Introduction to the Stock Market Part I. The Basics
This article serves as a brief introduction to the stock market.
By Kaitlin Meyer — February 28, 2023
The stock market influences the economy; the economy drives the cost of living; the cost of living often drives our way of life. Despite its immense impacts on individual lives, many people are ignorant about the stock market, why it exists, and how it works. While a hefty topic—books have been written about the stock market—this article serves as a brief introduction.
What Exactly is the Stock Market?
Trade between individuals and companies has existed as long as human civilization and is fundamental to existing together. Fundamentally, the stock market is a form of this age-old tradition of trade, while its unique nature makes it utterly modern. The stock market is a place where individual investors, companies, and institutional investors can trade shares in stock. Stocks are "ownership interest" in public companies. If an individual investor buys a share in Amazon, for example, the investor owns a small part of Amazon and will profit when the company is successful.
The prices of stocks are determined by supply and demand. If more investors are interested in buying stock than selling it, then prices will increase. If more investors are interested in selling as opposed to buying, prices will decrease. This dynamic means that market prices are variable and sometimes difficult to predict. Stock market prices represent investors' predictions of how well or poorly certain companies will do, and, as a result, the stock market is fundamentally ordered toward the future.
Terms surrounding the stock market can be very confusing. The stock market represents the entirety of the thing: all the stocks, bonds, and trades between companies and investors. A stock exchange is a particular market in which certain companies participate. Examples include the New York Stock Exchange, the National Association of Securities Dealers Automated Quotations (NASDAQ), the Shanghai Stock Exchange, and Euronext.
How Does it Work?
Let's say an individual, maybe you, wishes to purchase a share in the stocks of a certain company. Rather than companies constantly selling more and more stock, most trading goes on between individual investors. When an individual buys a share of stock, they usually purchase it from another individual selling their stock in that company. When the market is open, purchases of stock go through in seconds. How is this possible? Individual investors are not constantly approving sales. Rather, "market makers" serve as middlemen between investors and make the day-to-day functioning of the stock market possible. They buy and hold stocks as soon as they go on sale. Actual transactions must go through brokers. A broker can be an individual person or company with a license to operate within the stock market. When an individual presses "buy" on a broker's website, the broker communicates the purchase to a market maker, and the market maker transfers the share of stock to the individual.
Because stocks are controlled by supply and demand, prices are variable. In practice, this results in a "bid-ask spread," which is the difference between the lowest price a seller offers and the highest price a buyer is willing to pay. This spread represents the transaction cost. An individual buying a stock share will pay the asking price, while one selling will receive the selling price. The bid-ask spread is generally a good representation of the supply-demand situation at a given time. For example, if the spread for a particular asset is low or narrow, demand is likely high for that asset. Similarly, if the bid-ask spread is high, it may signify that demand for an asset is low. While these are the basics, several other complicated factors drive the bid-ask spread.
What is the Purpose of the Stock Market?
The stock market allows companies to raise "public capital" for running their operation and growing their business by selling shares to investors. Secondarily, it gives individual investors the opportunity to profit from a successful business. Entrepreneurial success is advantageous for businesses because they do not take on any debt in the process but are still able to expand and build. This advantage does not come without some caveats.
A public company must sell a certain amount of stock and are subject to public reporting requirements. This means that they have to disclose information about how their business operates, as well as financial information, to the public regularly. In addition, a public company becomes accountable to its shareholders. Once shareholders reach a certain amount of stock in a company, they elect a board of directors who supervise the operations and management of the company.
The benefit to companies is clear, but given highly variable prices, how do investors know they will benefit from their investments? While investing in the stock market always involves some risk and relates to the type of investment, the stock market has increased investments by 10% per year on average throughout its history. Meaning that, on average, if an individual rides out the lows and highs of the market, he will receive a dependable return on his investment. Many investors look towards a stock market index to evaluate how well or poorly the market is doing at a given time. The index measures the state of the market by tracking the prices and trends of several different companies and reporting the average. The two most common indices are the Dow Jones Industrial Average and the S&P 500. The former tracks 30 of the largest American companies in certain stock exchanges, and the latter tracks 500 of the largest American companies.
Takeaways
- The stock market is a place where individual investors, companies, and institutional investors can trade shares in stock.
- A stock exchange is a smaller part of the stock market: it is a particular market in which certain companies participate and is generally regional.
- Prices in the stock market are driven by supply and demand, allowing fluctuation.
- Most of the transactions within the market are between individual investors , like you and me!
- Market makers serve as middlemen between investors, facilitating instantaneous trading when the market is open.
- The stock market allows public companies to raise public capital without incurring debt and allows individual investors to profit from companies' successes.
- A stock market index measures how well or poorly the market is doing by analyzing and averaging the performance of several different companies.
Kaitlin Meyer
Kaitlin Meyer is a Master's student at Ohio State University (OSU), and is writing a thesis on snow microstructure inspired by her love for skiing. She earned a B.A. in Liberal Arts from Wyoming Catholic College (WCC).
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