A Nation of Investors

An unprecedented boom in the stock market, combined with the ease of investing in stocks, led to a sharp increase in pub­lic participation in securities markets during the 1990s. The annual trading volume on the New York Stock Exchange, or "Big Board," soared from 11,400 million shares in 1980 to 169,000 million shares in 1998. Between 1989 and 1995, the portion of all U.S. households owning stocks, directly or through interme­diaries like pension funds, rose from 31 percent to 41 percent.

Public participation in the market has been greatly facilitat­ed by mutual funds, which collect money from individuals and invest it on their behalf in varied portfolios of stocks. Mutual funds enable small investors, who may not feel qualified or have the time to choose among thousands of individual stocks, to have their money invested by professionals. And because mutual funds hold diversified groups of stocks, they shelter investors somewhat from the sharp swings that can occur in the value of individual shares.

There are dozens of kinds of mutual funds, each designed to meet the needs and preferences of different kinds of investors. Some funds seek to realize current income, while others aim for long-term capital appreciation. Some invest conservatively, while others take bigger chances in hopes of realizing greater gains. Some deal only with stocks of specific industries or stocks of for­eign companies, and others pursue varying market strategies. Overall, the number of funds jumped from 524 in 1980 to 7,300 by late 1998.

Attracted by healthy returns and the wide array of choic­es, Americans invested substantial sums in mutual funds during the 1980s and 1990s. At the end of the 1990s, they held $5.4 trillion in mutual funds, and the portion of U.S. households holding mutual fund shares had increased to 37 percent in 1997 from 6 percent in 1979.

How Stock Prices Are Determined

Stock prices are set by a combination of factors that no ana­lyst can consistently understand or predict. In general, economists say, they reflect the long-term earnings potential of companies. Investors are attracted to stocks of companies they expect will earn substantial profits in the future; because many people wish to buy stocks of such companies, prices of these stocks tend to rise. On the other hand, investors are reluctant to purchase stocks of com­panies that face bleak earnings prospects; because fewer people wish to buy and more wish to sell these stocks, prices fall.

When deciding whether to purchase or sell stocks, investors consider the general business climate and outlook, the financial condition and prospects of the individual companies in which they are considering investing, and whether stock prices relative to earnings already are above or below traditional norms. Inter­est rate trends also influence stock prices significantly Rising inter­est rates tend to depress stock prices — partly because they can foreshadow a general slowdown in economic activity and corpo­rate profits, and partly because they lure investors out of the stock market and into new issues of interest-bearing investments. Falling rates, conversely, often lead to higher stock prices, both because they suggest easier borrowing and faster growth, and because they make new interest-paying investments less attractive to investors.

A number of other factors complicate matters, however. For one thing, investors generally buy stocks according to their expectations about the unpredictable future, not according to cur­rent earnings. Expectations can be influenced by a variety of factors, many of them not necessarily rational or justified. As a result, the short-term connection between prices and earnings can be tenuous.

Momentum also can distort stock prices. Rising prices typ­ically woo more buyers into the market, and the increased demand, in turn, drives prices higher still. Speculators often add to this upward pressure by purchasing shares in the expec­tation they will be able to sell them later to other buyers at even higher prices. Analysts describe a continuous rise in stock prices as a "bull" market. When speculative fever can no longer be sus­tained, prices start to fall. If enough investors become worried about falling prices, they may rush to sell their shares, adding to downward momentum. This is called a "bear" market.