RV Blog How Does The Stock Market Work?

How Does The Stock Market Work?

Today’s financial markets can feel like an opaque and incomprehensible force. Much of the world seems to revolve around and depend on these markets, but the forces driving them are only vaguely identifiable, even for insiders and experts. The stock markets, as one of the center pillars of the financial markets, usually stand in the brightest spotlight, as news outlets around the world report their every movement. In this article, we are taking a closer look at how the stock markets work, their origin, the basic functionalities and explain how to invest in stocks in a few simple steps.

What is a stock market and why do we need it?

A stock market, also called stock exchange, is a digital platform (formerly physical) where investors can buy and sell stocks (also called shares) and bonds in publicly traded companies. Prices for stocks are determined by supply and demand. The more people want to buy a specific stock, the higher its price rises. When demand drops, the price of a stock decreases as well. 

This type of marketplace allows for efficient transactions between buyers and sellers of financial instruments, without having to know or trust the counterparty. Also, due to the continuous trading of financial instruments on these markets, investors know at any time the current market value of their investments.

Origins of the stock market

The modern stock markets in Western Europe had humble beginnings, but they have constantly evolved to the fully digitized platforms they are today.

1612: In 1612, the Dutch East India Company was the first publicly traded company. With its headquarters located in Amsterdam, the city became home to the first modern stock trading exchange. For many years, the Dutch East India Company was the only traded company on the exchange.

1790: The Philadelphia Stock Exchange, originally named Board of Brokers of Philadelphia. was founded as the first stock exchange in the United States to help spur the country’s west expansion. 

1792: On May 17, twenty four New York brokers signed the Buttonwood Agreement to set standards for their daily stocks and bonds trading activities. The earliest securities traded were mostly governmental war bonds and First Bank of the United States stocks. The Buttonwood Agreement is the founding document of what today is the New York Stock Exchange.

1896: Charles Dow created the Dow Jones Industrial Average index, which is highly regarded till this day. It initially contained 12 industrial companies, of which none still remains in the index today. 

1926: Standard & Poor’s, initially known as the Standard Statistics Company, developed a 90-stock composite price index computed daily, which developed into the S&P 500 index over the years.

1971: NASDAQ, standing for National Association of Securities Dealers Automated Quotations, began operations as the world’s first electronic stock market in New York.

Today: There are 16 stock exchanges worldwide that have an equity market capitalization of over $1 trillion each. Together, these exchanges account for over 80% of the global equity market capitalization.

Top 5 stock exchanges:

1: New York Stock Exchange (USA)
2: Nasdaq (USA)
3: Shanghai Stock Exchange (China)
4: Japan Exchange Group (Japan)
5: Hong Kong Stock Exchange (Hong Kong)

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Why are stock markets needed?

Stock markets today exist in most countries and are a centerpiece of the basic financial infrastructure. But why are they so important for a country’s economic development?

  • Stock markets help companies to raise capital: Public companies were invented to make large, capital-intensive investments possible. Investors would pool their funds into the cooperation and share the profit and the risk according to their initial investments. Stock markets allow companies to raise capital more efficiently on a large, worldwide scale. By selling shares to investors, companies can raise large amounts of money for substantial investments without having to take on costly debt capital. Further, investors are giving indirect feedback to companies and their projects by (not) investing in them, which allows for an efficient capital allocation in the overall financial markets.
  • Stock markets help create wealth. Stock markets allow individuals to participate in the success of corporations and thereby generate personal wealth. Low capital requirements and easy access to the financial markets make it possible for a large percentage of society to benefit from economic growth and prosper financially.
  • Stock markets increase investments in the economy. The stock market is a tool for worldwide investors to participate in local economies. Promising, well run economies attract capital investments which allow companies to further innovate and invest. In return, this benefits the overall economy and the country as a whole.

In summary, the stock market allows corporations and public investors to transfer capital and ownership in a secure and controlled environment. It is a convenient way for companies to raise capital and for individuals to buy, trade or cash out investments. Additionally, the stock market helps to keep corporate practices in check and fuels a nation’s economic growth and individual prosperity.

How does the stock market work?

