Stock prices go up and down, people make and lose money. But why do the prices move? Who or what decides where those stock prices land every day? There are some basic principles that can help give you a sense of why a stock is valued the way it is.

Understanding Capital Markets

A big part of understanding the rationale behind stock prices is understanding the capital markets in general. The capital markets, often simply referred to as "Wall Street," serve three main purposes.

First, capital markets establish the primary market by connecting savers of capital with those who want to raise capital. In other words, a business owner who wants to start or grow a business can use the capital markets to connect with potential investors. There are two primary ways a business raises capital; they can issue bonds and they can issue stocks.

A company that issues bonds is essentially establishing a loan deal with an investor, and the company agrees to pay back the loan plus interest over a set timeline. A company that issues stock is selling partial ownership in the company. Instead of getting repaid, like a loan, the investor will instead sell that partial ownership later, hopefully after the company has grown and increased its value. As the company's value rises, the stock's price is likely to rise too but there are other factors to consider.

Secondly, capital markets facilitate a secondary market for existing owners of stocks and bonds to find others who are willing to buy their securities. if you want to buy Tesla stock for example, you will purchase the stock from investors who already own the stock rather than Tesla who would not be involved in the transaction. Capital markets provide a way for regular people to outsource their investment decisions. When investment decisions are handled by someone else, people can focus on their primary career or activity. 

That investing is often done through a broker/dealer which should have a fiduciary duty to put the interests of clients above the interests of the firm.

Thanks to the capital markets, you can pay someone else to handle your portfolio. You can spend more time generating income and less time reading 10k filings or mutual fund prospectuses.

How Stock Prices Are Determined

After shares of a company's stock are issued in the primary market, they will be sold—and continue to be bought and sold—in the secondary market. Stock price fluctuations happen in the secondary market as stock market participants make decisions to buy or sell.

The decision to buy, sell, or hold is based on whether an investor or investment professional believes that the stock is undervalued, overvalued, or correctly valued. If a stock costs $10 but is believed to be worth $9, then it is overvalued in some people's view. If it is believed to be worth $11, then it is considered undervalued.

So why would the stock price be $10 when it's potentially worth $9, or even $11 per share? It comes down to the supply and demand in relation to the volume of shares being bought and sold. It's the investors, or partial owners, buying and selling among themselves that determine the current market value of a trade.

The Ask and the Bid

The potential buyers announce a price they would be willing to pay, known as the "bid." The potential sellers announce a price they would be willing to sell, known as the "ask." A market maker in the middle works to create liquidity by facilitating trades between the two parties. 

Put simply, the ask and the bid determine stock price.

When a buyer and seller come together, a trade is executed, and the price at which the trade occurred becomes the quoted market value. That's the number you see across television ticker tapes, internet financial portals and on your cell phone.

Theories Behind Stock Prices

While the ask and bid essentially create a stock's price, that doesn't touch on bigger issues like why a seller was willing to sell at a given price, or why the buyer was willing to pay a certain amount.

Efficient Market Hypothesis

Some people don't think there's a point in asking those deeper questions, and that kind of thinking is known as Efficient Market Hypothesis. The theory is that a stock price reflects a company's true value at any given time, regardless of what any analysis might suggest.

EMH believers are proponents of passive investing, a strategy that takes a broad and neutral approach, as opposed to focused analysis and timing. The thinking is that no amount of research could predict the randomness of the market, so it's best to buy as broad a range of stocks as possible and hold onto those stocks for as long as you can. EMH is not a universally accepted theory and is highly controversial in some investing circles.

Intrinsic Value Theory

On the other side of the theoretical spectrum, you'll find the Intrinsic Value Theory. This theory states that companies trade for more or less than what they are worth all the time.

The company's intrinsic value is the net present value of the earnings. It is the cash that can be extracted from the company from now until the end of time, based on the actual productive capacity of the business itself. Simplified, how much money is the company making, and how long can it continue making that amount?

Investors that follow this theory are called value investors. They include famous investors like Warren Buffett. His belief is that if a business does well, the stock eventually follows and that it's far better to buy a wonderful company at a fair price than it is to buy a fair company at a wonderful price. When something causes a company's stock price to fall, a value investor will scrutinize it and decide whether it presents an opportunity to buy.

The Bottom Line

There are many factors and theories on why stock prices fluctuate but buyers and sellers collectively help determine the stock price. Understanding all this will help to dispel the biggest myth out there, the myth that there are individuals who can predict stock prices and market directions ahead of time.

If I predict the winner of a hockey game correctly, everyone knows it’s a lucky guess, a 50/50 chance which are good odds of being right. A short-term prediction of a stock price or the overall markets moving up or down has those same odds. But there are plenty of people who claim to have some gift or ability because they got a few of these predictions right. And if they find enough people to believe them, there are significant financial rewards through media and subscription sales. There are great strategies out there, some of them with decent track records, but the truth is that there is nobody who can actually predict where markets are headed short term. It’s not fundamentals, financials, events or news that determine a stock or markets direction, it’s how investors react to all these things. There are great strategies out there that can help creating a path to success. But there is also no shortage of salesmen and media out there who consistently contribute to people losing money.

If I predict a Leafs win tonight, then that is not really a prediction. It’s a guess, and if I get it right it doesn’t make me a hockey expert. It’s 50/50, pretty good odds. Having a successful retirement portfolio is not about predicting the stock market, it’s about having a strategy that has the highest possibility of protecting and growing your bottom line.