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The price is right

Lesson in Course: Market movements (beginner, 7min)

What does “the market” mean? Who decides what the price of something is?

Eureka!

What it's about: Prices for most things are determined by the markets made up of buyers and sellers.

Why it's important: Changes in the demand (buyers) and/or supply (sellers) move prices up and down.

Key takeaway: Price and value are not the same. Price is what everyone pays for something, while value is what we individually believe it's worth. 

We often hear the term "markets" used in economics and finance, but what are they? Markets are simply a place where people exchange one thing for another. These exchanges can be for anything, between anyone, and happen anywhere. All of the buyers and sellers make up the market. Long ago, we were trading spices for fur. Today, the stock market is where investors trade ownership in companies for money.

How do markets work?

The question used to be, "how many jars of our spices do we trade for a pelt of fur?" 

Markets are where goods or assets are bought and sold

In the stock market, we ask how the price of a particular stock is determined. How many dollars do we trade for a share? Here, our answer depends on:

  1. Supply - How many shares are investors willing to sell
  2. Demand - How many shares are investors willing to buy

The supply and demand for ownership in a company are the dynamic forces that determine the market price of a stock.

What is Supply?

How much of something everyone in a market is willing to sell or how much is available to buy

When the supply of a given good or service increases, the resource becomes less scarce. The market responds by decreasing the price to sell the excess amount. We see this happen at gas stations when oil-producing countries ramp up production. 

OPEC nations coordinate on production to keep prices stable

More oil leads to lower prices for us at the pump.

The dangers of a low supply and fake lip kits

If supply drops or isn't high enough to meet demand, scarcity causes the market to drive up prices. Otherwise, new sellers will enter the market and add supply if the price doesn't change. This is critically important for businesses we might want to invest in. 

Kylie Jenner's line of lip kits sold out in just one minute. Demand that massive is difficult to keep up with and her business couldn't make more fast enough. The lack of supply created an opportunity for other manufacturers to start selling fake Kylie Jenner products to consumers wanting to get their hands on sold-out products. 

High demand is great, but it's good to consider if the businesses we're invested in is capable of producing the supply to match. Our investment is missing out on potential profit and growth if the company is getting ripped off by scammers peddling counterfeits of our products. 

In the stock market, companies create the initial supply of stock by selling shares to investors, leading to the secondary markets where we trade. To change the supply of shares, companies can perform certain corporate actions. Stock splits will increase the supply of shares and reverse stock splits will reduce it.

What is Stock split?

When a company issues more shares of stock to its current shareholders by dividing existing shares into multiple shares.

What is Reverse stock split?

When a company reduces the number of shares of stock for its existing shareholders by consolidating existing shares into fewer shares.

 

While supply can be manipulated, nothing matters if there's no demand.

What is Demand?

How much of something everyone in a market is willing to buy

Intuitively, we are willing to pay more if we really want something, and we'll pay less if we don't want it as much. 

People vote with their wallets

The same is true with how we view investments like stocks. If we really want to own a share of Apple stock then we're willing to pay more for it. Therefore, the price of a product or investment will increase if there is greater demand for it. On the other hand, the price will decrease if the demand for it falls. 

 

The price is right

In the stock market, investors who are willing to sell their shares of Apple stock make up the supply for Apple stock. New or existing investors who want to own more shares of Apple become the demand for Apple stock. In one way or another, each seller has a price they would be willing to sell or buy shares of Apple stock. 

New entrants to the market change supply and demand

The prices at which we decide to buy and sell vary for each individual investor and it's true for our everyday life. Is there something a friend or family paid full price for that we would only consider buying if it went on sale?

Price vs. Value

Price is what we pay for something, while value is what we believe it's worth. Value is more subjective, guided by individual tastes, preferences, beliefs, and circumstances. It's more along the lines of what we think the price should be.

Certain assets have more value for the same price

When investing, we could figure out what we think a stock is worth by using all kinds of impressively complicated models that include tons of characteristics and predictions about the company. At the same time, another investor will do something else, see things another way, and come up with a completely different value.

While subtle, this distinction is what drives the market dynamics of supply and demand that cause prices to change. We experience this difference when we decide something is "overpriced" and decide not to purchase it. At this point, we believe its value is less than its price so "it isn't worth it." However, if the price falls and we choose to buy it, we decided that its value is now the same or higher than its new price.

Creating a market

A transaction occurs when the price someone is willing to sell matches the price someone is willing to buy. 

A market is made when the supply and demand agree on a price

The headline stock price we usually see quoted by the markets or our brokers is the price the last transaction occurred.

Increasing market price:

  1. More investors in the market wanting to buy Apple stock, an increase in demand
  2. The new investors outbid each other for available shares, pushing up the market price

Decreasing market price:

  1. More investors in the market wanting to sell Apple stock, an increase in supply
  2. The sellers undercut each other to offload shares, pushing down the market price

Actionable ideas

Whichever method you decide to use for deciding whether to buy an investment, be wary of the impulsive side of human nature that plays a role in supply and demand dynamics.

Fads are a form of emotional trading that causes demand to rise and prices to skyrocket, which are followed by selloffs and collapses in demand. These bubbles have happened throughout history including the dot-com bubble in the early 2000s, as well as meme stocks (GME and AMC) and meme cryptocurrencies (Dogecoin and Shiba Inu coin) more recently. Avoid getting caught up in bubbles by comparing what you think it's worth to the market price.

Supplementary materials

Check out this short video on the basics of supply and demand.
https://www.youtube.com/watch?v=720uyg0Dd_M&t=1s

Glossary

What is Supply?

How much of something everyone in a market is willing to sell or how much is available to buy

What is Stock split?

When a company issues more shares of stock to its current shareholders by dividing existing shares into multiple shares.

What is Reverse stock split?

When a company reduces the number of shares of stock for its existing shareholders by consolidating existing shares into fewer shares.

What is Demand?

How much of something everyone in a market is willing to buy