Investing in the stock market can be very rewarding, offering a route to financial independence over the long term. For this reason, it’s important that you know how it works.
The stock market may seem intimidating to understand at first, but it’s actually quite simple. You will realise that yourself once you read this article!
Big ideas
The stock market is where investing in stocks happens.
It is governed by the law of supply and demand; stock prices go up when there are more buyers than sellers, and they go down when there are more sellers than buyers.
Most of the time, when people talk about the stock market, they refer to a market index that tracks the performance of a group of large companies.
An introduction to the stock market
Let’s begin with a brief history of the stock market. Knowing how things started can give you a better feeling about what modern stock markets are all about.
DEFINITION
A stock exchange is an organised market where the trading of stocks takes place.
The first company that issued shares was the Dutch East India Company in Amsterdam, as early as 1602. For this reason, the Amsterdam Stock Exchange which was created in the same year is the oldest stock exchange we know of that is still in operation today.
Fast forward to 1792 in the United States, 24 leading merchants in New York created and signed a document called the Buttonwood Agreement. This agreement is considered the founding document that the New York Stock Exchange (NYSE) was based on. Its purpose was to bring order into the securities markets by agreeing to a brokerage commission and excluding anyone who was not a broker from the business of buying and selling shares.
First traders meeting under the Buttonwood tree (68 Wall Street) 1792
Source: Time MagazineInterestingly enough, the NYSE wasn’t the first stock exchange in the U.S. That would be the Philadelphia Stock Exchange established in 1790, which was initially named the “Board of Brokers of Philadelphia”. Today, it’s owned by another exchange company, Nasdaq.
In 1971, the National Association of Securities Dealers founded the National Association of Securities Dealers Automated Quotations (NASDAQ). Today, NASDAQ is the largest stock exchange based on trading volume and the second largest based on the market capitalisation of the stocks traded.
NASDAQ marks an important point in the history of the stock market because, unlike other stock exchanges like the NYSE, it did not provide a physical infrastructure for the trading of stocks. Instead, all trades were processed through a network of computers.
Today, there are still trading floors, but even traditional exchanges like NYSE accommodate electronic trading. Over-The-Counter (OTC) markets, which are marketplaces where unlisted stocks can be traded, also operate electronically.
The stock market explained
DEFINITION
The stock market in the sum of all the existing stock exchanges and Over-The-Counter (OTC) markets for stocks.
So, how does the stock market work? In this section, we will give an overview of the purpose of the stock market to help you understand the idea before we move on to the details.
Firstly, a stock is a financial security that a corporation can issue to raise capital. Issuing stocks is usually a practice for a company that has reached a certain level of growth but needs more money than they have to propel further growth. Issuing stock is a way for a company to raise money without taking out a loan.
DEFINITION
A stock is a financial security that represents partial ownership of a business.
A corporation can issue shares with the help of investment banks. These are banking institutions that specialize in helping companies raise capital through the sale of securities.
What is stock market?
Once an investment bank has helped a company get its stock listed on a stock exchange, its shares will be publicly available for buying. The company will receive the proceeds from the sale of the stock and the stock buyers will practically own a portion of that company’s business.
Once the process of issuing the shares is completed, they will be traded back and forth by investors through their brokers. It’s common for companies to issue more shares as they go if they need more funding.
That is the general concept of the stock market. It begins with the need for funding and it ends with shares being traded through an exchange.
Naturally, this explanation must have generated even more questions than you had before you read it. So, let’s address them all, one by one.
What drives stock market prices?
First, what makes stock prices move up and down? How are stock prices set?
A stock market is where buyers and sellers meet (virtually and physically) to trade stocks. Just like any other market, prices are determined by supply and demand.
Think of the stock market as an auction where sellers suggest a price they want to get for their stocks (called “asks”) and buyers place “bids”. When the ask and bid are the same, a transaction will take place.
A stock's price is directly influenced by its demand and supply balance. When there are more buyers than sellers, the price rises, but when supply overtakes demand, the price falls. This means that a stock's value is constantly fluctuating and is determined by market demand.
