Why Does the Stock Market Fluctuate?

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The Stock Market Is a Market

In the same way that there's a market for oil, housing, cars, iPods and smoothies, there is a market for investments. And in the same way that some people prefer a sports car over a compact or sedan, some people prefer certain investments over others. In other words, the stock market is a market much like other markets, except that a stock market deals in stock (also referred to as securities, as in the Securities and Exchange Commission, which monitors the stock market). These stocks are bought and sold in stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ.

Why Do Prices Fluctuate?

A market is a place where buyers and sellers come together for voluntary exchange, and price is determined by supply and demand. If more people would like to buy at a certain price than are willing to sell at that price, then buyers will buy out the stock and there will be a shortage. This gives sellers more incentive to produce, because it indicates to them that even if it costs them more, it's worth it. In this case, price rises, and equilibrium is restored.
The system works in the return direction, to reduce price, as well. If more people would like to sell at a certain price than would like to buy, there is a surplus. To reduce inventories, sellers lower the price and cut back on production, and buyers purchase the item at the new, lower price.

Stocks and Stock Characteristics

Practically speaking, investors are motivated to buy or sell stock based on changes in the expected return on the stock or in the risk level associated with a stock. Investors are constantly seeking the best investments, and the best investments are the ones that pay out the most (return) and aren't likely to go bad (risk).
However, no investor knows what's going to happen, and all investors are different, so it's no surprise that there is no agreement among investors. This, in part, explains some of the wide variation in pricing of different securities and investments. As each investor examines real-time business occurrences (mergers, acquisitions, etc.) and periodic financial documents, each forms his own opinion about which stocks are going to have lower risk and higher return, and enters into the market to buy or sell accordingly. In other words, the actions of every individual investor in the stock market cause the stock market to fluctuate, and individual investors can change their opinion based on any facts they like.

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References

  • Economics: Private and Public Choice, 11th ed.; Gwartney, et al.; 2006
  • Microeconomics, 7th ed.; Pindyck and Rubinfeld; 2009
  • The Motley Fool Investment Guide; David & Tom Gardner; 2001
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