Three questions I get asked often are, what is the stock market, how does it work and how do I invest in the stock market to create wealth or financial independence?
In this article, I will explain what is the stock market and how the stock market works in a very simple and easy to understand way.
Stock Market and How The Stock Market Works
To understand how the stock market works let’s look at the origin of the stock market.
Origin of The Stock Market
In the 1600s, the Dutch East India Company employed hundreds of ships to trade gold, porcelain, spices, and silks around the globe.
But running this massive operation wasn’t cheap.
In order to fund their expensive voyages, the company turned to private citizens– individuals who could invest money to support the trip in exchange for a share of the ship’s profits.
This allowed the company to afford even grander voyages, increasing profits for both themselves and their savvy investors.
Selling these shares in coffee houses and shipping ports across Europe, the Dutch East India Company unknowingly invented the world’s first stock market.
Since then, companies have been collecting funds from willing investors to support all kinds of businesses. And today, the stock market has schools and even whole television channels dedicated to understanding it.
The Modern Stock Market And What Is The Stock Market
In order to answer the question of what is the stock market and how does it work, we need to see the modern stock market as significantly more complicated than its original incarnation.
In order to facilitate the trade of the securities to the public, a company needs a marketplace to make their transactions.
This is where the stock market comes into play.
The stock market is a global network of exchange where large sums of money move on a daily basis. The stock market trade securities. Securities are rights to financial assets like a business share.
We have many stock markets called stock exchanges around the world where stocks are traded.
In the USA we have the New York Stock Exchange in the Nasdaq in New York City and a few others, in the UK we have The London Stock Exchange, in Canada we have the TSX, the NSE in India, and the jpx in Japan, just to name a few.
These are global exchange system where shares can be traded all over the world. This allows companies to raise money to continue the growth and expansion of their companies.
For example, Facebook in its initial public offering sold over 421 million shares at $ 38 per share. This earned Facebook over 16 billion dollars from investors.
A share is a portion of ownership in a company.
When a person buys a share of a company in the stock market, they are buying part ownership in this company.
Shares are traded because companies need large amounts of capital. To fund their operation, growth, and expand their business to achieve their corporate aims.
How Do Companies And Investors Use The Market Today?
For example, the stock market works this way. A new fitness company decides to launch on the market and needs capital.
Now, imagine this company as a pie, the pie is divided into slices.
These small slices of the pie are shares of the company. Companies typically sell their shares to raise capital to grow and expand their business.
First, the company will advertise itself to big investors.
If they think the company is a good idea, they get the first crack at investing, and then sponsor the company’s initial public offering or IPO.
Initial public offering or IPO
This is when a company begins selling a portion of its shares to public investors. In other words, the company goes public and anyone can buy parts of the company.
This launches the company onto the official public market, where any company or individual who believes the business could be profitable might buy a stock.
Buying stocks makes those investors partial owners in the business.
Their investment helps the company to grow, and as it becomes more successful, more buyers may see potential and start buying stocks.
As demand for those stocks increases, so does their price, increasing the cost for prospective buyers, and raising the value of the company’s stocks people already own.
This increased interest help to fund new initiatives and also boosts its overall market value by showing how many people are willing to invest in their idea.
Typically share values reflect how well a company is doing in business and as the company expands in market cap, so do the individual slices of the pie…
This is great for investors because it means that as the company grows in value, so does their original investment. But sometimes the pie gets so big that the individual slices also get big and expensive.
When the stock price gets so big that the individual slices also get big and expensive.
This is when a stock splits occur.
For example, if you bought 10 shares of Apple right after they went public in 1980, you will now own 560 shares without any further investment.
This happens when the company gets too big and their individual shares get too expensive for the average investor to buy.
For example, let’s say you took your company public with 100 shares.
You decided to sell 50 of these shares for $ 100 each as your initial public offering, but now your company has grown significantly and your shares are now worth $ 500.
Each the average investor is no longer able to afford to buy your stock, so to make sure your shares are easier for the public to buy.
You do a two-for-one split, which means that each share splits into two shares now, instead of having 100 shares in your company, your company now has 200 total shares.
Splitting shares also means that you split the value of the original share by two. Your $ 500 share.
After a two-to-one, split are now two shares worth 250 dollars each.
This encourages more investors to buy your stock and continue investing in your company.
This also means that investors, who initially bought 10 stocks of your company, now own 20 stocks, the value of their investment, remains the same.
