I have often heard clients say “I don’t understand the stock market.” A simply answer is most people do understand the stock market, which includes many who think they do. The reality, the stock market is very simply and complex at the same time.
First of all, it is important to understand why individuals and institutions buy stock and invest in the stock market. The simple answer is build wealth for the future. In my estimation, it is the best means of participating in the growth of the US economy over time by owning shares of businesses or corporations in the US. Global investors own shares of business or corporations all over the world. Too often, average investors focus on short term declines in the stock market and forget about the long-term gains going back to the late 1920’s.
In understanding the stock market, let’s start with the simple part by breaking down the name, stock market.
Stock is simply a means of owning a business as a corporation. When a corporation is formed, it issues shares of stock. The number of shares initially issued is up to the corporation and can be increased or decreased in the future.
- Privately held stock is owned by one or more shareholders with the majority shareholder controlling the business and any buys or sells of the stock.
- Publicly held stock can be owned by a wide variety of entities. For example, an individual can own stock, as well as mutual funds, trusts, corporations, hedge funds etc. Each stock is traded on public exchanges.
Market is simply the various exchanges on which shares of publicly held stock is traded. In a real sense, it is similar to other markets or auctions.
- For example, most investors understand the real estate market. A house comes on the market at a listed price. However, the actual sales price of the house is dependent on a variety of factors including buyer’s estimation of the actual value of the house, demand for housing at that specific time, current economy of the community in which the house is located along with economic outlook. The sales price is often much different than the listed price.
- Note: The only time one knows the actual market value of the house or item on a market is when it is sold.
One reason the stock market can be difficult to understand is its sheer size and the volume on a daily basis. For example, the estimated total market value of the US stock market over $24 trillion. The daily volume of shares traded on can vary greatly depending on a variety of factors. For example, the first quarter of 2018, the average number of shares traded daily was over 137,000. Despite its size and volume, it is helpful to remember the stock market is simply a group, a very very large group of buyers and sellers exchanging property.
A second reason the stock market can be difficult to understand is the impact institutional investors have on both daily trading and long-term trends. Institutional investors include endowment funds, commercial banks, mutual funds, hedge funds, pension funds and insurance companies. The majority of trading on the various exchanges is done by institutions and they may and often do have different objectives than long term investors.
Institutional investors may use a variety of techniques to achieve investment objectives. These techniques can lead to substantial volatility, especially short-term, which can be both difficult and confusing for the average investor.
We will exam three of these techniques, but before so doing, let’s exam short-term. Short-term can be a nano-second. Using algorithms and state of the art computers, large institutions can buy or sell substantial numbers of shares in less than a second, and this takes place during market hours every day and can lead to substantial shifts in market values in a very short period of time. The good news for the “average investor” is if the average investor is not planning on buying or selling that day, month or year, as long as long-term fundamentals and outlook have not changed, all this day to day volatility can be ignored.
Again, following are brief summaries of three types of strategies that can affect the stock market overall or a specific holding in specific in a very-short period of time. After the summary, there is a little more detail on each of these strategies. If an investor wants more detail, simply Google each name and there will be articles on each.
- Momentum investing is a strategy which institutional investors, based primarily on technical analysis, decide if the trend of a stock or asset class is up or down. If up, they continue buying driving the stock or asset class up. On the other hand, if they believe the trend is down, they sell the stock or asset class and the price declines. There is research this strategy may enhance return, but it can lead individual investors to make poor decisions.
- Short sellers are another driver of the stock market, especially short-term. Short sellers are able to sell a stock [it also could be an exchanged traded fund ETF which tracks a particular index or asset class within the stock market] they actually do not own believing the stock will decline in price. The have to cover or buy the stock at some point. For example, let's say a stock is trading at $50 per share and for one reason or another short-sellers believe the company's prospects or overall asset class or index are declining. Short sellers will sell the stock or ETF tracking an index, which they actually do not own, with the objective of buying it back a later time or date at a lower price. When the short-seller actually buys the holding, it is called covering their short. When short-sellers begin selling a stock or ETF in large numbers, this can drive the holding down by itself, especially if other short-sellers join them, regardless of long-term fundamentals. A significant factor in the stock market decline in 2008 was due to short-sellers. It is important for the average investor to not make a panic or emotional decision based on short-sellers.
- Finally leverage or margin investors, especially hedge funds can accelerate a decline. Margin investors borrow money from the brokerage company against their investment account enabling the margin investor to buy more of a stock or standard ETF. If the stock or ETF goes up in price and the margin investor sells, the profit is greater. However, if the stock or ETF goes down in price, at a certain point, the margin investor has to either pay down on the loan or the brokerage company sells shares of the stock or ETF to pay down on the loan. If a stock or ETF is highly leveraged do margin investors and the stock market declines, margin investors who do not have cash have their stock or ETF shares sold which accelerates their decline. Keep in mind, institutional investors who are also margin investors can drive the stock market down very quickly do to margin calls. Once margin investors have paid off their margin or debt, the stock or ETF will often stop declining and begin to recover. Again, this may not be related to long term fundamentals and the average investor should not make an emotional or uninformed decisio
In summary, when trying to understand the stock market, keep in mind the following
- The stock market is simply a market where investors buying and/or selling stock of ownership of public companies.
- Large institutional investors drive the stock market on a short-term basis both up and down. Always remember the only time an individual investor makes or loses money, is at the time of sale. Sudden declines in the stock market can happen for a number of separate or related reasons which are often short-term. This should not cause the investor to make an emotional uninformed investment decision turning a paper or unrealized loss into a realized loss.
- Individual investors generally control three decisions, what they buy, when they buy it, and when they sell it. Letting large institutions influence when to sell do to emotion or lack of understanding is often a very poor decision.
- And again, the only time an investor actually makes or loses money is when the stock or ETF is sold. The rest of time, the current market value is only a reflection of the gain or loss “if” sold or liquidated at that time.