What markets do….
In bringing together buyers and sellers, “the market” performs an important function – it discovers how much something is worth. If you own a shiny piece of metal or a home and you want to find out how much it is worth you have to find out its “market value”. In other words, if you are a seller you have to know how much a buyer is willing to pay for your “thing” and this leads to a very thorny question – if nobody wants to buy what you’re trying to sell, how much is it really worth?
Markets that can give you a price for an item immediately are called “spot markets” i.e. you can sell/buy something on the spot. The other type of market price you might be interested in is how much something is worth in the future. Farmers, for example, need to know how much a crop is worth before they decide to plant it (i.e. will they make more money planting corn or soybeans?) so the prices for these items are set for a time period which gives predictability on pricing. For the moment we will focus on the stock market (which is a spot market).
One of the easiest examples of a “market” to think of is when people sell their houses. Lots of things can motivate a person to sell their house. Regardless of the reason, one of the first things a homeowner has to do is to figure out what their house is worth and what they are willing to sell it at. Most homeowners know that if the price is too high nobody will buy regardless of how “great” the owner thinks the house is (e.g. location, nearby amenities, age, condition etc.). If the price for the house is too low, the owner will have to deal with lots of interested offers but will not make as much money.
Somewhere between “too high” and “too low” is “just right” – the price that both a buyer and a seller can accept. When the number of potential buyers is high, they will likely try to outbid one another in order to obtain the item. When there are too few buyers, however, they may have a very different price that they want to pay than what a seller wants to sell at, leading to a wide difference between what people want to pay (known as a “spread”). So what is the house actually worth? Is it what the buyer wants to buy it for or is it what the seller wants to sell it for or is it the price that something similar was sold at? The term for that price is usually referred to as “Fair market value”. On a side note, it’s exactly because “fair market value” couldn’t be figured out that the global financial system was cast into such turmoil.
In the stock market, the “thing” that people are buying and selling are stocks (shares of a company also called “equities” or “securities”) and therefore the stock market should really be considered as “a market of stocks”. When thought of in this way, many of the seemingly strange occurrences of the “stock market” begin to make sense. When there are huge swings in prices of stocks, it is usually because of dramatic shifts in opinion between buyers and sellers. One of the questions you can ask when you hear about these wild swings is whether there are lots of buyers/sellers or few – the more buyers/sellers the more accurate the price will reflect supply/demand. When there are fewer participants there is greater uncertainty as to what something is worth and so prices jump around all over the place.