The Law of Supply and Demand (Again)

As with other investment sectors, stocks follow the laws of supply and demand. When more investors are interested in buying than in selling a stock, the price of that stock will rise, and when more investors want to sell than buy, the price will decline. This is true not only of individual stocks, but of stocks as a whole. When investors are optimistic and in a buying mood, the level of the market itself (the S&P 500, say, or the Dow or Nasdaq) will rise. When investors are pessimistic markets will decline. Note—as we'll discuss in a moment—that individual stocks and entire markets can rise or decline based on fundamental business or economic conditions, but they can also rise and fall simply as a result of investor sentiment, whether that sentiment is factually based or not.

Supply and demand can be confusing in the capital markets context. For example, it might seem sensible to suppose that an investor—a money manager, for example—who wishes to buy a very large supply of a particular stock should get a bargain, a “quantity discount.” In fact, most large purchases drive up the price of the stock, resulting in the odd phenomenon that money managers attempting to purchase a large block of stock will pay more than investors attempting to purchase more modest positions.⁵

Similarly, sales of large blocks of stock will push the price of the stock down, so that a large-money manager will receive less for his stock than will a small investor selling only a few shares. As a result, the main cost involved in buying or selling shares for most money managers or other large investors is not commissions or spreads between the bid and ask price—the main cost is “market impact,” the increase or decrease in the stock's price caused by the investor's attempt to buy or sell it.