What is the Stock Market?

What is the stock market?

As a beginner, coming to terms with the dynamics that define the stock market can be quite overwhelming. For most investors, the risk of losing a proportion of their portfolio value is terrifying. However, with an understanding of the mechanics of the stock market and how it works, this can be one of the most efficient ways to accumulate wealth and build your net worth. Apparently, some of the people listed on Forbes List of World Billionaires like Warren Buffet, have made their fortunes by investing in the stock market. This guide helps you better understand what a stock market is, how it works, and why it is important to investors and companies globally.

Understanding the Stock Market

The stock market is a composition of public markets and exchanges that facilitate the issuance, buying, and selling of publicly-traded stocks. In this case, publicly-traded stocks refer to the stakes or securities of publicly-held companies and corporations. All the financial activities carried out within the stock market are done through a securities exchange, such as New York Stock Exchange and London Stock Exchange.

Essentially, the stock market is the place where hundreds of thousands of market participants meet to sell or buy securities. Through the stock market, transparent transactions and fair pricing practices are facilitated. Traditionally, physical and paper-based share certification was applied to issue, sell, or buy shares. However, today, all stock market transactions are executed electronically.

Also, the stock market provides corporations with access to capital by offering a proportion of their ownership to interested investors. On the other hand, investors can earn income from an already established company without having to start a new, unproven enterprise. Of course, there are risks involved depending on the volatility of the securities held.

Stock Market Basics

To understand how the stock market works, it is essential to understand the following components;

[1] Stocks

A stock, also known as an equity or share, is a type of financial security representing a proportion of ownership in a corporation. Stocks also reflect an investor’s claim on a company’s earnings and assets. This implies that the shareholder is entitled to the ownership of a corporation equivalent to the number of stocks held as a proportion of the total company shares. The total shares of a company can go to as much as millions or billions of stocks.

Types of Stocks

There are two types of stocks, including the following;

Common Shares.

These are shares that confer voting rights and a claim on dividends to the shareholder. Therefore, shareholders have a say when it comes to making decisions relating to the corporation, including voting in board members in an election. Typically, a shareholder bears one vote per share held. A significant percentage of stocks issued in the stock market fall under this category.

Preferred Shares

These are stocks that offer a fixed dividend in perpetuity. This means that an agreed-upon dividend is paid out to the shareholders at regular intervals. Again, in matters of liquidation and dividend payment, preferred stocks are given priority over the common shareholders. Unlike common shares, this category of stocks does not confer voting rights. As a result, preferred shareholders do not have a say in the management issues or corporate policies of a company.

[2] Stock Market Participants

The stock market consists of a wide range of participants, each of which plays a different role. They include the following;

Stock Market Regulator

A stock market regulator is responsible for the oversight of the securities industry. The legal body is also mandated to oversee all the stock exchanges and any institution involved in the sale of securities. The stock market regulator does all documentation made by publicly-held companies, as well as registering new securities. In the US, the stock market is controlled and regulated by the Stock Exchange Commission (SEC), while the Financial Conduct Authority regulates the UK markets.

Investment Banks

When a privately-listed company decides to go public, an investment bank is consulted to facilitate the process. Ideally, investment banks act as intermediaries between investors and corporations by handling the initial public offering (IPO) of a company’s stock.

Stockbrokers

Professionally, stockbrokers are intermediaries or middlemen. They buy or sell securities in a stock market on behalf of their clients in exchange for a commission. These clients may include individual retail investors or institutional investors. Typically, stockbrokers are licensed and approved by market regulators, with most of them working for brokerage firms.

Investors

These are individuals or institutions that buy and sell company stocks to generate profits.

Research Analysts

These are individuals that act on behalf of their clients to offer research coverage over publicly-held corporations. The role of research analysts is to predict the movement of stock prices based on various market factors.

Fund Managers

Fund managers are best known for buying and selling large amounts of securities in a stock market. A decision by fund managers to purchase or sell stocks is significant enough to trigger a stock price movement.

[3] Market Types

The collection of markets within a stock market are divided into two;

Primary Market

This is the place where the creation and issuance of new securities take place. In most cases, corporations issue securities in the primary market in the form of the initial public offering, where stocks are made available to the public for the first time. When issuing stocks to the public through the primary market, most companies hire underwriters to determine the share prices and review the transactions. Notably, every transaction taking place in a primary market must strictly adhere to the regulations as stipulated by a regulator, such as SEC.

Secondary Market

Once a company has issued or sold its first offering in the primary market, its subsequent transactions are carried out in the secondary market. In the secondary market, the underlying corporation is not involved. The selling and buying of stocks is facilitated by brokers or stock exchanges. Examples of secondary markets include the London Stock Exchange, New York Stock Exchange, and Nasdaq. Anyone can buy securities in secondary markets as long as they pay for the stipulated price per stock.

How the Stock Market Works

Generally, the stock market provides a network of regulated environments where the market players can freely transact financial securities. This way, companies can sell or issue securities to the general public for the first time through the primary market. For private companies, the decision to go public is fundamental. It is an effective way for such companies to raise capital from a wide range of investors.

