What Is The Stock Market and How Does It Work?

What Is The Stock Market and How Does It Work?

Stock markets are some of the most important parts of today’s global economy. If you want to invest in the stock now, you need to understand the stock market is and how it works. The stock market is where investors connect to buy and sell investments — most commonly, stocks, which are shares of ownership in a public company.

To know more about the details, keep reading our article to understand deeper before investing in the stock.

What is the stock market?

The stock market is a marketplace where people buy and sell shares, or stock, in companies based on how much they think they will be worth in the future. There are stock markets all over the world, with some of the bigger ones, including America’s New York Stock Exchange and the UK’s London Stock Exchange. Each piece of stock you buy means you own a share of the company you’re buying it from.

The performance of each stock market is best observed by looking at the value of large indexes within the stock market. An index contains the top-performing companies within the stock market, examples being the S&P 500 in the US, the FTSE100 in the UK, and the Nikkei Index in Japan.

You’ll frequently hear on the news headlines that the stock markets have moved up or down, which typically means that the stock market indexes have moved. This movement refers to the value gained or lost by the index as a whole, and investors who make stock market transactions look for profits through the movement of stock prices.

History of The Stock Market

Early stock and commodity markets

The first genuine stock markets didn’t arrive until the 1500s. However, there were plenty of early examples of markets that were similar to stock markets.

In the 1100s, for example, France had a system where courtiers de change managed agricultural debts throughout the country on behalf of banks. This can be seen as the first major example of brokerage because the men effectively traded debts.

Later on, the merchants of Venice were credited with trading government securities as early as the 13^th century. Soon after, bankers in the nearby Italian cities of Pisa, Verona, Genoa, and Florence also began trading government securities.

The world’s first stock markets (without stocks)

The world’s first stock markets are generally linked back to Belgium. Bruges, Flanders, Ghent, and Rotterdam in the Netherlands all hosted their own “stock” market systems in the 1400s and 1500s.

However, it’s generally accepted that Antwerp had the world’s first stock market system. Antwerp was the commercial center of Belgium and it was home to the influential Van der Beurze family. As a result, early stock markets were typically called Beurzen.

All of these early stock markets had one thing missing: stocks. Although the infrastructure and institutions resembled today’s stock markets, nobody was actually trading shares of a company. Instead, the markets dealt with the affairs of government, businesses, and individual debt. The system and organization was similar, although the actual properties being traded were different.

The world’s first publically traded company

The East India Company is widely recognized as the world’s first publically traded company. There was one simple reason why the East India Company became the first publically traded company: risk.

Put simply, sailing to the far corners of the planet was too risky for any single company. When the East Indies was first discovered to be a haven of riches and trade opportunities, explorers sailed there in droves. Unfortunately, few of these voyages ever made it home. Ships were lost, fortunes were squandered, and financiers realized they had to do something to mitigate all that risk.

As a result, a unique corporation was formed in 1600 called “Governor and Company of Merchants of London trading with the East Indies”. This was the famous East India Company and it was the first company to use a limited liability formula.

Investors realized that putting all their “eggs into one basket” was not a smart way to approach investment in East Indies trading. Let’s say that a ship returning from the East Indies had a 33% chance of being seized by pirates. Instead of investing in one voyage and risking the loss of all invested money, investors could purchase shares in multiple companies. Even if one ship was lost out of 3 or 4 invested companies, the investor would still make a profit.

The formula proved to be very successful. Within a decade, similar charters had been granted to other businesses throughout England, France, Belgium, and the Netherlands.

In 1602, the Dutch East India Company officially became the world’s first publically traded company when it released shares of the company on the Amsterdam Stock Exchange. Stocks and bonds were issued to investors and each investor was entitled to a fixed percentage of East India Company’s profits.

Read More: Top 10 Largest Stock Exchanges In The World

Selling stocks in coffee shops

Photo: KnowInsiders

Before investors yelled across trade floors and threw order forms into the air, they conducted business in coffee shops. Early stocks were handwritten on sheets of paper, and investors traded these stocks with other investors in coffee shops.

