Economics 101: Why Your Investment Activities Don’t Influence the Price of Stocks
They tumble, slide, jump, soar. They get the jitters and often seem moodier than a hormone-addled teenager. They are the stuff of which dreams are made—the rise and fall of fortunes in mythological proportions. I’m thinking of how fortune smiled on that lucky mortal who bought Apple shares for a song back in the ‘80s and became a bajillionaire.
Yes, I’m talking about financial markets. Yes, it’s a vast, complicated subject. In this post, I’ll give you a crash course in economics 101 and explain how this information relates to you, as an investor—so you can separate fact from fantasy.
A successful investor likely has an understanding of basic economic mechanisms and the way the markets work. A wise investor may also have questions…
Have you ever wondered what makes stock prices go up and down? When you and all the other individual investors in the country buy and sell stocks or mutual funds, how much does that influence the price of those funds? If you and a lot of people like you want to buy, rather than sell a stock, does that make the price go up?
Do you also wonder why the price of toilet paper goes up in a pandemic? Okay, that’s a little off track, and the increase in the price of TP at the onset of the COVID-19 pandemic was due to hoarding and price gouging. Price gouging is illegal in about 35 states, by the way, where price increases are prohibited when there is a declared emergency (e.g., hurricanes, earthquakes, flooding, or pandemics).
Unlike toilet paper, however, there is no cap on the price of a stock, so it can vary tremendously based on supply and demand.
You’re probably familiar with the economic theory of “supply and demand”, which defines the effect that the availability of a product and the desire for that product has on its price. Generally, low supply and high demand are associated with increased price and vice versa.
For example, when the radiology market is booming, there are lots of good jobs and employers have a hard time filling open positions. The high demand for radiologists coupled with a low supply of radiologists usually results in an increased “price,” either in the form of higher salary offers, a sign-on bonus, or other incentives.
How does the law of supply and demand apply to the stock market? Before answering this, I should define the terms “stock market” and “broker.”
The stock market refers to the collection of markets and exchanges where buying, selling, and issuance of shares of publicly-held companies takes place. While both terms – stock market and stock exchange – are used interchangeably, the latter term is generally a subset of the former. One of the leading stock exchanges in the U.S. is the New York Stock Exchange (NYSE). All of the exchanges operating in the country form the stock market of the U.S.
Though it is called a stock market, other financial securities (like corporate bonds) are also traded in the stock market. The stock market brings together hundreds of thousands of people and institutions to buy and sell securities (e.g., stocks, bonds, etc.).
A broker is an individual or firm (e.g., Fidelity or Schwab) that acts as an intermediary between an investor (you) and a securities exchange. Because securities exchanges only accept orders from individuals or firms who are members of that exchange, individual traders and investors need the services of exchange members. Brokers provide that service and are compensated in various ways, either through commissions, fees or through being paid by the exchange itself.
Back to supply and demand…
Stock exchanges provide liquidity in the market, giving you and others a place to sell your shares. The exchange tracks the supply and demand for each stock, which sets the stock price. For example, an investor may tell the exchange that they are willing to buy a stock for $40 (the “bid” price). At the same time, somebody else is willing to sell the stock for $41 (the “ask” price). The difference between the two is referred to as the bid-ask spread.
The New York Stock Exchange (NYSE) is the world’s largest equities exchange. (Note: In stock market parlance, the terms “equity” and “stocks” are often used interchangeably.) Although some of its functions have been transferred to electronic trading platforms, the NYSE remains one of the world’s leading auction markets, meaning that there are people physically present on its trading floor (wearing masks these days), each specializing in a particular stock, and buying and selling the stock through auction.
These professionals are under competitive threat by electronic-only exchanges that claim to be more efficient by executing faster trades and decreasing bid-ask spreads through the elimination of human intermediaries.
Many exchanges now allow trading electronically, meaning there are no traders and no physical trading activity. Instead, trading takes place on an electronic platform and doesn’t require a centralized location where buyers and sellers can meet. The Nasdaq is one of the world’s leading electronic exchanges.
How much do you, an investing radiologist, influence the price of stocks?
When you buy or sell shares of an individual stock or a mutual fund, say within your 401k or taxable brokerage account, how much does that change the share price? Here’s where it gets interesting, because as it turns out, you as an individual do not influence share prices much at all.
There are two types of investors:
- An institutional investor is a person or organization that trades in large quantities, qualifying for lower fees and other preferential treatment; they invest other people’s money.
- A non-institutional investor (aka “retail” investor) is an individual or non-professional investor who buys and sells stocks or other securities through brokerage firms (e.g., Fidelity, Schwab, TD Ameritrade); they invest for themselves. Almost all radiologists fall into this group.
Who are the institutional investors?
They are the heavyweights, the big cheeses, the big guns, the investing behemoths. These are all metaphors for pension funds, mutual funds, insurance companies, money managers, investment banks, endowment funds, etc. Together, they account for three-fourths of the volume of trades on the NYSE. (And remember, the NYSE is only one of many exchanges that makes up the total stock market.) Because they buy and sell in large quantities, they have tremendous influence on the movement of the stock market.
