How the stock market works

The key to smart investment is to understand how the stock market works.

If you are scared of investing in the stock market, it is not a surprise. With the increasing stories of how investors lost more than 50% of their investments and how difficult it is to predict when a stock will fall or rise, investing in stock would be the last thing you want to do. However, amidst the bad news, there are still some investors who are hitting it big in the stock market. There are a lot of stocks that can withstand the test of time such as bear market and inflation. What then are these investors doing right and what is the key to investing at the right time? This key is to understand how the stock market works. The reality is that investing in stock has its risks and challenges, but when you know how the market works, you will know when to invest and when not to. 

Stock investment has been one of the ways most of the rich individuals in our society today build their net worth. Although individual net worth is often tied to the quality of their home, most of these persons have the majority of their wealth tied to their investment. To understand how an investment works, we will, first of all, examine what stock market is and the different types of investments to choose from. 

Note 

• Investing in a company’s share is one of the many ways to become a shareholder in the company. This is because a company’s share represents ownership equity in the company. When you become a shareholder, you automatically have the right to vote and also get some benefits like regular dividend and capital gains
• A market is a place where an individual buys and sells stocks, bonds, and securities. Recently, this exchange exists in the form of an electronic marketplace.
• The price of stocks is often determined by the supply and demand of stocks. Other factors that can determine this include market sentiment and

What is the stock market?

A stock market is a place where both investors and companies meet to buy and sell an asset, in this case, stocks. The process of buying and selling stock is done through the stock exchange. 

The United States has the world's two largest stock exchanges. They include the Nasdaq and the New York Stock Exchange (NYSE). When combined, the market value of the two would be up to $21 trillion in market capitalization – the value of all its shares.

Each of these two exchanges has a unique way of matching the buyer of stock to the seller. For the NYSE matches, the highest bid is matched to the lowest sales price with a market maker who fills in the gap to ensure that the matching process is without any complication. But in the case of Nasdaq, buyers and sellers trade with a dealer instead of each other. The matching process is done electronically, hence, trading is easier to complete and takes less time. Also, the electronic method ensures transparency and effective investing.

How to track the performance of stock

In the United States, the performance of the stock market is often tracked by the three principal market indices. They include the Dow Jones Industrial Average (DJIA), the S&P 500 (stocks of 500 large-cap U.S. companies), and the Nasdaq. There are different components of these markets. For instance, the Russell 2000 reports on 2,000 small-cap companies.

A market index is a way of measuring the performance of the stock market. Most of the market indices we are familiar with are market-cap. Market cap implies that the weight of each index constitutes a proportion of its market capitalization. Although most of the market indices are market-cap, two out of the three popular market indices are price-weighted. These two include the Dow Jones Industrial Average (DJIA). Aside from the above-mentioned market indices, others include:

TSX Composite (Canada).

Nikkei 225 (Japan)

FTSE Index (UK)

Dax Index (Germany)

CSI 300 Index (China)

CAC 40 Index (France)

Sensex (India)  

Investors can trade the indices indirectly through the future market or via exchange-traded funds (ETFs) which trade like a stock on stock exchanges. 

A stock is a financial instrument which when acquired grants the individual a part-owner of the company. This is why it is often referred to as a company’s equity. A company’s investor is also known as a shareholder. As s shareholder, he or she has some voting rights in the company and also share some benefits that come in the form of dividends or capital gain. The shareholders' benefit is determined by the level of stock portfolio. For instance, an individual who has a 200,000 share in a company with an outstanding with 2 million implies that the individual has a 20% ownership stake in the company.

Types of stocks

There are two major types of stock: the common and the preferred stock. Common stock is usually referred to as equity because it grants the investors more claims to a company asset than the preferred stock. The market value of the common stock and its trading volume is larger than the preferred market. 

The major difference between these two types of stock is that common stock carries more benefits than preferred stock. An individual who invested with a common kind of stock has some rights to the company’s decision making. As such, the individual can be involved in important matters such as the appointment of the board of directors, the appointments of auditors. Also, the investor can be involved in the company’s annual general meeting or AGS. 

However, in the preferred stock, the investors do not have any voting rights or share any claim to the asset. Preferred stocks are so-called because they have preference over the common stock in terms of receiving dividends as well as assets in the case of liquidation. 

Although the major aim of common stock is to have equal voting right – one vote per share, some companies have more than one kind of votes. A company might have different classes of voting powers each representing the extent the investor has a say in the companies matter. There is a dual-class structure. In this type of structure, class A, for example, can have 5 votes per share while the subsequent class B would only have one vote per share. The major reason a company uses the dual-class method is to be able to control how the company’s future of the company is determined. 

