Investing in stocks can seem like a crazy rollercoaster ride, but there's a logic behind it all. Veteran investor Vikram Sachatheva explains it to us in plain and simple English.
Like all markets, the price of stocks is driven by supply and demand. If more people want to buy a stock (demand) vs selling it (supply), the price moves up. If more people want to sell, the price goes down.
The demand and supply for stocks are influenced by different factors and can be divided into movement in the short-term vs long-term.
How stocks work in the SHORT-term
By short-term here we mean a period ranging anywhere from 1 minute to 3 months. Over this short-term period, the supply and demand of stocks are essentially driven by the mood of investors in the market.
For example, there might be a large shareholder who wants to sell their shares as they need cash to buy a new home, leading to an increase in supply and therefore, a fall in the share price. More recent real-world examples include negative Donald Trump tweets leading to a fall in share prices, and companies announcing their entry into the cryptocurrency space seeing a large jump in their share price.
The mood of investors can also be influenced by chart patterns in the short-term. A chart for Netflix might show a sell signal for tomorrow, resulting in an increase in sell orders, pushing down the price of Netflix’s stock.
Protip: Look for patterns
How does one profit from short-term movements in stock prices? Clearly, there are some things that are just unpredictable – a Donald Trump tweet for example. But, in the short-term, it is possible to trade profitably around upcoming events and chart patterns.
For example, we bought Apple’s stock in August 2017, expecting them to announce an exciting new phone for their 10th anniversary, pushing up their stock price, which occurred when the iPhone X was revealed.
However, the many different factors that can influence stock prices over the short-term means that its incredibly difficult to determine the day-to-day or even month-to-month movement of stock prices.
How stocks work in the LONG-term
As stated in my earlier article, as a shareholder in a company, you are considered a part-owner and are entitled to receive dividends and vote on the direction of the future of the company at shareholder meetings.
As a shareholder, you are effectively participating in the success or failure of the business. Because of this relationship, over the long-term, the price of stocks is almost always determined by the earnings generated by the specific company.
The graph above clearly shows that Google’s stock has moved in line with its earnings over the last 18 years. Also evident is that there are short-term periods where its earnings and share price don’t move together due to the short-term factors discussed above.
As investors, it’s our job to evaluate the company’s management team, products, industry and financials to figure out whether the company can grow over the long-term.
While it sounds simple in theory, it’s much more complicated in practice. The future is uncertain and there are many different methods for evaluating the strength of a company’s management team, product or financials.
However, as discussed in my previous article and as can be seen by Google’s graph above, the rewards of correctly evaluating a company’s long-term strength is enormous.
We hope that this article helped you have a better understanding of how stocks work!
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