In other words, coffee shops were the first real stock markets due to the fact that investors would visit these markets to buy and sell stocks. Before long, somebody realized that the entire business world would be more efficient if somebody made a dedicated marketplace where businessmen could trade stocks without having to order a coffee or yell across a crowded café.

The first stock market bubble

Nobody really understood the importance of the stock market in those early days. People realized it was powerful and valuable, but nobody truly understood exactly what it would become.

That’s why the early days of the stock market were like the Wild West. In London, businesses would open up overnight and issue stocks and shares of some crazy new venture. In many cases, companies were able to make thousands of pounds before a single ship had ever left the harbor.

There was no regulation and few ways to distinguish legitimate companies from illegitimate companies. As a result, the bubble quickly burst. Companies stopped paying dividends to investors and the government of England banned the issuing of shares until 1825.

The first stock exchange

Despite the ban on issuing shares, the London Stock Exchange was officially formed in 1801. Since companies were not allowed to issue shares until 1825, this was an extremely limited exchange. This prevented the London Stock Exchange from preventing a true global superpower.

That’s why the creation of the New York Stock Exchange (NYSE) in 1817 was such an important moment in history.

The NYSE has traded stocks since its very first day. Contrary to what some may think, the NYSE wasn’t the first stock exchange in the United States. The Philadelphia Stock Exchange holds that title. However, the NYSE soon became the most powerful stock exchange in the country due to the lack of any type of domestic competition and its positioning at the center of U.S. trade and economics in New York.

The London Stock Exchange was the main stock market for Europe, while the New York Stock Exchange was the main exchange for America and the world.

Modern stock markets

Today, virtually every country in the world has its own stock market. In the developed world, major stock markets typically emerged in the 19^th and 20^th centuries soon after the London Stock Exchange and New York Stock Exchange were first created. From Switzerland to Japan, all of the world’s major economic powers have highly-developed stock markets which are still active today.

Canada, for example, developed its first stock exchange in 1861. That stock exchange is the largest in Canada and the third-largest in North America by market capitalization. It includes businesses based in Canada and the rest of the world. The TSX, as it is known, hosts more oil and gas companies than any other stock exchange in the world, which is one major reason why it has such a high market cap.

Even war-torn countries like Iraq have their own stock markets. The Iraq Stock Exchange doesn’t have a lot of publicly-traded companies, but it is available to foreign investors. It was also one of the few stock markets unaffected by the economic crisis of 2008.

Stock markets can be found around the world and there’s no denying the global importance of stock markets. Every day, trillions of dollars are traded on stock markets around the world and they’re truly the engine of the capitalist world.

After dominating the world economy for nearly three centuries, the New York Stock Exchange faced its first legitimate challenger in the 1970s. In 1971, two organizations – the National Association of Securities Dealers and Financial Industry Regulatory Authority – created the NASDAQ stock exchange.

NASDAQ has always been organized differently from traditional stock exchanges. Instead of having a physical location, for example, NASDAQ is held entirely on a network of computers and all trades are performed electronically.

Electronic trading gave the NASDAQ a few major advantages over the competition. First and most importantly, it reduced the bid-ask spread. Over the years, competition between Nasdaq and the NYSE has encouraged both exchanges to innovate and expand. In 2007, for example, the NYSE merged with Euronext to create NYSE Euronext – the first transatlantic stock exchange in the world.

Types of Stock

Photo: KnowInsiders

While there are two main types of stock—common and preferred—the term equities is synonymous with common shares, as their combined market value and trading volumes are many magnitudes larger than that of preferred shares.

The main distinction between the two is that common shares usually carry voting rights that enable the common shareholder to have a say in corporate meetings (like the annual general meeting or AGM) where matters such as election to the board of directors or appointment of auditors are voted upon while preferred shares generally do not have voting rights. Preferred shares are so named because preferred shareholders have priority over common shareholders to receive dividends as well as assets in the event of a liquidation.2

Common stock can be further classified in terms of their voting rights. While the basic premise of common shares is that they should have equal voting rights—one vote per share held—some companies have dual or multiple classes of stock with different voting rights attached to each class. In such a dual-class structure, Class A shares, for example, may have 10 votes per share, while the Class B subordinate voting shares may only have one vote per share. Dual- or multiple-class share structures are designed to enable the founders of a company to control its fortunes, strategic direction, and ability to innovate.