Apple, for example, had their initial public offering on December 12, 1980, selling their shares at $ 22 per share Apple had her first Two-To-One split in 1987, when the stock hits $ 79 per share, reducing the share price to $ 39.50 per share.
This means that if you bought 10 shares right after the IPO, you will now own 20 shares of Apple. Their second two-to-one split happened in the year 2000 when the stock was trading at 111 dollars per there.
This means that your original 10 shares are now 40 shares worth fifty-five dollars and fifty cents.
Each Apple had a third two-to-one split in 2005 when the stock traded a $ 90 per share, dropping down the share price to $ 45 per share, meaning your 10 shares are now 80 shares at $ 45, each and recently, in 2014 Apple had a 7 to 1 split when their stock hits 656 dollars per share.
Making your original 10 shares become 560 shares at the value of 93 dollars and 71 cents each as of February of 2020 Apple stock is worth three hundred and twenty-seven dollars per share.
Making the value of your initial ten shares you bought for two hundred and twenty dollars to be one hundred and eighty-three thousand one hundred and twenty dollars.
This means that if Apple didn’t split their stock today, each original share that sold for twenty-two dollars in 1980 would be worth around Eighteen thousand three hundred and twelve dollars a little intimidating for the average investor.
However, if for some reason a company starts to seem less profitable the reverse can also happen.
If investors think their stock value is going to decline, they’ll sell their stocks with the hopes of making a profit before the company loses more value.
As stocks are sold and demand for the stock goes down, the stock price falls, and with it, the company’s market value.
This can leave investors with big losses– unless the company starts to look profitable again.
This see-saw of supply and demand is influenced by many factors.
Companies are under the unavoidable influence of market forces – such as the fluctuating price of materials, changes in production technology, and the shifting costs of labor.
Investors may be worried about changes in leadership, bad publicity, or larger factors like new laws and trade policies. And of course, plenty of investors are simply ready to sell valuable stocks and pursue personal interests.
All these variables cause day-to-day noise in the market, which can make companies appear more or less successful.
And in the stock market, appearing to lose value often leads to losing investors, and in turn, losing actual value.
In understanding the stock market and how it works, we should always remember that stock prices don’t always reflect the state of the company.
Human confidence in the market has the power to trigger everything from economic booms to financial crises.
And this difficult-to-track variable is why most professionals promote reliable long term investing over trying to make quick cash.
A bad rumor about the company can bring its stock value down, regardless of its actual business performance. The opposite can also be true.
Many investors can buy shares of a company if they see the great potential behind an idea.
This is great for new companies. Young companies can raise capital for their businesses, even if they’re currently losing money.
A great example of this is Snapchat. The social media platform was actually not profitable before it went public, yet they raised over three billion dollars in their IPO.
In the best-case scenario, companies can use this capital to make their idea a reality and begin making profits.
In the worst-case scenario, the company runs out of money before they can become profitable, which can lead investors to lose their money.
Speculation of Financial Bubble
Companies can be worth billions on paper due to speculation, creating a financial bubble where the stock price is much higher than the practical value of the company.
This can lead to the loss of some or all the money invested. This happened in the United States in 2001.
Many internet companies were starting up and since the internet was a new trend, many investors poured money into new companies that failed to turn a profit, many investors bought shares at a high price, expecting companies to grow in value.
When this didn’t happen. Many investors sold their stock bursting this bubble, resulting in the 2001 economic recession.
Daily fluctuations of share prices
Now share prices are influenced by many different factors from the company’s image to investors’ confidence, supply and demand of the company shares, and many other factors.
This leads to daily fluctuations in share prices. This is one of the reasons why investment experts recommend diversifying your investment portfolio and invest in the long term. If we take a look at the history of the stock market, it has both expansions and recessions, but historically the US market trends up in the long term.
One thing worthy of note is that the stock market is not just for the rich and powerful since the dawn of the Internet, everyday investors like you and me can buy stocks in many of the exact same ways a large investor would.
And as more people educate themselves about this complex system they too can trade stocks, support the businesses they believe in, and pursue their financial goals.
Now that you understand what is the stock market and how it works, if you want to learn how to safely invest in the stock market, make sure to follow the posts on this blog.
They are detail and explain simple strategies to begin safely investing in the stock market and as always if you enjoyed reading share this post and leave a comment.
(PS: This link to another post will explain how to invest in the stock market to create wealth or financial independence?)