A stock market is a place where companies raise capital by selling shares of stock (also known as 'equity') to investors. Stock ownership givesshareholdersvoting rights and a residual claim on corporate earnings in the form of capital gains and dividends.
Stock markets also allow existing shares of publicly traded companies to change hands, where individuals and institutions can invest in companies to potentially profit from their success or speculate on shorter-term price movements. They play a crucial role in price discovery, as the collective actions of buyers and sellers determine the market value of companies. Moreover, stock markets promote corporate transparency and accountability, as public companies must adhere to regulatory standards and disclose financial information to shareholders.
Through their functioning, stock markets serve as important economic indicators, reflecting investor sentiment and a barometer of overall economic health. When stock prices rise, it often signals investor confidence in the economy, while falling prices may indicate concerns about economic stability.
Key Takeaways
- Stocks represent ownership equity in the firm and give shareholders voting rights as well as a residual claim on corporate earnings in the form of capital gains and dividends.
- Individual and institutional investors come together on stock exchanges to buy and sell shares in a public venue.
- Share prices are set by supply and demand as buyers and sellers place orders.
How Do Stock Markets Work?
Stock markets work as organized platforms where buyers and sellers come together to trade shares of publicly listed companies. At their core, these markets operate on the principle of supply and demand, with share prices fluctuating based on the perceived value of companies and overall market conditions. When more people want to buy a stock than sell it, the price typically rises, and vice-versa.
Stock markets facilitate both a primary and a secondary market in stocks. The primary market is where new stocks are first issued through initial public offerings (IPOs). Here, companies sell shares directly to investors, raising capital for business operations or expansion. Once these shares are in circulation, they enter the secondary market, where most daily trading occurs. In the secondary market, investors trade existing shares among themselves, with the company no longer directly involved in these transactions.
Stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ, provide the infrastructure for these trades to take place. They maintain orderly markets, ensure compliance with regulations, and disseminate real-time price information. Modern stock markets largely operate electronically, with sophisticated computer systems matching buy and sell orders almost instantaneously.
Various market participants play important roles in the functioning of stock markets. These include individual and institutional investors (like mutual funds and pension funds) who own shares, traders who buy and sell over short time horizons, market makers (MMs) who provide liquidity, and brokers who facilitate trades. Additionally, regulatory bodies oversee market operations to protect investors and maintain market integrity. Together, these elements create a complex ecosystem that enables the efficient allocation of capital and provides opportunities for investment and wealth creation.
What are Stocks?
Stocks, also known as shares or equity, represent ownership in a company. When an investor purchases a stock, they are essentially buying a small piece of that company and becoming a shareholder. This ownership comes with certain rights, such as voting on company matters and potentially receiving a portion of the company's profits through dividends or capital appreciation.
The total value of a company's outstanding shares is known as its market capitalization, which fluctuates based on the current stock price and the number of shares issued.
Why Stock Markets Are Important
Stock markets are integral to modern economies. They provide companies with access to capital by allowing them to sell shares to the public, enabling businesses to fund growth, innovation, and expansion. The influx of capital received from IPOs drives economic development, job creation, and technological advancement, benefiting society as a whole.
Beyond capital raising, stock markets facilitate the efficient allocation of resources. They do this through the price discovery process, where the prices of stocks are determined in real-time by the collective actions of buyers and sellers. This mechanism helps ensure that capital is directed towards the most promising and productive enterprises. Investors, through their buying and selling decisions, signal which companies they believe will succeed and grow--and those which may not. This dynamic process helps allocate resources to their most efficient uses, promoting overall economic efficiency.
For investors, stock markets provide opportunities to grow wealth over time. By purchasing shares, individuals and institutions can participate in the financial success of companies, potentially earning returns through capital appreciation and dividends. Access to stock markets allows a broad range of people to build financial security and work towards long-term goals such as retirement or education funding. Today, many individuals rely on stock investments to fund future goals such as retirement savings, college tuition, and even healthcare spending.
Stock markets also serve as barometers of broad economic health and investor sentiment. Market indices, such as the or Dow Jones Industrial Average, provide snapshots of overall market performance, often reflecting broader economic trends and expectations. Policymakers, businesses, and individuals frequently use these indicators to inform decision-making, from monetary policy to business strategies and personal financial planning.