A stock market has two basic functionalities. Firstly, companies and banks offer newly issued shares, bonds and other financial products to investors. Secondly, investors offer their financial instruments to other investors.

Today’s stock markets are fully automated and digitalized. They allow for real-time trading and orders are usually fulfilled within seconds. Prices of financial instruments are determined through an order book, which displays all the buy and sell orders for each instrument. As soon as the bid and ask price of a buy and sell order matches, the trade is automatically executed.

What time do stock markets open & close?

Stock markets have conservatives trading hours. Wall Street exchanges are open from 9:30 am to 4:00 pm Easter Standard Time (GMT-5) on weekdays and closed on weekends. The London Stock exchange is open for trading from 8:00 am to 4:30 pm UK time on weekdays only. Similar hours apply for most other stock markets, like Zurich or Frankfurt.

As stock markets are spread around the world (New York, Shanghai, Tokyo, Sydney, … ), stock trading happens around the clock on different exchanges in different time zones and only rests on weekends.

What is a stock? A stock (also share or equity) represents fractional ownership in a company. Stock owners are entitled to parts of a company’s assets in proportion to how much stock they own. Usually, owing stock comes with certain privileges, such as voting rights and the right to possible dividend payouts.

Stock exchanges: Stock exchanges (also stock markets) are marketplaces where stocks are purchased and sold. In the past, these were physical locations where brokers would meet to fulfill their clients orders. Today, stock exchanges are fully automated digital platforms running on computer servers. Nevertheless, running a stock exchange is strongly regulated and requires the financial regulator’s permission.

Stock brokers: Stock brokers are the intermediaries between an investor and a stock exchange. Most exchanges only accept orders from members of that exchange. Individual traders and investors are therefore reliant on the service of an exchange member. Brokers provide such services and are compensated through trading fees, commissions and other means.

Stock market indices: Stock market indices track the performance of a basket of shares. Their goal is to provide a simple market overview over a specific market segment. Shares represented in an index usually have a common denominator, such as jurisdiction, industry, or market capitalization. The most common stock market indices are the S&P 500 (500 largest US companies), the Nasdaq 100 (100 largest US tech companies) and the Dow Jones Industrial Average (30 largest US companies from all industries).

How are prices set? Prices are determined according to supply and demand. Normally, prices are dependent on the expected future performance of a company, but can also have other drivers. The current price of a stock is the price of the last fulfilled order. Investors wanting to sell a stock can place an offer with a quantity and a price in the order book. The same goes for buyers. Matching or accepted offers are automatically executed. 

What happens when you buy a stock? Once an order has been fulfilled, the purchased stock will be visible in your personal account immediately. You now have all the rights that come with owning this stock, such as voting rights and the right to dividend payments. You can also resell the stock, within the stock market’s trading hours, any time you’d like.

Note: technically, the final settlement for stock deliveries is T+2, meaning the counterparty has to hand over the stock to your broker only two business days after your purchase. During this period, you carry the counterparty risk, should the other party become insolvent.

What is stock market volatility & what causes it?

Stock market volatility describes the rate at which the stock market increases and decreases over a particular time period. Higher volatility means more and larger fluctuations in prices, low volatility means more stable prices. A certain amount of volatility is normal and an inherent characteristic of the stock markets. Volatility can have different causes, such as:

  • Supply / Demand: Changes in supply and demand of a certain stock influence price and lead to volatility. An extreme case for a demand shock are so-called short-squeezes, where investors have to buy large quantities of a particular stock at a given day to fulfill financial contracts, which lets prices skyrocket.

A supply shock happens when a large stockholder wants to sell off his positions all at once and floods the market with sell orders, leading to a price drop.

  • Earnings reports & company press: Quarterly financial reports can influence prices significantly and investors look forward to them with great anticipation. Financial analysts often release their estimated earnings prior to the reports. Should the reality not reflect the expectations, then prices often move accordingly.

The same goes for good and bad publicity. Good news such as innovations or the release of a new model can lead to price increases. Failed acquisitions, environmental disasters, scandals and other bad press usually lead to price corrections.

