“The stock market is a device for transferring money from the impatient to the patient” – Warren Buffet.
The stock market is a collection of markets and exchanges, where regular activities of buying, selling, and issuance of shares of publicly-held companies takes place. So, this is the most important thing first off, the stock market only includes public companies. Your local corner shop, if it is not a large chain is likely to be privately held. This means if you would like to buy some of the company, you would have to find the owner and negotiate privately, and the owner of the company would have to be willing to sell.
Once a company goes public, this means that you can buy shares without any negotiation and the prices of the companies are listed on the stock exchange.
A company that goes public is often referred to as stock. A stock (also called a share) is a financial instrument that represents ownership of a company. Once you own a company you have the right to the company’s assets and earnings. Stock ownership implies that the shareholder (the person who bought the share) owns a slice of the company equal to the number of shares held as a proportion of all the total shares that the company had. Most companies have a large number of shares that can run into the millions or billions.
This leads to a very important point on share ownership, the price of a share.
We all know who Apple is, but a slightly less known company, Shopify trades at $1474 per share (as of November 2021). However, this does not mean that Shopify is a more valuable company compared to Apple. What is important here is the number of shares outstanding. The value of a stock IS NOT indicated by the share price. Shopify is not worth more than applying just because its share price is higher.
Apple has approximately 16,406,400,000 shares outstanding, whilst Shopify has only 125,575,200. So, therefore, the market capitalisation, which is the share price multiplied by the number of shares outstanding is much much larger for Apple than it is for Shopify. Apple is worth close to 40 times more than Shopify based on market capitalisation.
So now we know what a stock is, what is the purpose of the stock market?
In simple terms, the stock market exists because some businesses have great ideas but do not have the money to make them happen. You can imagine when Facebook first started operating, a young entrepreneur with some friends hoping to turn a website into an international brand. These kinds of things cost a lot of money and one way to raise this money is to sell some of the shares on the stock market. When shares are first sold in the stock market, this is called an initial public offering (IPO). This is the first time you can buy these shares publicly, and an investment bank helps the company decide on which price they should sell the shares at. After they have first been sold, they are sold on the public market called the secondary market and that is where most investors will buy or sell their shares.
So who buys and sells shares?
A number of different market participants are present in the stock market. Fund managers manage the money of the public and corporations through things like investment funds and pensions. Individuals like you and I can buy or sell shares and we are described as retail investors.
Does anyone invest in the stock market?
Research from the United States suggests that over half of households have some form of investment in financial markets. This is slightly less in the UK, but most of us are exposed to financial markets in some way via a pension. When we or our employer puts money into a pension every month, this is then invested in the financial markets to make a return on our investment so that by the time we retire we have some money to live without working.
How does it work?
- Does the investor choose which company they want to invest in?
- The investor goes online and places an order (similar to buying a product online).
- The investor becomes a partial owner of the company.
- The investor is then entitled to a portion of the future profits if the company makes any money.
How do companies make money?
The primary reason to invest is the hope that the company will make money. Returns generally come in two ways: (i) the stock price appreciates, which means it goes up, or (ii) the stock pays dividends (giving money back to the shareholders). For either of these to happen, generally, the company has had a positive time and made some money. In some cases, share prices can go up even if a company loses money because people expect the company to earn lots of money in the future.
What is a stock market index?
A stock market index represents a collection of stocks. For example, the Standard & Poor’s Composite 500 (S&P 500) is an index of 500 firms. It’s a weighted index based on market value (written as a value-weighted index). This means that firms will have more weight in the index if they are larger companies.
Investing in the stock market generally makes money over the long term, but in the short term, you can see large fluctuations.
For example, one of the safest assets you can invest in is a government bond of a large nation like the UK or the US. This is when investors lend their money to the government and they pay you a small return back.
To provide an example, let’s compare the returns of investing in the US stock market and a US government bond.
You can see that in some months, the stock return will be high, e.g. 10% and in some months it could be low, e.g. -17%.
With bonds, this is generally much smoother.
But how does any of this relate to actual money?
If you would have invested $1000 in the stock market (S&P 500) in 2007, you would now have somewhere in the region of $4500. Investing the same amount in bonds and you would have closer to $1100. The difference between what you can earn in the stock market versus the government bond market is called the equity premium.
However, as you can see from the graphs investing in the stock market can be much riskier in the short term. Look at the grey bars in the graphs, these are the 2008 recession. You can see that $1000 investment in the stock market went closer to $500 in 2008/09 but the $1000 dollar investment in the bond market never dropped below $1000. This shows that whilst stocks have more risk, they also have more potential rewards.
But the stock still made more money over the long term right?
Even in times of crisis and uncertainty, the stock market made a considerable amount of money between 2007 and 2021. A quote from Warren Buffet explains that over the long term the stock market seems to keep rising.
“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497”. – Warren Buffet
Are there international stock markets?
Yes, there are many stock markets around, the world, some examples of them include.
– Nikkei (Japan).
– FTSE (UK) – pronounced footsie.
– DAX (Germany)
– Hang Seng (Hong Kong)
– TSX (Toronto)
– Shanghai and Shenzen stock exchanges (China)