Major Stock Exchanges
Stock exchanges dates back to the 17th century, with the Amsterdam Stock Exchange, established in 1602, often cited as the world's first formal stock market. However, the concept of trading company shares existed even earlier, with the Roman Republic having a system for trading shares in publicani companies. As commerce and industry grew, so did the need for organized markets to facilitate the trading of securities.
In the United States, the first U.S. stock exchange was the Philadelphia Stock Exchange (PHLX), founded in 1790 and which still exists today. The more famous New York Stock Exchange (NYSE) dates back to 1792, when 24 brokers signed the Buttonwood Agreement, establishing rules for trading securities. The NYSE has since grown to become one of the world's largest and most influential exchanges. The second major U.S. exchange, NASDAQ, was founded in 1971 as the world's first electronic stock market. Today, these two exchanges dominate the U.S. landscape, with the NYSE known for its auction-based trading system and blue-chip stocks, while NASDAQ is home to many technology and growth companies.
Internationally, several major exchanges also exist. The London Stock Exchange, founded in 1801, is one of Europe's oldest and largest. In Asia, the Tokyo Stock Exchange, established in 1878, is Japan's primary bourse, while the Shanghai Stock Exchange, reopened in 1990 after a long hiatus, has become increasingly important as China's economy has grown. Other significant exchanges include the Hong Kong Stock Exchange, Euronext (which operates markets in Amsterdam, Brussels, Dublin, Lisbon, London, Oslo, and Paris), and the Frankfurt Stock Exchange.
In most developed countries, stock exchanges are formed as self-regulatory organizations (SROs), nongovernmental organizations that have the power to create and enforce industry regulations and standards. The advent of electronic trading has revolutionized stock exchanges worldwide. Starting with NASDAQ's electronic system in the 1970s, most major exchanges have now either fully transitioned to electronic trading or operate hybrid systems. This shift has dramatically increased trading speed and efficiency, reduced costs, and improved market access for a wider range of participants. It has also facilitated the rise of alternative trading systems (ATS) and dark pools, challenging traditional exchanges and reshaping the global financial landscape.
The original method of stock market trading was based on a manual system known as the open outcry system,where traders used verbal and hand signal communications to buy and sell large blocks of stocks in the trading pit or the exchange floor.
Over-the-Counter Exchanges
There also exist several loosely regulated over-the-counter (OTC) exchanges, which may also be referred to as bulletin boards (OTCBB). Shares listed OTC tend to be riskier since they list companies that fail to meet the more strict listing criteria of bigger exchanges. Larger exchanges may require that a company has been in operation for a certain amount of time before being listed and that it meets certain conditions regarding company value and profitability.
| Top Stock Exchanges by Total Market Capitalization (as of Q1 2024) | ||
|---|---|---|
| Exchange | Location | Market Cap ($ billions) |
| NASDAQ | U.S. | $25.00 |
| NYSE | U.S. | 24.9 |
| Euronext | Europe | 6.6 |
| Shanghai Stock Exchange | China | 6.5 |
| Tokyo Stock Exchange | Japan | 6.5 |
| India National Stock Exchange | India | 4.6 |
| Shenzhen Stock Exchange | China | 4.0 |
| Hong Kong Stock Exchange | Hong Kong | 3.8 |
| London Stock Exchange | U.K. | 3.4 |
| Toronto Stock Exchange (TMX) | Canada | 3.1 |
| Saudi Stock Exchange (Tadawul) | Saudi Arabia | 3.0 |
Why Does the Stock Market Go Up and Down?
The stock market's movements are influenced by several factors that affect investor sentiment and economic conditions. These factors can range from macroeconomic indicators, such as interest rates, inflation, and GDP growth, to company-specific news, like earnings reports, product launches, or leadership changes. Political events, international trade policies, and geopolitical tensions also play significant roles. When positive news or data points emerge, investors are often more willing to buy stocks, driving prices up. Conversely, negative news can lead to selling, causing prices to fall.
When the demand for a particular stock increases due to favorable news, profit outlook, or investor optimism, its price tends to rise. Conversely, when supply outweighs demand, often driven by negative sentiment or poor performance, stock prices fall. A constant flux in supply and demand is the essence of price discovery, where the collective actions of buyers and sellers determine the fair market value of stocks based on available information.
