What is the Stock Market? This is the first question that people usually ask when they find out that they can make money somewhere other than a bank. Instead of providing a textbook definition of the stock market, I felt it would be important to provide a graphical understanding of the general dynamics of the market and how it functions.
The above graphic displays how a stock goes first from being a part of a company to its final destination of the investor’s hands—or stock portfolio.
To better understand how a stock is formed, one must first understand how corporations raise capital. Corporations have two options from which they can obtain money to run their businesses; they can borrow (issue debt) or sell equity (issue stock). Each option has its own benefits and drawbacks for the corporation. For example, taking on debt means the company will have to pay the money back whereas issuing stock means giving away some ownership in the corporation; overall, it depends on what direction the owners want for the company. However, when a corporation chooses to issue stock in their company, buying in becomes the most appealing option for individual investors who are seeking returns in excess of those available through a bank. Stocks are not available on all companies because there are private company whose owners feel that they can access capital by other means without giving up ownership in their company—this is especially the case for family-owned corporations.
The process through which a corporation goes about issuing stock involves two markets. First, in the primary market, the corporation must pitch their company to underwriters who manage the sale of the stock in the Initial Public Offering (IPO). Following the IPO, the company is traded on a public stock exchange, such as the New York Stock Exchange (NYSE) or the NASDAQ. The trading that takes place in the public stock exchange is taking place in the secondary market. When an individual investor purchases a stock during the day, he or she is actually buying someone else’s share of the company because it is on the secondary market; the shares are no longer coming directly from the company.
Shareholders share certain unique benefits when they purchase a stock. Each share carries one vote in the election of the corporation’s Board of Directors, and though that may seem small, it still provides some say in the management of the company. Also, owning a stock entitles the investor to share in the company’s earnings. Though the investor cannot directly access this money, the company’s Board of Directors could elect to pay out a portion of the earnings through the issuance of a cash dividend or stock buyback. Finally, each share entitles the investor to a portion of the company’s assets should the company be liquidated. This, however, is not necessarily a benefit because usually after all the creditors are paid, very little is left over for the equity shareholders. In fact, this so-called benefit is actually one of the biggest risks in owning stocks. Still, if the public company is bought out by a private firm—one that does not offer public shares—shareholders receive some of this equity. For example, Penn National just sold for $6.1 Billion; its final price per share when the deal closes will be $67.00 per share. Though not exactly a result of liquidation, one could consider this the benefit that outweighs the risk of liquidation when choosing to invest in stocks. Overall, each share carries a proportion of the ownership, for instance, if the company had issued 10,000,000 shares, and an investor owned 1,000,000 shares they would effectively be entitled to 10% of the above benefits. More information can be found in Investopedia’s article “Knowing Your Rights As a Shareholder.”
To buy shares of stock, a common investor cannot go directly to the New York Stock Exchange, plop down $10,000 and buy 100 shares of General Electric on the exchange floor. Investors must go through authorized brokers who handle the buying and selling of stocks. Brokers do cost additional money, so the average investor cannot trade for only the amount of the stock’s cost. Whenever an investor makes a trade, the broker will charge a commission per trade (or per share) to cover the administrative costs and fees of their business. The internet offers an array of resources for investing; therefore, finding a broker suited to one’s own investing style is easier than ever before. Newer investors can choose full-service brokers who provide research but charge a higher fee. Seasoned investors or those who enjoy doing their own research can trade through discount brokers who provide a basic interface to enter stock orders and charge lower commission fees.
The basic concept of the stock market is that it provides a centralized-location for buyers and sellers to come together to exchange stocks. Because of the constant exchange between buyers and sellers during trading hours, stock prices move up and down throughout the day, and each trade usually generates a new price. The reason stock prices increase or decrease is simply due to the supply and demand of that stock. More buying pressure (meaning more people want to buy the stock than sellers want to sell their stock) creates an imbalance of supply and demand, and the stock price rises to bring the supply and demand back to equilibrium. The opposite occurs if there is more selling pressure existing in the market.
I hope that this explanation has helped give a brief overview of the stock market and the different aspects that go into it. If you should have any questions, please do not hesitate to contact me at bryan@thefinancialwhiz.com or post a comment below.
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