It would be hard to find a podcast-hosting duo more fully invested in answering your financial questions than Alison Southwick and Robert Brokamp -- they even put "Answers" in their show's name! This week, they're at it again, combing through the Motley Fool Answers mailbag in search of conundrums to address for their listeners. But because three heads are better than two, for this episode, they have recruited senior analyst Ron Gross to help out.
In this segment, they respond to a listener who is trying to understand an issue at the very core of investing: What causes a stock's price to rise or fall -- and why does it seem that they do one thing when he expects them to do another? Is there a valuation formula that will tell him what a stock's price should really be? Boy, wouldn't that make things easier...but no. Here's what is actually going on to put the price tags on your stocks.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.
This video was recorded on June 25, 2019.
Alison Southwick: And our last question comes from Al. "I have a very basic question. I'm trying to work out how the price of the shares in my portfolio are calculated. Often when I think the price will remain steady or go up a little, it will go down. Is there an algorithm that is used or some sort of formula that I can use to determine share prices?"
Ron Gross: No, there is not, Al, and this is important. Share prices of stocks are all based on the supply and demand for that stock. So all day long the stock market is a huge auction in which people want to buy stock and sell stock, and the prices move up and down based on the supply and demand.
The supply and demand is based on fundamentals. Is the company a good company? Are earnings growing? Is it a good management team? What are the expected growth rates? And all day long, auction, auction. Buy, sell, buy, sell. No algorithm.
Robert Brokamp: Basically when you look that stock up, and I'll quote Yahoo Finance or Motley Fool, "That's the price." No calculations involved.
Gross: No calculations. It's often the last trade of the day. If you're looking after the market has closed, the market really matches up a buyer and a seller. That's what it really is. It's like eBay. You want to sell a Cabbage Patch doll and somebody wants to buy it, and you settle on a price. That's really what the stock market is. So whenever you look at a quote, at any point of the day, that's typically the last trade that happens in the actual stock market.
Now one other thing. If it's a mutual fund price you're looking at, or an ETF -- an exchange-traded fund price you're looking at -- that's different. That's the actual value of all the stocks in the portfolio divided by the shares outstanding in that portfolio. That's actually a calculation that mutual funds and ETFs have to calculate on a daily basis to figure out what the price is of that fund; but, I think Al was talking mostly about stocks. You've just got to think it's an auction. Supply and demand. People asking to buy. People asking to sell. Market makers match those two things up. Actually computers do it nowadays most of the time, and that's the price.
Brokamp: I'll build on what you just said and it builds on our previous question. Really one of the big differences between ETFs and traditional open-end mutual funds: ETFs trade throughout the day, so you will see their prices go up and down. Open-end mutual funds like the ones you probably have in your 401(k) are not valued until the end of the day, so when you put in an order to buy or to sell, you actually don't know the price you're going to get until the market closes and it gets settled up at the end of the day.
Gross: That's actually a good point. I think I actually misspoke, because ETFs are based on supply and demand. The price of those move just like stocks.
Brokamp: But what you said was true in that price is reflective of all the underlying securities and there does have to be some calculating going on.
Gross: But what's interesting is sometimes the actual price that an ETF is trading at can diverge from the actual underlying value and there are actually investors that make a living trying to find that divergence.
Brokamp: That small little arbitrage, and that's what keeps the prices, generally. And for the big ETFs, it's almost negligible. For smaller ETFs and more obscure ETFs...I just learned about an ETF that invests in companies that provide pet care. The ticker is PAWS.
Brokamp: I don't know how frequently traded that ETF is.
Southwick: I feel for Al, though. When I think the price will remain steady or go up a little, it will go down.
Gross: But that is an interesting point that we didn't address. It's all based on what the market, as a whole, thinks. What institutional traders think. What analysts are putting out there. You might read a headline and say, "Ooh, I think this company is going to have a really good day." Then when you look under the hood a little more, or maybe read the press release, or listen to the transcript, or hear what an analyst has to say, it turns out it wasn't as rosy as maybe the headline indicated and the stock will actually trade down that day whereas you would have guessed it would have traded up.
Southwick: There is some amount, as with anything in life. When you get experienced enough reading financial news and reading how analysts react that you miss as a new investor...like it took me a while to realize a company can have an amazing quarter, but because they didn't beat analysts' expectations, the stock will take a hit. Or maybe they didn't meet analysts' expectations as much as the analysts wanted.
Gross: In the short term, stocks trade on reality vs. expectations. In the longer term, stocks trade based on whether the companies are good or not. So take heart that if you're a long-term buy-and-hold investor it all shakes out in the end; but, on a daily basis, anything can happen.