’s the kicker: we can’t know. The way the stock market works necessitates that no one, not even experts, can know. Investors can guess that certain news will cause make lots of investors want to buy (meaning higher demand and an increased price), but we have to remember that it’s just that: a guess. Renowned financier Michael Mauboussin explains that even the financial press (all hail The Journal) frequently provides erroneous explanations for past market movement with scant evidence of true causation. So if even financial experts can hardly explain past market performance, should we really believe that anyone can predict future market movement? No.
What we can do, however, is make a sound, statistically informed investment decision. Leading investment experts enthusiastically endorse index investing, buying a broad basket of stocks that track an index like the S&P 500 (see SWPPX, SPY, or VOO for solid starters). These are ETFs or Mutual Funds that have ultra-low fees (think less than 1/10 of 1%). Let’s look at the last decade. Investing $100 in an S&P 500 index funds in 2011 would be worth $359.73 in 2021, a return on investment of 259.73%, or 13.66% per year, even after the COVID crash. Not only does this beat choosing specific stocks ourselves (think my GE or biopharma blunder), but it also beats paying someone else to try to select winners (actively managed ETFs, even hedge funds). In his famous book ‘A Random Walk Down Wall Street’, Burton Malkeil concludes “[e]xperience conclusively shows that index-fund buyers are likely to obtain results exceeding those of the typical fund manager, whose large advisory fees and substantial portfolio turnover tend to reduce investment yields… The index fund is a sensible, serviceable method for obtaining the market’s rate of return with absolutely no effort and minimal expense.”
That doesn’t mean we can’t also play around with a few speculative investments here and there. Sure, take an industry that you love and put a few dollars on company you especially believe in. Have some fun trying to ‘outguess the market’, but let’s take some advice from stock market legends like Malkeil, Mauboussin, Greenblatt, Buffett, Graham, Fama, Greenspan, and more. For the majority of our stock market exposure, stick with low-cost index funds.
Interested in More? Worthwhile Reading:
(Amazon affiliate links attached, but check your public library first)
- A Random Walk Down Wall Street |Burton Malkeil
- More Than You Know | Michael Mauboussin
- You Can be a Stock Market Genius | Joel Greenblatt
I’d also highly recommend checking out first your public library audiobooks, then Amazon’s Audible Plus (awesome unlimited listens, but $7.95/month and limited selection), or Amazon’s Audible Premium Plus (unlimited listens and monthly tokens, but $14.95/month). Or, students grab 6 months of Prime, then sign up for a Premium Plus trial and get an extra free token.
In this story, I included my own stock market and finance opinions and advice. While these are always historically supported and fact-based, please check with a trusted finance expert before acting on this subject matter.
