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Who Is the Stock Market?
A prerequisite for managing a listed company is understanding how the stock market works. By understanding the market better, executives can have more confidence that their decisions will both create value and be reflected in the price of their shares.1 When executives don't understand how the stock market works, and how it values companies, they can make such poor strategic decisions as passing up value-creating acquisitions or making value compromising acquisitions.
In this chapter we examine how the market works, in particular the interaction of investors who have different strategies and different beliefs about the future. The market isn't a monolith, and the interaction of investors creates volatility that isn't necessarily driven by new information. We also show that stock price levels are largely influenced by the most sophisticated investors.
A MODEL OF THE MARKET
Executives and journalists often talk about the market as if it were a monolithic entity with a single point of view, but if that were the case it wouldn't be a market. What makes a market is different investor strategies and points of view that interact to set prices and also drive volatility. So understanding investors and their strategies is the best way to understand the market.
We begin with a simple illustration of how different strategies by different investors can drive market behavior. Assume that the stock market has two types of investors (A and B) trading one company's stock. ...
