What is the Stock Market?
The stock market is really just like any other market but instead of buying apples and bananas you can buy shares in businesses. Unlike apples and bananas whose price will only change slightly over time the price of stocks can vary considerably depending on how well they are performing. It is the price variation coupled with the fact that stocks do not have a ‘use-by date’ that means we can invest and potentially make money on the stock market.
If share prices rise then your stock holding is worth more than you paid for it and so when you sell it you will have made a profit. If value of the stocks drop then you would lose money if you sold them. This is a crucial point which I think many people do not quite understand. You only truly have a profit or loss when you cash in your investment.
Why Do Stock Prices Change?
There are many reasons why stock price fluctuate. The most obvious is that supply and demand will drive the price until a balanced position is reached. I.E. over supply would drive down the price until it attractive enough for more investors to buy, hence balancing the supply.
Reasons why people buy and sell are complicated and not always logical when viewing the market from a value perspective. For example, when a company receives bad news about its trading or some aspect of its business then people institutions will sell vast amounts of stock. This leads to oversupply of the stock and its price drops. At this point, other institutions see the price drop and panic sell their shares. This panic adds to the oversupply and the price drops further. If the company is fundamentally good there is no reason it can not revive and survive. Therefore, for the private investor, this panic period is a great time to pick up bargain shares. It may be very difficult to pick the bottom of the price drop before it starts to gain ground so don’t worry if the shares drop a little after you purchase them. There are lots of examples of these kinds of situations and I will give some examples in a future post.
Of course over the long term share prices are determined by how well companies are performing and how well they are expected to perform in the future. Therefore, we need to pick stock in companies with a good history and future prospects. The companies accounts should also be a fundamental factor in determining the overall value of the company and will be reflected in the share price.
Do stock Prices Matter
There are really only two points in time when the quoted share price matters; when you buy the stock and when you sell it. It is for this reason that it is crucial to buy at a good price; if you overpay for your shares then you will struggle to make a profit. Similarly you should not buy shares with a strict timescale for when to sell them. This has been a strategy used very successfully by Warren Buffet. If you need to sell your shares within a certain time frame then you will have to accept whatever price is available then. This price may not reflect the companies true value and may mean you lose out on profit or worse still are forced to take a loss. When the price for the share you own seems to fully value the company and you decide you want to cash in your profit then is the time to sell. However, if the company pays a healthy regular dividend you may never be bothered by the price of the shares unless it seemed so overvalued that you could achieve better returns elsewhere.
My advice is buy shares at a good price and then check the price occasionally. Do not be scared or excited by the short term fluctuations in price. Investing is a long term project so it is long term price rises and dividends which we want. More important than the share price is the true value of the company in terms of its assets and general business. I will cover this more later.