Why do share prices go up and down?

December 3, 2014

The stock market affects a huge number of us. Owning shares is not that common in the UK, in part (we suspect) down to the fact that people don’t really understand how the stock markets work. However, even if you don’t directly invest in shares, share prices may still affect you. If you have a pension, for example, it’s quite likely that at least part of your pot is invested in shares in the hope/expectation that it will grow. If share prices go up, the value of your investment increases. If the market’s not doing well, your pension won’t be worth as much.

Share prices can be big news. Just recently, the news was filled with pub share prices sliding and Royal Mail shares falling sharply. But what caused these price changes, and the hundreds of other fluctuations that occur on a daily basis?

What is a share and what is a stock market?

Back to basics for a moment…

The stock market is essentially a giant auction where ownership of companies is for sale in the form of shares. The idea of a share is that you share in the fortunes of the company. If things are going well, you benefit. If things aren’t going so well, your shares suffer alongside the business. That happens through the changing price of shares and the share of the profits that you get (through the dividend payment).

Every time a stock is sold, the stock exchange (e.g. the London Stock Exchange) records the price at which it changes hands. If, a few seconds or minutes later, another trade takes place, the price at which that trade is made becomes the new market price, and so on.

So what determines the share price?

At its most basic level, share prices are determined by supply and demand. Stock prices go up when more people want to buy than sell. People are willing to bid higher prices than the stock has currently been trading at. If more people want to sell than buy, share owners are willing to accept lower prices in order to sell quickly.

But what influences this demand?

There are three main factors:

1)     How well the business is doing: i.e. the profit a company makes. However, it’s not just current performance of the company, but how market analysts predict the business will perform in the future based on their earnings projection. If a company’s results are better than expected, share prices can jump up.

To give an example, an investor might buy shares in a company that has reported low profits because they expect business to improve. This can mean that even though the business appears to not be doing so well, share prices rise. Assuming the business does then improve, another investor might take a look and think that’s a successful business they want to invest in. But the market is again looking further ahead and not seeing such a bright future, so share prices fall and our investor finds that he’s bought at the top of the market and now faces a loss.

2)     How well the economy is doing: if the economy is growing, there will be more jobs, people have more to spend, businesses tend to do better giving investors confidence in the business performance, so demand for shares rise and share prices increase.

Seems quite straightforward so far, but the third main reason is what makes share price changes so tricky to read or predict:

3)     Investors’ and traders’ sentiments, attitudes and expectations: the vast bulk of stock trades are made by professional market participants, investors, market makers, and speculators.

Speculators, who buy and sell shares all day long hoping to profit from small changes in share prices, do not hold stocks over the long haul. They are not terribly interested in long-term considerations like a company’s profitability or the value of its assets. Or rather, they’re only interested in such factors insofar as news that would affect a company’s long-term prospects might cause other traders to buy the stock, causing its price to rise. If a trader believes that others will buy shares (in the expectation that prices will rise), then they will buy as well, hoping to sell when the price rises. If others believe the same thing, then the wave of buying pressure will cause the price to rise. These predictions can lead to counter-intuitive share price movements.

Investors are more interested in the longer term value of a company, and the dividend or return they receive on their investment.

Market makers are essentially stock holders who will make a price on a company and look to buy on the bid and then sell on the offer, much like Tesco buys wholesale and sells retail.

However, there are lots of other factors which can affect demand, for example:

  • If a business is doing well or has unique products, other businesses may look to buy them and the share price can move rapidly (for example, Pfizers bid for Astra Zenica earlier this year)
  • Many shares are held by insurance companies, pension schemes and investment companies. If one such owner decides to pull out of the shares in a particular company, the price can fall dramatically (look at the price moves in Tesco shares when Warren Buffett sold out of his holding)
  • News stories, for example new people being employed at the top of business, new products or services being introduced, good company reviews, competitor going out of business, buy-outs, good or bad PR, new legislation…

In the case of the pub companies mentioned above, share prices fell as it was announced that MPs had voted to break beer “ties” which force pub tenants to buy from their landlord at inflated prices. I won’t go into detail here, but this change has led to fears of job losses and pub closures. In the case of Royal Mail, the drop last week came as the firm announced that competition from rival parcel delivery firms were threatening future profits. This shows just how diverse the influences on stock prices can be.

And sometimes, there’s no fathomable reason whatsoever.

Is it possible to predict forthcoming share price changes?

Investors have developed hundreds of variables, indicators and strategies which they monitor to try and determine the best times to buy and sell. Some are very complicated and obscure (Chaikin Oscillator, anyone?).

However, because there are so many variables, it’s largely guesswork (some would argue educated guesswork). That’s why things can change so rapidly.

How to protect yourself if you invest in shares

Even if it is hard to fathom a reason for it, we do know that stocks can be volatile and sometimes prices do move really quickly. The successful trader is the one who anticipates and outfoxes the market, buying before a stock’s price rises and selling before it falls, but that can be very difficult to do. So here’s our advice on how you can protect yourself if you decide to invest in shares:

Be in it for the long haul – prices can go down as well as up. Over the long-term however, markets tend to reward robust, well-managed companies and their share prices rise.

Spread the risk – invest in different business sectors. If one suffers as a result of economic conditions, for example, hopefully another area will be benefitting so your overall investment remains safer.

Work with experts – because the stock markets are unpredictable and complicated, it pays to work with someone who can make wise decisions for you and who’s keeping a close eye on what’s happening so they can react quickly if needed.

Remember – gains and losses are only realised when you actually try to sell your shares.

 

The price and value of investments and their income fluctuates: you may get back less than the amount you invested. This article is for information purposes only and is not personal advice based on your circumstances. If you are in any doubt about investing in these types of investments, you should consult an independent financial adviser.

GreenSky Wealth Ltd is an appointed representative of Financial Limited which is authorised and regulated by the Financial Conduct Authority. FCA No: 516410