Why are stock markets essential?

*Stock markets enable companies to be traded publicly and raise capital. The transfer of capital and ownership is traded in a regulated, secure environment.

*Stock markets promote investment. The raising of capital allows companies to grow their businesses, expand operations and create jobs in the economy. This investment is a key driver for economic trade, growth, and prosperity.

*For investors, stock markets provide a way to invest money in order to potentially earn a share of the company’s profits (knowing that the risk of losses exists too). Active investors and traders can easily buy and sell their securities due to the abundant liquidity in most major stock markets.

Why trade stocks?

There are numerous reasons why companies, banks, funds, investors, and traders buy and sell company stocks:

Investment Gains

Stock ownership may help your money grow. Over the long term, the benefits of investing in stocks typically far outweigh those of holding money in lower-return assets like cash.

Diversification

Trading a variety of stocks can help you spread your risk across different asset classes, economic sectors, and geographical locations. This will expand the potential for positive returns in your portfolio.

Income

Some stocks provide income as regular dividends, even if the stock has lost value. That is income you can keep or reinvest. You can also register votes in company activities.

Control

Stocks trade by the millions every day so you can easily trade, buy and sell stocks and shares when you want. This flexibility also means you decide which company to invest in and when.

Trading stocks let you own a part of a company’s present and future. Depending on your risk tolerance and timeframe, the benefits can be many and varied.

What is the difference between Stock Market vs Stock Exchange?

Photo: KnowInsiders

Although the terms are used interchangeably, the stock market is not the same as a stock exchange. Think of a stock exchange as a part of a whole—the stock market comprises many stock exchanges, such as the Nasdaq or New York Stock Exchange (NYSE) in the U.S.

When people talk about how the stock market is performing, they mean the thousands of public companies listed on multiple stock exchanges. And more generally, the stock market can be thought of as encompassing a very broad universe of bonds, mutual funds, exchange-traded funds (ETFs), and other securities beyond just stocks.

How does the stock market work?

The concept behind how the stock market works is pretty simple. The stock market lets buyers and sellers negotiate prices and make trades.

The stock market works through a network of exchanges — you may have heard of the New York Stock Exchange or the Nasdaq. Companies list shares of their stock on an exchange through a process called an initial public offering or IPO. Investors purchase those shares, which allows the company to raise money to grow its business. Investors can then buy and sell these stocks among themselves, and the exchange tracks the supply and demand of each listed stock.

That supply and demand help determine the price for each security or the levels at which stock market participants — investors and traders — are willing to buy or sell.

Buyers offer a “bid,” or the highest amount they’re willing to pay, which is usually lower than the amount sellers “ask” for in exchange. This difference is called the bid-ask spread. For a trade to occur, a buyer needs to increase his price or a seller needs to decrease hers.

This all may sound complicated, but computer algorithms generally do most the price-setting calculations. When buying stock, you’ll see the bid, ask, and bid-ask spread on your broker's website, but in many cases, the difference will be pennies, and won’t be of much concern for beginner and long-term investors.

Historically, stock trades likely took place in a physical marketplace. These days, the stock market works electronically, through the internet and online stockbrokers. Each trade happens on a stock-by-stock basis, but overall stock prices often move in tandem because of news, political events, economic reports, and other factors.

How volatile is the stock market?

The stock market is volatile by nature, and many factors affect its volatility. Regional and national economic factors, such as tax and interest rate policies, may contribute to a change in the market. For example, if a bank sets short-term interest rates for overnight borrowing, this can violently influence the stock market.

Other factors, such as a change in inflation trends, may influence long-term stock market trends and its volatility. For example, a huge weather event affecting a major oil-producing area may suddenly increase oil prices. This increase can also spike the prices of oil-related stocks.

