What is the Stock Market?
A stock market is a place where investors trade certificates that indicate partial ownership in businesses for a set price. Through these transactions, companies can raise the initial capital necessary for various aspects of operation, and those who buy the certificates become entitled to a portion of the business' assets and earnings. Although the value of the certificates is not static and depends to a large extent on public perception, the stock market remains one of the major means of investment and can be used as an indicator of overall economic health.
Stocks and Shares
When companies need money for various goals, one option they have for getting capital is to divide ownership of their businesses up into parts known as shares. They sell these shares and use the funds for tasks like developing products or buying buildings and equipment. To provide some proof of this ownership division, they print certificates called stock, and individuals who purchase the certificates are called stockholders. Many people use the words "stocks" and "shares" — or similarly, "stockholder" and "shareholder" — interchangeably because of their close relationship, but the former term technically talks about certificates for all companies in a very general sense, and the latter usually connects to a single, specific business.
As partial owners in a company, shareholders are entitled to a percentage of the assets and earnings for the business. They usually hope that the business in which they have invested will make money, because then they will receive some of the profits — in fact, the basic goal usually is to buy stock when the price is low and sell it when the value is high. With common stock, they also usually have voting rights, typically getting one vote on company issues for every certificate they own, and they generally receive annual or quarterly reports that let them know how the company is doing financially. Preferred stocks don't usually give voting rights, but they many people like them because they give more of the earnings and assets to the shareholders, and because they give investors payment priority if the company goes bankrupt and liquidates what it owns.
Purpose of the Market
At the most basic level, the stock market provides an organized way for businesses to connect with potential investors who might want to purchase stocks and become partial owners. When a corporation wants to sell shares of its company, it usually lists its stock on an exchange, which is an organization that hosts all the activities related to buying and selling certificates. A business typically has to meet specific requirements to get on an exchange, so investors usually see them as less risky when compared to businesses that sell "over the counter" (OTC), or without being listed. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ) are commonly used stock exchanges in the United States.
Basic Sales Process
When individuals are interested in buying or selling stock, they usually contact a stock broker, who is a person who works at a firm authorized to trade at stock exchanges. He relays the trade message to the floor of the correct exchange, usually receiving a commission for his service, and a representative of the company then completes the trade request. In the past, the floor was a physical place on the exchange where stock brokers met to carry out sale and purchase transactions, but today, virtual, electronic floors using the Internet or phone interactions are much more common.
A common misconception is that a person has to have a lot of money to go through this process. An individual does need to weigh the potential for earnings against the fee to buy, but many stocks are relatively inexpensive and provide good returns over the long term, and because brokers get a commission on each trade, they're usually willing to complete transactions handling a fairly low number of certificates. Additionally, many people pool their resources into what's called a mutual fund, which allows investors to work together to buy more or pricier stocks.
The value of a stock is determined initially when a company holds an event called an Initial Public Offering (IPO), during which an investment bank uses various complex techniques and formulas to estimate how much the company is worth. The business then divides this valuation by the number of shares it wants to offer. After this, however, the worth of stock certificates depends to a large degree on public perception. Under the basic principles of supply and demand, when people think the company isn't doing well, they usually don't want to buy the stock certificates, and demand for them goes down, reducing their value. Conversely, if the public thinks the business is successful and will have profits and assets to divide up, investors typically want to purchase the stocks, and the certificate demand and value goes up.
Bear and Bull
If an individual believes the stock market is going to go down, he or she is referred to as “bearish" and usually buys stock very cautiously. People who think it will go up are called “bullish” and tend to invest more aggressively. Likewise, if the prices of stocks collectively tend to rise, the stock market is called a "bull market." When stock prices as a group tend to fall, however, people refer to it as a "bear market."
Connection to Financial Portfolio
Investors have many different options in terms of where to put their money, such as real estate properties, savings accounts, retirement funds, education savings plans and bonds. Stock certificates are simply one more choice. Traditionally, however, they generally have outperformed other investment areas, providing bigger payouts. For this reason, most financial experts consider them to be a vital part of a healthy investment portfolio, and they encourage people to participate regularly in the stock market.
Even though experts don't always agree on what is the "best" way to buy or sell stock, they typically advise investors to buy stocks from many different companies. Doing this reduces the risk of extreme money loss, because if one business goes bankrupt, a person still can have plenty of other certificates that are valuable. Some individuals take this even further and assert that simply buying from more than one company isn't quite enough — they say that people should make sure their stocks come from multiple industries, because shortages or disputes often affect entire sectors.
Indicator of Economic Health
To some degree, the stock market can show how solid an economy is. In general, it drops when the economy is in trouble, because people tend to stop buying certificates when money is tight, focusing instead on necessities, such as food or mortgage payments. The drop also connects to the fact that many companies are intertwined, such as a computer business buying microprocessors from a manufacturer. When one business suffers, others often do, as well. Bullish markets, by contrast, usually indicate that individuals can afford to invest and make purchases again, or, considering the link to perception and supply and demand, that they simply believe the economy is recovering.
The first public stock market is reported to be the Amsterdam Stock Exchange. This Dutch exchange was founded in the early 17th century and started the trend of buying and selling shares of company stock. There are now exchanges in a majority of developed countries. The largest ones are in the United States, the United Kingdom, Canada, Germany, China and Japan.
@ Parmnparsley- I would like to add some information about the effects of overvalued shares on a company.
When a company is overvalued, the company can benefit greatly. Overvalued companies are less likely to be takeover targets. These companies are also more likely to use their own stock in acquisitions.
The chief officers of the company may realize that their company's stock is overvalued, and in turn use stock to purchase another company at a discount. When the stock eventually corrects, the company was able to acquire another for less than cash value.
Some would consider Berkshire Hathaway’s acquisition of BNSF as an example of this.
Many analysts believe that Berkshire is overvalued (not necessarily a bad investment). The BNSF deal pays investors in either cash or stock, with a limit of 60% of the payments in cash. This means that the company is acquiring at least 40% of the company in Berkshire class A or B stock.
If more investors choose stock, than Berkshire has more money to invest in other acquisitions. This should also push Berkshire's stock price higher causing it to become even more overvalued and increasing Berkshires discount on BNSF.
@ GlassAxe- I would like to add to your assertion that the rise and fall in stock prices does not directly affect the entity that issued the shares. For ease of understanding, I will refer to "the stock issuer" as "the company".
A company's stock price is simply a reflection of public sentiment about said company. When the price goes up, investors are optimistic. When stock prices decline, investors are pessimistic.
Stock prices have little sway over day-to-day operations, but they can affect the mid-term to long-term prospects of the company. When the market undervalues a company’s stock compared to its equity then the company becomes an easy target for acquisition. An undervalued company can also cause the board to replace the top officers. If public sentiment does not improve, excessive management turnover can begin to affect the operational efficiency of a company.
Those interested in learning about the stock market should understand that there are two categories of financial markets.
The primary market is where institutions; i.e. governments, municipalities, utilities, and companies, make their initial stock offering to the public. Primary markets use underwriters to broker the stock offering to individual investors; essentially raising capital for the institution offering the stock. This process of converting private assets into public capital is what companies refer to as going public. The job of the underwriter is to hype up the potential of the stock so the institution can raise the most capital.
The secondary market is where investors trade stock amongst themselves. Unlike the primary market, the stock issuing institution does not benefit directly from the sale of stock. However, the stock issuing institution does benefit from the rise in stock prices. Any stock the company retains will rise in price just as it does for investors. The same also holds true when investors lose confidence in a company; declining prices lead to losses for the company.
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