If you have a pension plan or invest in a mutual fund, you are benefiting from the expertise of institutional investors who make investment decisions for you. Because of their size, institutional investors are able to negotiate lower trading fees compared with individual investors and can access investment opportunities that individual investors cannot because of a minimum buy-in requirement that individual investors cannot meet.
Buys and sells by everyday investors represent only a fraction of total market volume.
Who are non-institutional investors? YOU!
Non-institutional investors, by definition, are any investors that are not institutional investors (Duh!). Although an individual investor can also be an institutional investor, this is not the usual case and when people talk about individual investors, they are generally referring to non-institutional investors (and that’s how I will regard them in this post).
What is important to realize is that households directly hold about ¼ to ⅓ of U.S. stocks. Yet, small retail trades represent just 2% -2.5% of total trading volume. Buys and sells by everyday investors represent only a fraction of total market volume and the value of their trading is small relative to what they own. This means that the trading done by you and other individual investors does not greatly influence individual stock or mutual fund share prices.
Can individual investors pick “the winners”?
The retail investment market in the United States is huge. Over 50 million households are retail investors of some kind and over 50% of households have savings accounts or investment plans like 401(k)s. A radiologist who wants to actively manage their portfolio now has access to more financial information, investment education, and trading tools than ever before. Brokerage fees have fallen, and mobile trading means you can actively manage your portfolio from your smartphone or other mobile device. A huge range of retail funds have modest minimum investment amounts or minimum deposits of a few hundred dollars, and some ETFs (exchange-traded funds) and roboadvisors don’t require any.
Armored with all this information and easy access to trading, you might think you can beat the market by picking your own stocks or mutual funds. Alas, there are many people who think they can outperform the indices, such as the S&P 500. They think they know something important when they invest, but almost always what they think they know is either not true or not relevant or not important new information. The amateur’s “scoop” is usually already well known and factored into the market prices by the professionals who are active in the market all the time.
Today’s trading volume is in the billions and 99% of it is done by institutional investors.
Charlie Ellis (investment consultant and author, who taught at the Yale School of Management and the Harvard Business School), calls this “The Loser’s Game” in his seminal paper by the same title that was published in 1975. In a recent podcast, he talked about what it was like back in the ‘60’s, when you could type in a stock exchange symbol on the keyboard of a large electronic device that would then spit out (on heat-sensitive tape) the high, low, and last price of the day as well as the total trading volume for that stock. Those were the days of slide rules (think analogue images for comparison), when daily trading volume on the exchange was ~3 million shares.
In those days, 90% of trading of those 3 million shares was done by individuals (like you) who did a trade every year or two or three. Today’s trading volume is in the billions and 99% of it is done by institutional investors. That means virtually every time you buy, you buy from a professional, and every time you sell, you’re selling to a professional. Note: This is the situation in the U.S. but just the opposite is true in China. In 2019, 99.6% of total investors in China’s stock market were retail investors.
Also back in the ‘60’s, an investor learned about a company through private meetings – it was amazing how much information could be gleaned from such meetings that other investors would not be privy to. With that kind of advantage, it’s easy to see how someone back then might have been able to “pick the winners.”
Today, however, every investor has access to all the information. This is thanks to the Regulation FD (Fair Disclosure) Act that was passed by the SEC (Securities and Exchange Commission) in 2000. Now, when a publicly owned company reveals information that might be useful from an investment point of view to any one person, that company must make a diligent effort to make that same information available to every investor. This lack of “informational advantage” makes it hard for professional investors, let alone individual investors, to pick the “winners.”
And all this leads back to the debate on “passive” versus “active” investing
In a prior post, I discussed “active” and “passive” investing. Basically, an active investor attempts to pick stocks or stock funds that will beat the indices, or in other words to beat the “average return.” The goal of a passive investor is to earn the average return (say, that of the S&P 500, or some other major index). You may be wondering why anyone would want to shoot for “average.” After all, you made it all the way through medical school and radiology residency, and not because you were an average student.
The fact is that over a 10-year period, 85% of actively managed funds fall short of what they choose as their benchmark. And when they fall short, they fall short by a great deal more than those that don’t. And if you think you’re going to choose the 15% that do well, you’ll find that about 85% of that 15% will fall short in the next decade.
That was a bit of a ping-ponging between what controls stock prices, who the people/entities are that buy stocks, and whether you can “beat the average” by picking your own stocks. There are two points I want to make in this post:
- The great majority of market trades (i.e., buying and selling of stocks and funds) are done by institutional investors. The number of trades that you or any other average radiologist makes does not influence the price of stocks to any significant degree.
- Active investing (i.e., trying to pick the “winner” stocks and funds) is a “loser’s game.” You can feel good about this, since the alternative, which is passive investing (i.e., investing in low-cost, broadly diversified index funds), is cheap and easy.