How do stock markets work? Understanding the basics
When you start planning your finances, you’ll see that personal finance essentially comes down to this; earning, saving, and investing. The first two, earning and saving are pretty straightforward. You get a job, and you track your expenses and save as much as possible. But the third, investing- is not that simple.
At least that’s what it feels like for most individuals when they come across investing for the first time.
If the idea of investing in the stock market seems absurd and it scares you a little, you’re not alone. Even after people get to know about investing, many put it off, since they don’t feel comfortable or confident about it. That’s understandable – you don’t want to risk your money on something that you’re not sure about.
But the truth is, investing in the stock market is one of the most effective ways to grow your money over the long term. Studies show that stocks generate investment returns over long periods of time superior to those from every other asset class.
Is it risky? Yes, there are risks involved.
Is it worth taking the risks? Absolutely it is.
Before I go into the details of why you should invest, let’s address the elephant in the room – the stock market, and how does it work?
In a nutshell, the stock market is a place to buy and sell shares of publicly traded companies. Individual or institutional investors come together in the stock market to trade shares of stock.
Let’s break it down one by one – starting with the company.
Why do companies sell shares?
Any company – small or large – needs capital to thrive. There are capital expenses, R&D, marketing, operations – all of which must be well-financed for a company to grow. And a company can access capital by borrowing money from banks (debt) or selling shares. Raising capital using borrowed money has limits, as there is the burden of paying interest. And for a smaller company, they might only have a few assets to borrow against. Eventually, you need to pay back the money borrowed along with interest.
The second option – selling shares, is more viable, as you are not obliged to pay back money to investors. Having said that, most early-stage investors (Angel investors and VCs) might want to have a say in the company’s administration and management, especially if they own a relatively higher stake in the company.
Another way to raise capital is by selling shares to the general public through an initial public offering (IPO), so individuals like you and me can be a part of the company. For companies, this allows them to access large amounts of capital that can be used to expand the business, improve products, and grow the overall business. As for individuals, this is a chance to be a part of a promising company, and to get rewarded in the process.
How do you invest in a company?
So when a private company goes public, that is through IPO, the company is required to allot share certificates or simply – shares, to the public. These are certificates that represent partial ownership of the company. The more shares you own the more stake you will have in the company. Each share will have a face value (FV). If a company is valued at $500 million, it can either have 50,000,000 shares with a face value of $10 per share or have 5,000,000 shares with $100 per share. It is up to the company to decide how they want to allow the shares to the public.
More often than not, companies will try to increase the number of shares and decrease the face value, to increase participation from investors. However, keep in mind that the company won’t sell all the shares to the public, meaning that the company valued at $500 million will choose to retain some shares within the company, and only the remainder will be issued to the public.
So once the company successfully goes through an IPO, investors will be able to buy and sell shares of the company daily. And that’s where stock markets come into play.
What is a stock market?
The stock market is a marketplace where buyers and sellers can come together to trade stocks. Stocks or equities are tradable securities (meaning they can be bought and sold) that represent a portion of the ownership in a company. So when you buy Apple stock, you are buying a portion of the company. As Apple has 16.69 billion shares that are available to the public (this known as outstanding shares), your personal stake might be insignificant. But still, you are a shareholder of the company and you have certain rights within the company including voting rights.
The stock market exists for two reasons; the first one – it gives companies easy access to capital that can be used to expand their businesses. The second – it allows investors to be a part of companies and share in their profits.
I’ll be talking more about how investors make profits from buying stocks, later in the article.
It is important to note that when someone uses the term ‘stock market’, they might refer to stock exchanges or market indices. Stock exchanges are places where people come together to trade the shares they own. Because when you buy or sell a stock, you’re not directly trading with the company, instead you’re trading with other existing shareholders.
Stock exchanges act as an intermediary between buyers and sellers and help them in completing the transaction. So it’s no wonder when people use stock exchanges synonymously with the stock market. Today these exchanges exist as electronic marketplaces, even though there is a physical location attached to them. New York Stock Exchange (NYSE), one of the oldest and the largest by market cap of listed companies, is situated in Lower Manhattan, New York City. Stock exchanges are regulated by government agencies. The Securities and Exchange Commission (SEC) oversees the stock market in the US, ensuring the smooth functioning of the markets.
On the other hand, a market index is a hypothetical portfolio comprising some of the largest public companies in the country. It is used as a performance indicator of the overall market, even though it represents only a small portion of it. So when you hear people talking about how ‘the market is doing, they’re merely referring to a market index. The Dow Jones Industrial Average (DJIA) and S&P 500 are the most popular indexes in the US. While Dow Jones tracks the performance of 30 prominent companies, S&P 500 tracks the stock performance of the 500 largest public companies in the US.
How do stock markets work?
Now we know how companies issue shares to the public to raise capital, through an IPO. So once the shares are available to the public, they’ll start buying and selling shares. To understand how the stock market works, you need to look at the participants involved, starting with the investment banks.
These are some of the largest banks in the world. They handle the IPO of companies. They help the company with valuations and usually buy most of the shares and resell it to the public through IPO.
These are large financial institutions that play a major role in the market. During the IPO of a company, these institutions buy most of the shares from investment banks, and later they sell it to the public while retaining a portion of the shares. Hedge funds, pension funds, and mutual funds are examples of institutional investors.
They buy and sell shares in larger quantities, and therefore their actions can influence the price of a particular stock in the short run.
These are investors like you and me, and millions of others. Also known as retail investors, they use brokerage accounts for buying and selling stocks.
These are financial institutions that allow investors to buy and sell shares. In fact, they act as an intermediary between buyers and sellers. Nowadays, online brokerage platforms allow investors to transfer funds, buy and sell shares – electronically.
