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Dear Dr. Dollar:

During the course of a single day, a stock can go up and down frequently. These changes supposedly reflect the changing demand for that stock (and its potential resale value) or changing expectations of a company’s profitability. But this seems too vague to me. How can these factors be so volatile? Who actually decides, or what is the mechanism for deciding, when a stock price should go up or down and by how much?
—Joseph Balszak, Muskegon, Michigan

This article is from the May/June 2002 issue of Dollars and Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org/archives/2002/0502dollar.html

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This article is from the May/June 2002 issue of Dollars & Sense magazine.

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Let’s start with your last question first—how are stock prices determined? Shares in most large established corporations are listed on organized exchanges like the New York or American Stock Exchanges. Shares in most smaller or newer firms are listed on the NASDAQ—an electronic system that tracks stock prices.

Every time a stock is sold, the 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. Organized exchanges like the New York Stock Exchange will occasionally suspend trading in a stock if the price is excessively volatile, if there is a severe mismatch between supply and demand (many people wanting to sell, no one wanting to buy) or if they suspect that insiders are deliberately manipulating a stock’s price. But in normal circumstances, there is no official arbiter of stock prices, no person or institution that “decides” a price. The market price of a stock is simply the price at which a willing buyer and seller agree to trade.

Why then do prices fluctuate so much? The vast bulk of stock trades are made by professional traders who buy and sell shares all day long, hoping to profit from small changes in share prices. Since these traders do not hold stocks over the long haul, they are not terribly interested in such long-term considerations as a company’s profitability or the value of its assets. Or rather, they are interested in such factors mostly 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 she will buy as well, hoping to sell when the price rises. If others believe the same thing, then the wave of buying pressure will, in fact, cause the price to rise.

Back in the 1930s, economist John Maynard Keynes compared the stock market to a contest then popular in British tabloids, in which contestants had to look at photos and choose the faces that other contestants would pick as the prettiest. Each contestant had to look for photos “likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.” Similarly, stock traders try to guess which stocks other traders will buy. The successful trader is the one who anticipates and outfoxes the market, buying before a stock’s price rises and selling before it falls.

Financial firms employ thousands of market strategists and technical analysts who spend hours poring over historical stock data, trying to divine the logic behind these price changes. If they could unlock the secret of stock prices, they could arm their traders with the ability to always buy low and sell high. So far, no one has found this particular holy grail. And so traders continue to guess and gamble and, in doing so, send prices gyrating.

For small investors, who do hold stock for the long term and will need to cash in their stocks at some point to finance their retirements, the volatility of the market can be a source of constant anxiety. Every time a share in, say, General Electric is traded, the new price is used to revalue all outstanding shares—just as the value of your home appreciates when the house down the block sells for more than a similar house sold last week. But the value of your home wouldn’t be so high if every house on your block were suddenly put up for sale. Similarly, if all ten billion outstanding shares of General Electric—or even a small fraction of them—were put up for sale, they wouldn’t fetch anywhere near the current market price. Small investors need to keep in mind that the gains and losses on their 401(k) statements are just hypothetical paper gains and losses. You won’t know the true value of your stocks until you actually try to sell them.

Ellen Frank teaches economics at Emmanuel College and is a member of the Dollars & Sense collective.

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