Some investors focus on owning stocks outright others use a diversified approach through index funds, ETFs, or mutual funds. Both deal with the daily swings in stock prices.
Whatever your flavor, price changes have a big impact on your returns. Understanding what affects stock price changes in the short-term can lead to higher long-term returns.
Supply And Demand
The basic answer to what affects stock price is supply and demand. For every stock transaction a buyer and seller gets together and agrees on a price. When there are more sellers than buyers, the price is pushed lower. Alternatively, when there are more buyers than sellers, the price moves higher.
Still, there are limits to both sides. Supply is limited by the number of outstanding shares. Even then, that supply is limited further by the number shareholders willing to sell. And demand is bound by the price buyers are no longer willing to pay.
All of it is influenced by a number of short and long-term factors that affect the price buyers will pay and sellers will part ways with their shares.
Short Term Factors
There are any number of short-term factors that can make a stock price swing faster than a failed lie detector test. The most common are:
- Rumors and News – world, national, economic, or corporate, basically any rumors or news that directly or indirectly affect the company
- Economic Climate – changes in the economy (interest rates, inflation, and policy) impact a company’s ability to earn money
- Risk Changes – both the changes in real risk and the perceived risk will move prices
- Analyst Outlook – some investors rely on analyst expectations and ratings which can change often
- Index Changes – when an index like the S&P 500 adds and removes a stock, index funds follow suit
- Taxes – changes in the tax code affect how people invest
- Buyer/Seller – through reaction, behavior, and emotion
While there are a number of possibilities, most short-term price changes are driven by rumors and news and how we react to both. Unfortunately, it’s these same factors that often get us in trouble. Our behavior all to often drives us to sell when the news seems worse than it really is or buy when it’s too good to be true.
It’s these same factors that present great investing opportunities. The trick is deciphering which will have a long-term impact and what is fluff.
Long Term Factors
Over time, those short-term price swings get smoothed out. News and market reaction become less important in the long run. Instead, long-term stock prices are driven by two main factors:
- Earnings – the company’s ability to earn money drives its long-term success or failure
- Growth – investors pay more for companies that grow earnings over time. The higher the growth rate, the more investors will pay.
After all that, it’s hardly an exact science. Price is a function of earnings and growth. Both are future estimates based on past results and far from guaranteed. This is why many investors put so much emphasis on dividends.
Dividends are just a proxy for earnings. Investors look kindly on companies that consistently pay a dividend as opposed to those that cut or cancel them. Plus, a long track record of increasing dividends is a good sign and helps stabilize the stock price.
While there are many short-term factors that affect stock prices, performance is the deciding factor.