  • Economic & political news: News not directly related to a company but to the overall economy can lead to market volatility as well. The release of macroeconomics numbers, such as unemployment rate, inflation, GDP or non-farm-payrolls, can have a strong influence on the expected economic development and move the stock market accordingly.

The same goes for political news. Election results, new legislation and regulations or the rumor of war often have a strong impact on the financial markets. For investors trading short term such events can be of great importance. 

  • Fomo / herd instinct: Investors don’t always behave rationally and the stock markets are known to be driven by herd instinct. Many investors do what they see or expect others to do. This can lead to bizarre behavior, where investors make highly irrational investment decisions.

The same goes for Fomo (fear of missing out). Strongly increasing markets attract ever more investors willing to participate in the bull market. Notwithstanding the already overvalued markets, they still buy stocks until at one point the whole market collapses, leaving latecomers with large losses. 

Caution is therefore urged whenever the market fluctuations are highly irrational and stock prices are contradicting solid financial calculations.

Buy shares or invest in funds?

There is no right answer to this question, as both strategies can be successful. But research shows that the large majority of active asset managers fail to outperform the market. This shows that picking the right stocks is not an easy undertaking and requires lots of expertise and experience.

For investors convinced that they can distinguish the outstanding from the mediocre company, or believe to know the best performing industry of the future, buying selected stocks can be a profitable investment style. For all other investors, investing in low cost index funds is certainly a solid strategy for long term investment success.

When to buy & sell shares?

Timing the market can create both opportunities and pitfalls for investors. Studies show that timing the market just right is close to impossible. The difficulty doesn’t lie as much in getting out of the market at the end of a bull market, but to get back into the market at the end of a bear market

According to a study by Jess Chua and Richard Woodward, investors have to predict 70% of the bull markets and 80% of the bear markets correctly to outperform a simple buy-and-hold strategy. This said, it is certainly possible to identify buying and selling opportunities in under- and overvalued markets, but it needs patience, coolness and in-depth knowledge of the market.

A strategy to avoid this question altogether is the dollar-cost-averaging (DCA) approach, where investors buy investments each month for the same amount, no matter the current market situation. This leads to an averaging of the purchase price and potentially to peace of mind.    

How much money is needed?

Thanks to innovative concepts, the costs for buying stocks have dropped significantly with some brokers offering trading with no fees. Further, most brokers allow for the purchase of fractions of shares. Consequently, investing in stocks can be profitable with investments of any amount and some brokers let you invest with as little as $10.

How to invest in the stock market?

Investing in the stock market is easy. The following 4 steps will help you to purchase your first stock.

Step 1: Choose a broker

Most banks provide their customers with access to the financial markets. For smaller investors, their fees can be hefty though. It therefore makes sense to choose a broker with low or no fees, such as Fidelity, Robinhood and Schwabb. They have a simple user interface and provide access to the most common financial instruments.

Step 2: Create an account

In order to create an account basic identification is required, and if larger amounts are traded, a complete verification. Users will be asked to provide personal information such as name, address, an official public document (passport) and a proof of address (utility bill). Usually, this process takes only a couple of minutes. Once the documents have been submitted, it takes 1-2 business days for the account to be verified and fully operational. 

Step 3: Fund your account

Next, top up your account. Most brokers accept bank transfers from your local bank. Some also offer topping up via credit card (be aware of fees). Once your money has arrived, your account is ready for your first investment.

Step 4: Make your first Investment

The easiest way to start investing is buying a stock of a large publicly traded company such as American Airlines, Bank of America, Google or Tesla.  Pick a stock you like, enter the amount of stocks you’d like to buy (or a fraction of a stock), choose either the maximum price you are willing to pay (limit order) or the current market price (market order). After clicking ‘buy’, the stock is purchased within seconds and shown in your portfolio.

Closing thoughts

The stock markets are one of the fundamental economic drivers in today’s global business and financial world. Ever more of our daily life seems to be influenced by the current condition of the financial markets, especially the stock markets. Understanding their basic mechanisms will help you better comprehend financial politics, central bank policies and macroeconomics trends.

RELATED CATEGORIES: Investing, Stock Market