Sometimes the price discovery mechanism can fall out of whack, leading to price bubbles and crashes. A bubble occurs when stock prices rise significantly above their fundamental or intrinsic values, driven by exuberant market psychology, herding behavior, and speculative buying. For instance, the Dot-com Bubble of the late 1990s saw technology stocks soar to unsustainable levels, fueled by high expectations for internet-based companies. When the bubble burst in 2000, it led to a sharp market decline as investors realized the overvaluation.
A market crash is a sudden and severe drop in stock prices, often triggered by panic selling and widespread fear. The 2008 Financial Crisis is a prominent example, where the collapse of the housing market and the failure of major financial institutions led to a dramatic decline in stock prices worldwide. Crashes can lead to significant economic repercussions, including recessions and long-term market instability.
Despite their dramatic impact, both bubbles and crashes have historically resolved themselves over time. Markets eventually find a new equilibrium as investor confidence is restored, economic fundamentals improve, and regulatory measures are implemented to prevent future excesses. This cyclical nature of market movements underscores both the volatility and the resilience of financial systems and the importance of maintaining a long-term perspective in investing.
Market Volatility
Volatility in the market refers to the degree of variation in stock prices over a given period. High volatility means that stock prices can change rapidly and unpredictably, while low volatility indicates more stable prices.
Volatility is a natural part of stock markets and can be influenced by both systemic factors, such as economic changes or political events, and specific factors, such as company performance or sector-specific news. For investors, volatility can represent both a risk and an opportunity. While high volatility can generate significant gains, it also increases the risk of substantial losses. Managing volatility is a key aspect of investment strategy, requiring careful analysis and a long-term perspective.
Stock Market Indexes
Indexes represent aggregated prices of several different stocks, and the movement of an index is the net effect of the movements of each component. Major stock market indexes include the Dow Jones Industrial Average (DJIA) and the S&P 500.
The DJIA is a price-weighted index of 30 large American corporations. Because of its weighting scheme and the fact that it only consists of 30 stocks (when there are many thousands to choose from), it is not necessarily the best indicator of how the stock market is doing. The S&P 500 is a market-capitalization-weighted index of the 500 largest companies in the U.S. and is a much more useful indicator.
Indexes can be broad, such as the Dow Jones or S&P 500, or specific to a certain industry or market sector. Investors can trade indexes indirectly via futures markets or exchange-traded funds (ETFs), which act just like stocks on stock exchanges.
A market index is a popular measure of stock market performance. Most market indexes are market-cap-weighted, which means that the weight of each index constituent is proportional to its market capitalization. Keep in mind, though, that a few of them are price-weighted, such as the DJIA. In addition to the DJIA, other widely watched indexes in the U.S. and internationally include the:
- S&P 500
- Nasdaq Composite
- Russell Indexes (Russell 1000, Russell 2000)
- TSX Composite (Canada)
- FTSE Index (United Kingdom)
- Nikkei 225 (Japan)
- Dax Index (Germany)
- CAC 40 Index (France)
- CSI 300 Index (China)
- Sensex(India)
How to Invest in the Stock Market
Numerous studies have shown that, over long periods, stocks generate investment returns that are superior to those from every other asset class. Stock returns arise from capital gains and dividends.
Many of us are already invested in the stock market, whether we realize it or whether or not we play an active role in our investments. This happens through participation in retirement accounts like 401(k)s or pension plans, college savings accounts, or health savings accounts (HSAs).
To take a more active role in the stock market, you can also choose to hold specific stocks, ETFs, or mutual funds. Understanding how to invest in the stock market can help you make more informed decisions, maximize returns, and manage risks effectively.
Choose Your Investment Strategy
There are several strategies you can adopt when investing in the stock market, each with its own risk and return profile:
- Buy-and-Hold: This passive strategy involves purchasing stocks and holding them for a long period, regardless of market fluctuations. The idea is that, over time, the stock market tends to increase in value, and long-term investments will benefit from this upward trend. Buy-and-hold strategies include investing in index funds over long time horizons.
- Growth Investing: Growth investing focuses on finding companies expected to grow at an above-average rate compared to other companies. These stocks may not pay dividends but have the potential for significant capital appreciation.
- Value Investing: Value investing involves selecting stocks that appear undervalued. Value investors look for stocks that they believe are priced lower than their intrinsic value and wait for the market to recognize their true worth.
- Income Investing: This strategy emphasizes stocks that pay regular dividends. It’s suitable for those seeking a steady income stream from their investments.