Political uncertainty is another contributing factor to stock market volatility. The US election in November 2020 had a swift impact on stock markets around the world, and trade deals between major powers can also move stock markets up or down.

Finally, a global event can make the stock market swing wildly. The below graph shows how the coronavirus pandemic affected stock markets worldwide.

What are the risks of investing in the stock market?

Photo: KnowInsiders

The biggest risk of investing in the stock market is there is a chance of losing your entire investment if the price of the stock you own falls to zero, for example, if the company you own stocks in goes bankrupt.

When the value of the stock market decreases to less than 10%, this is known as a market crash. A bad market crash may even cause a recession. In the history of the stock market there have been several infamous crashes, such as the Wall Street crash of 1929, also known as ‘Black Tuesday’, and the 2008 financial crisis that followed the US housing bubble.

When a stock market decreases by 20% from its highest price, this is known as a bear market. Bear markets can occur in any asset class and can potentially wipe out years of gains.

If you’re buying and selling stocks, you stand to lose money. Some consider day trading to be risky because it’s impossible to guarantee you’ll make a profit. However, in contrast to short-term trading, investing in the stock market over the long-term may prove more profitable, but you still have to be aware of the risks of market crashes.

How to Invest in the Stock Market

If you want to invest in the stock market, the process to get started is easier than you think:

-Decide what kind of account you want to open. From retirement savings to college savings, from short-term goals to long, there really is an investment account for everything.

-Open a brokerage account. Once you’ve decided what kind of account you want, you’re ready to open an account at a provider called a brokerage. When choosing a company, consider its fees and available investment options.

-Deposit money. To get started, you need to make an initial deposit. You can also set up recurring deposits to automate your investments going forward.

-Choose your investments. Once your account is open, you can buy and sell securities. You can opt for individual stocks and bonds or mutual funds, index funds, and exchange-traded funds (ETFs) that contain hundreds of individual securities. Many experts recommend a diversified, fund-based approach to minimize the risk anyone bad investment loses you money.

-Purchase your investments. Once you’ve settled on what you want to buy, simply enter the ticker symbol in the buy field and indicate how many shares you want to buy.

When do stock markets close around the world?

One of the many advantages of having stock markets around the world is the fact that there is almost always a market open in some part of the world. Most of the world’s stock markets open between 9:00 am and 10:00 am local time and close between 4:00 pm and 5:00 pm local time. The NYSE, NASDAQ, TSX, and Shanghai Stock Exchange all open at 9:30.

Some stock markets also take a break for lunch. Four major Asian markets take a break for lunch that lasts for 1 hour to 1.5 hours in the middle of the day. Those markets include the Tokyo Stock Exchange, Hong Kong Stock Exchange, Shanghai Stock Exchange, and Shenzhen Stock Exchange.

Different countries celebrate different days of the year, which is why some global stock markets are still open on public holidays in the United States.

Read More: What time does the global stock market open and close?

What is the future of the stock market?

Stock markets aren’t going away anytime soon. They remain a driving economic force in virtually every country in the world. Analysts aren’t entirely sure what the future holds for the stock market, although there are some important things to consider.

First, the NYSE remains the largest and (arguably) the most powerful stock exchange in the entire world. It’s so large, in fact, that its market capitalization is larger than Tokyo, London, and NASDAQ combined.

Second, we will likely see stock markets continue to merge over the coming years. Some have even suggested that we’ll eventually see a single global stock market, although this appears to be unlikely.

Whatever the future may hold for stock markets, they’re going to continue playing an important role in global economies around the world for the long foreseeable future.

Top 10 Best Online Stock Brokers for Non-US Residents If you are looking to invest in the US stock market, below is a list of the 10 best online brokers for non-US residents.

Top 9 Most Expensive Stocks In The World Stock price is an indicator of a company's market value, but the price of a share of stock will also depend on the number of ...

Three Stocks Predicted to Soar In Next Ten Years Due to uncertain developments of megatrends, it is predicted that these stocks would flourish in the next decades. Let’s check out what are they?