Why share prices fluctuate?

Answer 1

Equilibrium stock price fluctuations This particular stock theory explains how the stock price of a large, publicly held corporation is determined in times without changes in corporate control and without speculation. The central idea is that the stock price is determined by some weighted average of investment acts from investors applying informational diversified investment strategies. The dynamics behind the price fluctuation is as follows: The higher the share of uninformed investors, the more uncertain the market price is relative to the fundamental stock value. This compares to larger fluctuations around this fundamental value and/or more frequent fluctuations. The picture is reversed when the share of informed investors increase and/or this share become better informed. In the exhibition the fluctuations are smooth. However, this needs not be the case. The fluctuation may be much more irregular. One should remember that the advantage of being an informed investor is to be more able to buy cheap and sell expensive because they have a better idea about the fundamental value of the stock. It should be obvious that this advantage increases the more the actual stock price fluctuates around the fundamental stock value. Altogether, this suggests that there exist an equilibrium stock price associated with a particular level of fluctuations around the true stock value. The text below explains that this equilibrium level of price fluctuations is restored if it is disrupted for some reason. Two cases must be considered; one with excessive fluctuation and one with understated fluctuation. Disequilibrium (excessive) stock price fluctuations Imagine that the market price for some reason begins to fluctuate more than its equilibrium level. This is illustrated in the exhibition by the large swings. This implies that the informed investors start earning abnormally high returns on their investments because the average benefits from being informed increases and the average cost of being informed remains the same. Furthermore, the uninformed investors bear the full burden of the higher risk following higher degrees of fluctuations, and they face lower mean returns because the higher returns the informed investors are making have to come from lower returns made by the uninformed investors. The higher risk does not hit the informed investors equally hard because they are more able to buy when the price is low and sell when it is high. They are therefore able to avoid some of the negative risk while maintaining most of the positive risk. Therefore as time passes, some investors discover that it pays to pursue informed investment strategies and the share of informed investors starts to increase. This mechanism restores the equilibrium fluctuation level. Disequilibrium (understated) stock price fluctuationsConsider the situation where the market price starts to fluctuate less than the equilibrium level. This situation is illustrated by the small waves in the exhibition. In this case, the benefit from being an informed investor fall but the cost remains the same so that informed investors begin to earn abnormally low profits. At the same time the uninformed investors benefit from the reduced risk that follows less fluctuations. This benefit is larger than the benefit that accrues to informed investors because the latter already has an advantage in handling risk (see above). The result is that the share of uninformed investors begins to rise at the expense of informed investors, and this process restores the equilibrium level of price fluctuations.

Answer 2

Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.

Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies.

That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don't equate a company's value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at $100 per share and has 1 million shares outstanding has a lesser value than a company that trades at $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250 million). To further complicate things, the price of a stock doesn't only reflect a company's current value, it also reflects the growth that investors expect in the future.

The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Wall Street watches with rabid attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company's results surprise (are better than expected), the price jumps up. If a company's results disappoint (are worse than expected), then the price will fall.

Of course, it's not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if this were the case! During the dotcom bubble, for example, dozens of internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the price/earnings ratio, while others are extremely complicated and obscure with names like Chaikin oscillator or moving average convergence divergence.

So, why do stock prices change? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price extremely rapidly.

The important things to grasp about this subject are the following:

1. At the most fundamental level, supply and demand in the market determines stock price.

2. Price times the number of shares outstanding (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless.

3. Theoretically, earnings are what affect investors' valuation of a company, but there are other indicators that investors use to predict stock price. Remember, it is investors' sentiments, attitudes and expectations that ultimately affect stock prices.

4. There are many theories that try to explain the way stock prices move the way they do. Unfortunately, there is no one theory that can explain everything.