Ideally, a company divides its ownership into a specific number of shares. The leadership of the company then decides on the number of stocks they are willing to sell to the general public. In this case, the stock market provides the marketplace where the sale of these shares will take place. If everything goes as anticipated, the corporation will sell the agreed shares at a given price, accumulating its capital successfully. For example, if a company decides to sell 2 million of its shares at $20 each, then the capital raised will amount to $40 million. In return, investors acquire the company’s shares, which they can hold as they anticipate movement in stock price and returns in the form of dividends. The entire process is facilitated by a stock exchange at a fee.

The stock exchange ensures that there is transparency in stock pricing and fairness in every transaction undertaken in the stock markets. Since the modern stock markets operate electronically, stock exchanges are responsible for maintaining all the systems used to facilitate stock trade. A stock exchange also facilitates price matching to ensure that all traders get the best price dealings. The financial reporting, announcements, company news, and liquidity aspects of the stock market are also managed and maintained by a stock exchange.

A Guide on Stock Exchanges

Basically, a stock exchange is a marketplace where stocks are traded. Since stock exchanges are secondary markets, companies listed on such exchanges are not directly involved in selling or buying stocks. The ownership of company shares is held by specific investors or shareholders from which you can buy them. Likewise, when selling stocks through a stock exchange, the underlying company does not buy them directly from you. Rather, your shares are bought by the company’s shareholder, an investor in the stock market. In addition to shares, exchanges are also known for listing other financial instruments, such as derivatives, bonds, exchange-traded funds (ETFs), and trusts.

Stock exchanges have been in existence for centuries. However, it is until 1773, when the London Stock Exchange was formed that regulated exchanges came into existence. This triggered the establishment of other stock exchanges, such as the Philadelphia Stock Exchange and the New York Stock Exchange.

Here is a list of the world’s largest stock exchanges by market capitalisation.

  • The New York Stock Exchange situated in the United States.
  • The National Association of Securities Dealers (Nasdaq) located in the United States.
  • The Japan Exchange Group located in Japan.
  • The Shanghai Stock Exchange located in China.
  • The Euronext located in France.
  • Hong Kong Exchanges and Clearing located in Hong Kong.
  • The London Stock Exchange (LSE Group) located in the UK.
  • The Shenzhen Stock Exchange located in China.
  • The TMX Group located in Canada.
  • The Tadawul (Saudi Stock Exchange) located in Saudi Arabia.

Stock Market Indices

Stock market indices play a critical role in determining the performance of specified shares, reflecting the state of the market or a sector in the stock market. The movement of a market index represents the overall impact of a component of the stock market. Investors rely on market indices to determine the performance of their investment portfolios. This way, an investor can inform their decisions when trading stocks. Again, stock market indices are created and maintained by stock exchanges.

It is also fundamental to understand that most of these indices are market-cap weighted, while a few are price-weighted. A market-cap weighted index is one whose value is measured as a proportion of its market capitalisation.

Here is a list of some of the world’s popular stock market indices.

  • The Dow Jones Industrial Average (DJIA) traded on the NYSE.
  • The Standard & Poor’s 500 (S&P 500) Index traded on the NYSE.
  • The NASDAQ 100 Index traded on Nasdaq.
  • The Financial Times Stock Exchange 100 Index (FTSE 100) traded on LSE.
  • FTSE 250 traded on LSE.
  • FTSE 350 traded on LSE.
  • FTSE SmallCap Index traded on LSE.
  • FTSE All-Share Index traded on LSE.
  • The Nikkei 225 Index traded on the Japan Exchange Group.
  • The Hang Seng Index traded on the Hong Stock Exchange.
  • The SSE 50 Index traded on Shanghai Stock Exchange.
  • The EuroStoxx 50 traded on Frankfurt Stock Exchange.

Stock Market Listing

Various exchanges differ when it comes to the procedure of listing companies in a stock market. However, the basic steps of listing a company are as follows;

  • Registration. The first step involves filing a registration with a stock market regulator, such as the SEC in the US or FCA in the UK. Companies must meet the basic requirements of the exchange they wish to be listed on.
  • Hire an investment bank or underwriter. The role of an underwriter is to act as a mediator between investors and the underlying company. Underwriters are also mandated to establish stock prices based on the risk assessment. The investment bank is also significantly involved in the sale of the company’s stocks.
  • Going public. Once its securities are sold through an initial public offering, the company is listed on the stipulated stock exchange.

Wrap up

The stock market is one of the most fundamental elements of a free-market economy. It is a place that facilitates mutual benefits for both companies and investors. If you are looking for a way to diversify your investment portfolio, investing in the stock market will definitely serve you right. You can channel your investments and savings to profitable investment proposals as availed by the stock market. In return, you will make money through dividend payments and earn profits through capital gains. Whichever investment strategy you deploy, you must be well acquainted with the fundamentals of stock trading and understand how the stock market works.