While stocks can be classified in several ways, two of the most common areby market capitalizationand by sector. Market cap refers to the total market value of a company’s outstanding sharesand is calculated by multiplying these shares by the current market price of one share.
Large-cap companies are generally regarded as those with a market capitalization of $10 billion or more, while mid-cap companies are those with a market capitalization of $2 billion to $10 billion, and small-cap companies fall in the $250 million to $2 billion range.
The industry standard for stock classification by sector is the Global Industry Classification Standard (GICS), which was developed by MSCI and S&P Dow Jones Indices in 1999 as an efficient tool to capture the breadth, depth, and evolution of industry sectors. GICS is a four-tiered industry classification system that consists of 11 sectors and 24 industry groups. The 11 sectors are:
- Energy
- Materials
- Industrials
- Consumer discretionary
- Consumer staples
- Healthcare
- Financials
- Information technology
- Communication services
- Utilities
- Real estate
This sector classification makes it easier for investors to tailor their portfolios to their risk tolerance and investment preference. Conservative investors with income needs may weigh their portfolios towardsectors with constituent stocks that have better price stability and offer attractive dividends through so-called defensive sectors such as consumer staples, healthcare, and utilities. Aggressive investors may prefer more volatile sectors like information technology, financials, and energy.
Choose a Broker
Brokers act as intermediaries between you and the stock market, facilitating the purchase and sale of securities. Today, it is quite easy to open a new account at a broker, or to transfer an existing brokerage account to someplace new. Often, accounts can be opened up online and funded within minutes. Here are different types of brokers to consider:
- Full-Service Brokers: Full-service brokers offer a wide range of services, including investment advice, retirement planning, tax guidance, and portfolio management. They typically charge higher fees but provide personalized service and expert advice. Examples include Merrill Lynch and Morgan Stanley.
- Discount Brokers: Discount brokers offer fewer services compared to full-service brokers but charge lower fees. They provide basic trading services, research tools, and customer support. This option is suitable for self-directed investors who prefer to make their own investment decisions. Examples include Charles Schwab and Fidelity.
- Online Brokers: These brokers operate primarily through online platforms, offering a convenient and cost-effective way to trade stocks. They provide a range of tools and resources for self-directed investors. Online brokers often have lower fees compared to traditional brokers, and may even off commission-free trading. Examples include E*TRADEm Robinhood, and TD Ameritrade.
- Roboadvisors: Roboadvisors use algorithms to create and manage investment portfolios based on your risk tolerance and goals. They offer a hands-off approach to investing with lower fees compared to human advisors. Roboadvisors are ideal for investors seeking a simple and automated investment solution. Examples include Betterment and Wealthfront.
- Direct Stock Purchase Plans (DSPPs): Some companies offer DSPPs, allowing investors to purchase shares directly from the company without using a broker. These plans often have lower fees and can be a cost-effective way to invest in specific companies.
Diversify Your Portfolio
Diversification is a key principle in risk management. By spreading your investments across various asset classes, industries, and geographic regions, you can reduce the impact of any single investment's poor performance on your overall portfolio. Diversification can be achieved through:
- Mutual Funds and Exchange-Traded Funds (ETFs): These funds pool money from many investors to buy a diversified portfolio of stocks and other securities.
- Index Funds: These funds aim to replicate the performance of a specific index, such as the S&P 500, providing broad market exposure.
- Individual Stocks: By carefully selecting stocks from different sectors and industries, you can build a diversified portfolio yourself.
Monitor and Adjust Your Investments
Regularly monitoring your investments is essential to ensure they align with your goals and risk tolerance. Over time, market conditions and personal circ*mstances change, and your portfolio may need rebalancing. Rebalancing involves adjusting your portfolio back to its original asset allocation by buying or selling investments. This helps maintain your desired level of risk and ensures that your investment strategy remains on track.
Other Kinds of Asset Markets
While the stock market is one of the most well-known avenues for investing, there are several other asset markets that offer different opportunities and risks. Diversifying investments across various asset classes can help manage risk and potentially enhance returns. Here are some other important asset markets to consider:
Bond Markets
The bond market, also known as the fixed-income market, involves the buying and selling of debt securities. Bonds are essentially loans made by investors to corporations, municipalities, or governments in exchange for periodic interest payments and the return of the principal at maturity. The bond market is often seen as a safer investment compared to stocks, as bonds typically offer more stable and predictable returns.