Note that these are only the major participants in the stock market, there’s more. But this is enough for a head start.
Now that you know who all are in the market, let’s see how trade will take place.
Take Apple Inc. for example. As of the time I’m writing this, the stock is trading at $136. Let’s assume that today, the NY Times reports that Apple is going to launch the Apple Car in a few weeks. Now, two traders, Ben and Peter saw the news; Ben believes that this is going to be a huge source of earnings for the company, and the stock price is going to rise. So Ben decides to buy 10 shares of Apple.
Meanwhile, Peter is not happy about the news. He thinks that Apple might be risking its earnings by entering an unknown market, and he believes that the stock price will eventually go down. So Peter now wishes to sell the stock, of which he has 10 shares.
So Ben will place the order to buy 10 shares of Apple with his broker, and Peter who uses a different broker will place the order to sell the 10 shares of Apple stock he owns. The brokers will redirect both of these orders to the stock exchange where Apple stock is traded, and in this case NASDAQ. Once the stock exchange receives the orders, they’ll match Ben’s order with Peter’s, and the trade gets executed.
This is the primary function of the stock market – act as a marketplace between buyers and sellers of stock shares. And the buyers and sellers don’t have to be individual investors, they could be any of the stock market participants mentioned above. And it doesn’t have to a single seller or a buyer; Ben’s order to buy 10 shares could be met by sell orders from Cathy (who is selling 6 shares) and Lauren (selling 4 shares). Stock exchanges take care of these aspects and they ensure that all the orders placed are executed and the shares are delivered accordingly.
Thus, the stock market allows market participants to access any public company, and trade their stock.
What moves stock prices?
To understand the price movement of a stock, let’s go back to the example of Apple stock and the news that came out.
Let’s assume that most traders saw the news in good light, and they believe this is going to increase the stock price. So what do they do? They try to buy the stock. But there’s a problem – there are only a few sellers but a lot of buyers. And when buyers outnumber sellers, the laws of supply and demand play out.
You see, when there are more buyers than there are sellers, buyers will be willing to pay the price the seller asks for. Once buyers buy the stock at a higher price, that becomes the latest stock price. Then the sellers will ask for more, on top of the last traded price. Why? Because they can. Buyers are looking to acquire the stock as soon as they can, and they’re willing to pay whatever price the seller asks.
You see, buyers are willing to pay because they believe they’ll be able to sell it in the future, for a price higher than they bought it for. As a result, the price increases. If you look at the example above, the price went up about 3% in less than an hour. Even though this is a fictional situation, the reality isn’t far from this. Price movements can occur very quickly, and they can be quite significant.
And if this was the other way around – there are more sellers than buyers, the seller will be willing to accept a lower price as they want to cash in as fast as possible. As a result, the stock price will go down.
The point is – price changes in the stock market are simply a matter of supply and demand from investors.
So naturally, you ask. What if there was no news – would the price stay constant?
Well, yes and no.
In the case of a rather unknown company, the stock price might not move, and even if it does, it would be marginal. But with most stocks, there will be significant price movements throughout market hours. The reason is, market participants are always looking for information; they’ll act based on the information they have, or they’ll simply act on the expectation of information. For example, traders might sell a particular stock if they believe bad news regarding the stock is going to be out.
Speculations and assumptions are abundant in the stock market, and so are price movements.
Why do people invest?
Why do people buy stocks in the first place?
Before I answer that question, let me talk about the different ways individuals participate in the stock market. Broadly speaking, there are two kinds of individuals in the market; traders and investors.
Traders are looking for opportunities to initiate a trade and profitably exit at the earliest possible time. Traders have a short-term view of the market. They are constantly analyzing price movements and other indicators in an attempt to predict the short-term price movements of stock to successfully execute a trade.
Investors, on the other hand, have a long-term view of the market. They are looking to gain from the capital appreciation of stocks over the long run. They are willing to hold stocks for years or even decades. Because they understand the power of compounding and the significant price appreciation it can bring to your investment.
Back to our initial question – why do people buy stocks?
Even though each individual has his/her own reason for investing, the idea remains the same – grow your wealth. Traders try to profit on the short-term price movements thereby taking up more risk, whereas investors capitalize on the long-term price appreciation of stocks, thereby mitigating risk.
How do you make money from stocks?
By this point, you have a good idea about how people make money from stocks. Nevertheless, let me reiterate.
There are two ways to make money from stocks; capital appreciation and dividends.
Capital appreciation is the increase in the price of an asset, in this case – stocks, over time. Simply put, if you select the right stock and buy it at the right price, you’ll be able to sell it later for a higher price and pocket the difference.
A dividend is a cash payout by the company to its shareholders. A portion of a company’s earnings is distributed to shareholders in the form of dividends as a token of appreciation for investing in the company. The payouts are made at frequent intervals, usually annually or quarterly, although some stocks pay a monthly dividend.
Basically, you get paid just for holding the stock.
So a lot of investors look to buy dividend-paying stocks as it provides additional returns to your portfolio, on top of capital appreciation. Since 1956, dividends have contributed nearly one-third of total equity return while capital gains have contributed two-thirds.
Contrary to what many individuals like to believe investing is not gambling. It is rather a proven way to build wealth over the long term. Consider this – if you had invested $8,000 in the S&P 500 index in 1980, your investment would be nominally worth approximately $783,086.76 in 2021.
Now you know how stock markets work and how powerful they are in building wealth.
The stock market can be a little intimidating at times, but this is everything you need for a headstart. And if you haven’t started investing in the stock market, yet, I suggest you start today. Meanwhile here’s a book to help you in your investing journey – The 8-Step Beginner’s Guide to Value Investing.
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