How Stocks and the Stock Market Work

Stock Prices

Stock prices aren't fixed. From the second a stock is sold to the public, its price will rise and fall based on free market forces. It is these ever-shifting market forces that make short-term movements of the stock market so difficult to predict. And that is precisely the reason why short-term stock market investing is so risky.

Market forces aren't a total mystery, though. We know, for example, that prices rise and fall primarily because of changes in supply and demand. In a free market system, the price of any commodity will rise as demand for it increases, as long as there's a fixed amount of the commodity in circulation. The same is true for stocks. If there are a fixed number of shares in circulation, then the price of the stock will rise as more people want to buy it, and fall as more people want to sell it.

Beyond supply and demand, the logic behind stock prices gets a little fuzzy. Since supply of stock is generally fixed, the riddle is to figure out what influences demand. Why do people want to buy or sell a certain stock? Earnings and profit certainly play a large role. If your pizzeria posts record sales in the most recent quarter, then it will probably attract more investors, pushing up the stock price. But earnings only tell half the story. There is local and global competition to consider, the rising costs of pizza ingredients, the possible unionization of pizza delivery boys and more. Professional stock analysts and brokers (as well as amateur investors) try to take all of these factors into account when trying to predict the future movements of a stock's price.

After all, it's the change in a stock's price over time that determines its ultimate value to shareholders. The key to investing is "buy low, sell high." You want to buy a stock at $2 a share and then sell it when it's $20 a share. The safest way to buy low and sell high is to invest in a slow growth stock -- usually an established company with a long track record of success like Coca-Cola or IBM -- and hold onto it for many years. This allows the stock price to weather short-term fluctuations, but average steady growth over time. A much riskier investment strategy is to try to pick the "next big thing" and cash out quickly after the stock price skyrockets.

The inherent risk of the stock market is that any number of forces -- logical or otherwise -- can push prices up or down. In recent years, we've witnessed the boom and consequent bust of two large stock market bubbles that formed around the Internet sector in the early 2000s and the housing market six years later. In both cases, commodities became overvalued, and investors poured money into unprofitable or unsustainable markets. When the truth came out, investors rushed to sell, sending stock prices through the floor.

One way to safely invest in the stock market is to find a stockbroker who understands your investment strategy and trades accordingly. Learn more about stockbrokers and ways to measure market performance on the next page.