More specifically, a transaction occurs when a seller accepts the bid price, and a buyer agrees with the ask(ing) price. If there are more sellers than buyers for a given stock, they are likely to accept lower prices to sell, thus lowering the price. Conversely, if the buyers outnumber sellers for a stock, they are more likely to accept higher prices to acquire it, driving the price up.
Why do companies issue shares?
The reasons for issuing and selling shares to private investors can be funding the operations of a startup, getting “free” direction from an experienced investor who is knowledgeable about a market, as well as scaling a business.
It can be a bit different for companies that issue shares to the public. Here are the reasons why a company would want to issue shares on a stock exchange (a.k.a. go public):
Expansion
The most common reason for a company to go public is the need to expand the business. A company may need the money to buy new offices, plants, workforce, and equipment, as well as for investing in R&D (Research & Development) projects to infiltrate a new market or become more competitive.
Refinancing
If a company has taken a lot of debt to finance its operations, issuing stock may be a good way to pay off some of it. Deleveraging through equity refinancing can also be a wise decision if the debt level is moderate, but the cost of that debt isn’t.
“Exits”
A very common reason for issuing shares to the public is so that the existing shareholders of a company can sell their shares. That could be anyone who owned the company before it got public; founders, angel investors, venture capitalist firms, etc.
Understanding Stock Quotes and Stock Prices
A stock quote is all the information about a stock’s price. It includes the bid and ask prices as seen on a trading platform’s page for a given stock, which are the last highest and the lowest prices that are bid and asked for the stock, respectively.
When the market is closed, the stock quote will also show the last price at which a stock was traded. Brokers also provide the opening price, which is the first price at which a stock was traded when the market opens.
The difference between the opening and closing price is used to measure the price performance for each trading day.
A stock quote can also include how many shares are being bid for and asked for at any given moment. Lastly, a quote will often include the high and low for any stock; the highest and lowest price at which a stock has traded in a day. This is a useful piece of information for gauging how volatile a stock is.
Indices to represent stock market performance
Most of the time when people talk about the stock market, they don’t refer to any stock exchange. Instead, they talk about a stock market index.
DEFINITION
A stock market index is a measure of a market’s performance. It is the average weighted price of a collection of stocks.
You have likely heard about the S&P 500 or the Dow Jones Industrial Average (DJIA) on the news. These are stock market indices, and they capture the performance of the broader equity market in the U.S. These indices track the price changes of the stocks that are most representative of that market.
You can think of an index like a researcher who uses a sample of the population they are studying which is most representative of that population. In the same way, an index to track the performance of the US market will use a “sample” of that market. In the case of the DJIA, it uses 30 large industrial-type stocks. In the case of the S&P 500, it uses 500 large stocks from across 11 different major industry groups.
DJIA came first. It was created in 1884 as a price-weighted average. This means a higher price-per-share stocks carries more “weight” in the index than those with lower prices per share.
The S&P 500 came later, in 1923. Still, it was in 1957 that it became the index that it is today: a capitalisation-weighted index tracking the performance of the 500 most prominent US stocks. It weights the stocks based on their market cap (the total value of a company’s shares); the higher it is for a stock, the more weight the index allocates to it.
FORMULA
Market Capitalization = Number of outstanding shares x Current price per share
There is also the Wilshire 5000, which uses a much larger sample of 5000 tradable stocks headquartered in the US. The idea is the same.
So going forwards, no more getting confused when someone talks about the stock market and really means an index!
Types of stocks in the stock market
There are two types of stock: common and preferred.
Common stocks, also known as “ordinary shares”, are what most investors refer to when they refer to a company’s “stock”. It is this type of security that gives you partial ownership of a business.
Preferred stocks, however, are fixed-income securities that can provide the owner with a higher dividend yield and sometimes greater voting rights. A preferred stock shares both characteristics of common stocks and bonds; it’s a fixed-income security that has the potential to appreciate more than bonds. They are often referred to as “preferreds”.
Trading the stock market
Now, the types of stock trading are numerous and there’s no reason to list them all. Some refer to the strategy being used and some to the holding period (the time frame of holding a stock). What you can keep in mind are the needs and interests you have as an investor.
