Why do we need the stock market? Function and importance
The answer is simple.
The stock market provides companies access to money.
That is the primary reason we need stock markets.
But that’s not the only reason.
Let’s take a look at what constitutes a stock market and why do we need it.
What are stocks?
Before we dive deeper into the stock market, it’s essential to understand stocks. Thankfully, it’s not that hard.
Let’s say four friends wanted to start a company, so they put in equal amounts of money for the initial capital. All of them will be given shares that represent the ownership of the company.
The number of shares each person will receive depend on the amount of money they put in. In this case, they all will receive the same number of shares as all of them put in equal amounts of money.
Owning shares means you have a chance of receiving a portion of the profits the company might make in the future. Now, this is not guaranteed. Because the company might never make profits, and even if they do, they might decide not to distribute profits among shareholders.
But if the company decides to distribute profits, each shareholder will receive a portion of the profits, in proportion to the number of shares they own.
The company always keeps track of who owns its shares and how many. So that if in future they decide to pay out profits as dividends they’ll know who to pay.
And the stock is transferable. Why is that so important?
Because it means that if you own stock shares of one company, you can hand them over to another individual or organization, in exchange for money. You can also gift your stock shares to your friends or family, or your children could inherit them.
The stock market exists because the stock is transferable.
Why would someone buy stocks?
Individuals invest in companies (by buying shares) to make profits.
When you invest in a company, there are two ways you can potentially make a profit. The first one is through capital appreciation. That means selling shares for a price, more than you bought them for, and pocketing the difference.
Over time, stocks tend to rise in value. The S&P 500 – an index that tracks the performance of the stocks of the 500 largest companies in the US – has a produced an average annual return of 13.6% in the last 10 years. And investors make money off of this price appreciation.
The second is through cash payouts called dividends.
Like I mentioned earlier, companies might distribute a portion of their profits among shareholders. The amount each shareholder will receive will be relative to the number of shares he/she owns. These payouts can act as an active income from your investments.
There are many more reasons why people buy stocks, but these are the most common.
What is the stock market?
The stock market serves as a marketplace for stocks.
The stock market refers to financial institutions that facilitate the transfer of shares from one party to another. The stock market makes it easy for people to buy and sell stock shares.
Why is this so important?
Every transaction – whether it’s goods, services, or money, involves a certain level of uncertainty. The buyer might be uncertain about the quality of the goods, whereas the seller might be worried whether the buyer will pay in time.
The same goes for transactions of shares. The stock market lowers that uncertainly surrounding the buying and selling of shares, by providing a common marketplace for all participants – known as stock exchanges.
If you would like to know more about how the stock market works, read this article.
A stock exchange is where the trading (buying and selling) of the shares happens. Market participants (individual and institutional investors) use the stock exchange to place orders to buy or sell. All the orders (to buy or sell shares) are processed at the stock exchange, and the shares and the cash is delivered to the respective participant.
New York Stock Exchange (NYSE) is one of the oldest and largest stock exchanges in the world. Stock exchanges in the US are regulated by the Securities and Exchange Commission (SEC). The institution oversees the smooth functioning of exchanges.
The stock market makes sure that you are free to buy and sell shares whenever you want. Institutions like the SEC lowers the uncertainty around investing in companies and protect investors from fraud and manipulation.
What if there was no stock market?
Buying and selling stocks won’t be easy
To begin with, investors would have a hard time buying and selling stocks. The whole investing process will be complex and expensive. You would need to approach the companies directly to buy shares. And every time you want to sell shares you will need to find a buyer on your own.
As a result, people will be very unwilling to invest in companies as they are not sure whether or not they can get their money back, let alone profits.
Funds will be hard to access
It’s worse for companies.
An initial public offering (IPO) is when a company’s shares are made available to the public to buy for the first time. An IPO has the potential to bring in a lot of funds to a company. And if the company is already well known at the time of its IPO, the company will be able to raise a significant amount of money.
But this won’t happen if there is no stock market.
And companies might decide to issue new shares in the future to raise capital. This opportunity gives them access to funds from the public, and they can access them as and when it seems necessary.
Needless to say, if there is no stock market, companies can forget about these funds.
So they’ll need to find and approach investors who would be willing to provide funds in exchange for money. It will be time-consuming and expensive. And companies won’t have access to large amounts of money. So they’ll be forced to look at alternate sources for capital.
This means they’ll have to take on debt; they’ll need to borrow money – large amounts, to grow the business. And that could be a burden later on, especially for newer businesses.
And due to the lack of sufficient capital, company growth will substantially slow down. As it would be hard for them to expand their business, introduce new products/services, or invest in R&D without enough money to spare. Also, if it’s a competitive market, the company might end up losing its customers and could potentially go out of business.
Now, let’s talk about the overall economy.
Economy and the stock market
Many of the largest publicly traded companies we see today grew their businesses using the funds they raised from the public through the stock market. And these companies might not exist today if it wasn’t for an active stock market and a large number of enthusiastic investors.
When these companies grow, naturally there will be more revenue, which means they’ll hire more people, which will grow the business. All of this means that the government will receive more money in taxes.
Don’t believe me? Check this out;
The US government received $230.2 billion in corporate taxes, in FY2019. Most of that money could disappear if there was no stock market.
So no stock market means fewer jobs, less income, fewer taxes, all of which will result in a weaker economy.
Financial markets are viewed as an indicator of the overall economy of the country; an active stock market shows a robust economy and vice versa. An active stock market can help individuals grow their wealth and companies grow their businesses.
To know more about how you can grow your wealth through investing, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.
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