Stock exchanges

The concept behind how the stock market work is very simple. The way the stock market works is similar to auction works. The stock market allows the buyer and seller of stocks to do their business. Both parties meet in the stock market to negotiate their business. To perform the business effectively, the stock market works through a network of exchanges. Some of the networks of exchange through which the stock market performs its business include the Nasdaq or the New York Stock Exchange.  

Stock exchanges area secondary markets where stock buyers and sellers conduct their transactions. It is important to note that when buying a stock in the secondary market, you are not buying directly from the corporation listed on the stock market. Rather, you are transacting with some existing shareholders. Also, when you are selling your stock, you don't sell back to the company, but you sell to other interested new investors. 

Stock exchange as a way of selling and buying stocks first took place in the 16th and 17thcenturiesy. The trade happened in port cities or trading hubs such as Amsterdam, Antwerp, and London. These stock exchange we're similar to bond as there were no equities involved. 

The stock market begins to gain ground in America in the late 18th century, notably the New York Stock Exchange (NYSE), which allowed for equity shares to trade. Philadelphia Stock Exchange (PHLX) is rated as the first stock exchange in America which includes equity. The NYSE was founded in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Before the agreement, traders used to meet unofficially under a buttonwood tree on Wall Street to buy and sell shares with brokers.

With the introduction of equity, stock exchange begins to gain ground. Today, the US has many stock exchanges throughout the whole world. These numerous stock exchanges can link and conduct transactions electronically. The advent of electronics trade strengthen the stock market and brought with it more liquidation. 

How companies list their stocks

Companies list their shares or stock on these exchanges using a method known as the initial public offering (IPO). The IPO change the status of the company's share from its private sector to a public one. Hence, investors among the public can see the shares and also purchase the shares. The company, in turn, use the money acquired from shares to expand its business and develop it. Investors can buy and sell the stock among themselves while the market exchange network tracks the demand and supply of the shares. 

With the IPO, early investors have the privilege to cash out part of their stake while reaping a good reward alongside. 

There are different ways to calculate the value of a stock, the most common method is the Price/Earning ratio. Also, the method of analyzing the stock often fall within these three, fundamental analysis, technical analysis, and market sentiment. 

Although the demand and supply of the stocks or shares are the major factors that determine the price of stocks, a company that just listed it shares through the IPO can decide to up the price after the few first sales. This is because the few first sales are used to attract investors, after which price will be set based on the intrinsic value of the company. This also determined the extent investors will be willing to invest and how investors will react to the stocks, bonds, or security. Computer algorithms are often used to calculate the demand and supply of stocks in the stock market. 

How the price of the stock is determined

To buy a stock, buyers usually offer their highest bid to the seller, usually, this offer is lower than what the seller asks for. The difference in the bidders' offer and the sellers' amount is what is referred to as the bid-ask spread. For a trade to occur, the buyer would either increase his or her offer, or the trader will reduce it.

Note that in the stock market, a bid is a price the investor wishes to buy the stock, an offer is offered by the seller to the buyer. When there is an agreement between the offer and the bid, trade takes place. 

In the early days, stock exchange or trade happens in the physical market. But with the development in technology today, the stock market works electronically through the internet or online stock dealer. Each of the trade on the network of exchange list happens on a stock by the stock method. However, factors such as market sentiment, news, or any important occurrence can influence investors' attitudes to stock.

How the stock market works

So far, a detailed explanation has been given to what transpires in the stock market and how a company reaches out to its potential investors. However, a large percentage of the explanation revolves around the two largest stock exchanges in the United States: the NYSE and the Nasdaq. Aside from these two, there are more than two dozen stock exchanges registered with the Securities and Exchange Commission. Some of them include:

Japan Exchange Group

Euro next

Shanghai Stock Exchange

Hong Kong Exchanges and Clearing

LSE Group

Saudi Stock Exchange (Tadawul)

BSE India Limited

National Stock Exchange of India Limited

Nasdaq Nordic and Baltics

Australian Securities Exchange.

Investing in stocks

When an investor invests in the stock of a company. He or she gets a return in the form of regular dividend and capital gain. Capital occurs when the investor sells the stock at a price higher than the amount he or she purchased the stock. The difference in the price of the stock and the amount it is sold for is what is referred to as capital gain. 

A dividend, however, is the share of profit an investor or shareholder gets from the company. Dividends are an important component of stock returns—since 1956, dividends have contributed nearly one-third of total equity return, while capital gains have contributed two-thirds.

The best way to earn a good return from a stock is to invest long term. Also, the higher the chance of getting a good return from an investment, the higher the risk attached to the investment. Hence risk and return work hand in hand in investment. 

Summary

Understanding how the stock market works is the easiest way to get a good return on investment. This article has provided a detailed explanation of how the stock market works.