If you mainly need high income, you may want to look into dividend or preferred stock investing. If you need growth above all, value or growth investing, as well as technical trading.
At the same time, your interests matter too. Technical trading is difficult and most traders fail to beat the market in the long run. You need to be willing to put an effort into becoming great in technical analysis. The same goes for buy-and-hold strategies like value and growth investing. If you’re not interested in fundamental analysis, you likely won’t be able to produce superior returns in the long term.
Stock Market Cycles
Another important concept you should understand is that of the stock market cycles. Similarly to other markets, the stock market moves in cycles. This means that it goes through periods of expansion and contraction.
The cycle includes four phases:
1. Accumulation
This is the stage where the market is at the bottom and the public is bearish, but a “correction” is starting to occur because of the acknowledgment of undervalued stocks by mainly experienced institutional investors.
2. Mark-up
The mark-up phase is a period of a growing demand for stocks as more and more buyers notice an uptrend in prices and jump in, pushing prices even higher.
3. Distribution
The third phase is where the sentiment of the market changes from “bullish” to “neutral” and people start selling stocks. This is the top of the trend and the end of a bullish market period.
4. Mark-down
This is the final stage of the stock market and is characterized by high selling pressure. This ends when stocks generally become undervalued and is followed by the accumulation phase that marks the beginning of a new cycle.
Recap
In conclusion, the stock market works like any other market governed by the law of supply and demand. It’s a place (mostly virtual today) at which interested buyers and sellers meet to trade stocks, driving the prices up and down according to supply and demand.
Remember that when people talk about the stock market, they usually refer to a stock market index. Indices are helpful in measuring the overall performance of the stock market. That is why they’re used as a proxy of the stock market.
Additionally, it’s important that you understand that the stocks most people refer to are called “common”. When someone refers to hybrid securities like preferred stocks, they will usually avoid plainly calling them stocks.
Last, you should remember that the stock market moves in cycles. This is an important concept for everyone, including long-term investors who simply buy mutual funds. All phases, whether bullish or bearish, are temporary no matter how long they last.
FAQ
Q: What is the impact of stock markets on the economy?
The stock market can impact the economy both positively and negatively because there is a definite correlation between the two. If the market is bullish, this can help businesses valued at high prices, get access to capital that will facilitate growth, and help create a higher economic output, as well as more jobs. By the same logic, if the market is bearish, the output will be lower and job opportunities will be fewer since money isn’t flowing in as much.
Q: Why is the stock market important?
The stock market plays a crucial role in our economy, serving as a powerful indicator of financial stability and growth potential. It provides investors with an opportunity to own a piece of a company and allows businesses to raise capital to fund operations and expansion.
The stock market also influences consumer confidence and spending habits, as rising stock prices can lead to increased purchasing power and a boost in consumer sentiment. The market's fluctuations can also have widespread effects, from individual investors to entire economies. Therefore, understanding how the stock market works and its importance is crucial for anyone looking to invest or stay informed about the broader economy.
The stock market also influences consumer confidence and spending habits, as rising stock prices can lead to increased purchasing power and a boost in consumer sentiment. The market's fluctuations can also have widespread effects, from individual investors to entire economies. Therefore, understanding how the stock market works and its importance is crucial for anyone looking to invest or stay informed about the broader economy.
Q: What is the role of stock exchanges in the market?
Stock exchanges play a vital role in the market as they serve as a platform for companies to raise capital and for investors to trade securities. By providing a transparent and regulated marketplace, stock exchanges promote fairness and efficiency in the buying and selling of securities. They also facilitate price discovery and provide liquidity, allowing investors to quickly buy or sell their holdings.
Additionally, stock exchanges like the London Stock Exchange play a crucial role in companies' growth and development by providing them with access to funding from a wide range of investors. Overall, stock exchanges serve as a key component of the financial system and contribute to the growth and stability of the economy.
Q: How are stock prices determined?
When it comes to the stock market, it's all about supply and demand. If more people want to buy a stock, its price will go up. And if there aren't enough buyers, sellers will have to lower the price to make a trade happen. It's like a game of tug-of-war between investors, with the stock price as the rope. Who will win: the buyers or the sellers? That's what determines the value of your investments.