Real Estate Markets
Real estate markets involve the buying, selling, and leasing of properties, including residential, commercial, and industrial real estate. Real estate can be an attractive investment due to its potential for capital appreciation, rental income, and portfolio diversification. Investors can participate in real estate markets through direct ownership of properties or indirectly via real estate investment trusts (REITs) that own, operate, or finance income-producing real estate.
Commodities Markets
Commodities markets involve trading raw materials and primary agricultural products. Commodities can be divided into two main categories: hard commodities and soft commodities. Hard commodities include natural resources like gold, silver, oil, and natural gas, while soft commodities include agricultural products like wheat, coffee, and cotton. Investors can access commodities markets through spot markets for physical goods, as well as futures markets that trade contracts to buy or sell a commodity at a predetermined price at a specific future date.
Foreign Exchange Markets
The foreign exchange (forex) market is the largest and most liquid financial market in the world, involving the trading of currencies. Investors and institutions trade currencies to profit from fluctuations in exchange rates. The forex market operates 24 hours a day, five days a week, and is influenced by economic indicators, geopolitical events, and market speculation. Key participants in the forex market include banks, hedge funds, corporations, and individual traders.
Cryptocurrency Markets
A newer entrant is the cryptocurrency market, which involves the trading of digital or virtual currencies or tokens that use cryptography for security and are decentralized through blockchains. Cryptocurrencies operate on decentralized networks based on blockchain technology. Bitcoin, Ethereum, and Ripple are among the most well-known cryptocurrencies. These markets are still highly volatile and speculative, offering the potential for significant gains and losses. Investors can participate through direct ownership of cryptocurrencies (or indirectly via ETFs), as well as other crypto assets such as ICOs, NFTs, and DAOs.
How Does Inflation Affect the Stock Market?
Inflation refers to an increase in consumer prices, either due to an oversupply of money or a shortage of consumer goods. The effects of inflation on the stock market are unpredictable—in some cases, it can lead to higher share prices, due to more money entering the market and increased job growth. However, higher input prices can also restrict corporate earnings, causing profits to fall. Overall, value stocks tend to perform better than growth stocks in times of high inflation.
How Much Does the Stock Market Grow Every Year?
The S&P 500 has grown about 10.5% per year since it was established in the 1920s. Using this as a barometer for market growth, one can estimate that the stock market grows in value by about the same amount each year. However, there is an element of probability—in some years, the stock market sees greater growth; in other years, it grows less. In addition, some stocks grow faster than others.
What Is the Bid-Ask Spread in Stocks?
The bid-ask or bid-offer spread, the difference between the bid price for a stock and its askor offer price, represents the difference between the highest price that a buyer is willing to pay or bid for a stock and the lowest price at which a seller is offering the stock. If the spread is tight, then the market in the stock is likely quite liquid. Meanwhile, if the bid-ask spread is wide, the stock is illiquid and harder to trade.
How Do People Lose Money in the Stock Market?
Most people who lose money in the stock market do so through reckless investments in high-risk securities. Although these can score high returns if they are successful, they are just as likely to lose money. There is also an element of psychology: An investor who sells during a crash will lock in their losses, while those who hold their stock have a chance of seeing their patience rewarded. Finally, margin trading can make the stock market even riskier, by magnifying one’s potential gains or losses.
Why Might a Company Choose not to List on a Stock Exchange?
There are significant costs associated with listing on an exchange, such as listing feesand higher costs associated with compliance and reporting. There are also burdensome regulations and disclosure requirements that may constrict a company’s ability to do business. This is why most companies choose to list on an exchange at a later, more mature stage.
The Bottom Line
Stock markets represent the heartbeat of the market, and experts often use stock prices as a barometer of economic health. But the importance of stock markets goes beyond mere speculation. They provide a structured and regulated environment where companies can raise capital to fund innovation, expansion, and operations, thereby driving economic growth. Exchanges also enable investors to buy and sell securities, facilitating liquidity and price discovery, which helps ensure that capital is allocated efficiently. Additionally, stock exchanges promote corporate transparency and accountability, as listed companies must adhere to strict disclosure requirements. By reflecting investor sentiment and broader economic trends, stock exchanges serve as crucial economic indicators, helping policymakers and analysts gauge the health of the economy. In essence, stock exchanges underpin the financial system, supporting both corporate development and investor engagement, which are essential for economic stability and progress.
