How Does the Stock Market Work?

If the thought of investing in the stock market scares you, you are not alone. Individuals with very limited experience in stock investing are either terrified by horror stories of the average investor losing 50% of their portfolio value – for example, in the two bear markets that have already occurred in this millennium – or are beguiled by "hot tips" that bear the promise of huge rewards but seldom pay off. It is not surprising, then, that the pendulum of investment sentiment is said to swing between fear and greed.

The reality is that investing in the stock market carries risk, but when approached in a disciplined manner, it is one of the most efficient ways to build up one's net worth. While the value of one's home typically accounts for most of the net worth of the average individual, most of the affluent and very rich generally have the majority of their wealth invested in stocks. In order to understand the mechanics of the stock market, let's begin by delving into the definition of a stock and its different types.

A stock or share (also known as "equity") is a financial instrument that represents ownership in a company or corporation and represents a proportionate claim on its assets (what it owns) and earnings (what it generates in profits).

Stock ownership implies that the shareholder owns a slice of the company equal to the number of shares held as a proportion of the company's total outstanding shares. For instance, an individual or entity that owns 100,000 shares of a company with 1 million outstanding shares would have a 10% ownership stake in it. Most companies have outstanding shares that run into the millions or billions.

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 they have preference over the common shares in a company to receive dividends as well as assets in the event of liquidation.

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 and strategic direction.

Today's corporate giant likely had its start as a small private entity launched by a visionary founder a few decades ago. Think of Jack Ma incubating Alibaba Group Holding Limited (BABA) from his apartment in Hangzhou, China, in 1999, or Mark Zuckerberg founding the earliest version of Facebook, Inc. (FB) from his Harvard University dorm room in 2004. Technology giants like these have become among the biggest companies in the world within a couple of decades.

However, growing at such a frenetic pace requires access to a massive amount of capital. In order to make the transition from an idea germinating in an entrepreneur's brain to an operating company, he or she needs to lease an office or factory, hire employees, buy equipment and raw materials, and put in place a sales and distribution network, among other things. These resources require significant amounts of capital, depending on the scale and scope of the business startup.

A startup can raise such capital either by selling shares (equity financing) or borrowing money (debt financing). Debt financing can be a problem for a startup because it may have few assets to pledge for a loan – especially in sectors such as technology or biotechnology, where a firm has few tangible assets – plus the interest on the loan would impose a financial burden in the early days, when the company may have no revenues or earnings.

Equity financing, therefore, is the preferred route for most startups that need capital. The entrepreneur may initially source funds from personal savings, as well as friends and family, to get the business off the ground. As the business expands and capital requirements become more substantial, the entrepreneur may turn to angel investors and venture capital firms.

When the company gets established, it may require access to much larger amounts of capital, which it can do by selling shares to the public through an initial public offering (IPO). This changes the status of the company from a private firm whose shares are held by a few shareholders to a publicly traded company whose shares will be held by numerous members of the general public. The IPO also offers early investors in the company an opportunity to cash out part of their stake, often reaping very handsome rewards in the process.

Once the company's shares are listed on a stock exchange and trading in it commences, the price of these shares will fluctuate as investors and traders assess and reassess their intrinsic value. There are many different ratios and metrics that can be used to value stocks, of which the single-most popular measure is probably the Price/Earnings (or PE) ratio. Stock analysis also tends to fall into one of two camps – fundamental analysis, or technical analysis.

The overall market is made up of millions of investors and traders, who may have differing ideas about the value of a specific stock and thus the price at which they are willing to buy or sell it. The thousands of transactions that occur as these investors and traders convert their intentions to actions by buying and/or selling a stock cause minute-by-minute gyrations in it over the course of a trading day. A stock exchange provides a platform where such trading can be easily conducted by matching buyers and sellers of stocks. For the average person to get access to these exchanges, they would need a stockbroker. This stockbroker acts as the middleman between the buyer and the seller. Getting a stockbroker is most commonly accomplished by creating an account with a well established retail broker. For those interested, Investopedia has a list of the best stockbrokers in the industry.

The stock market also offers a fascinating example of the laws of supply and demand at work in real time. For every stock transaction, there must be a buyer and a seller. Because of the immutable laws of supply and demand, if there are more buyers for a specific stock than there are sellers of it, the stock price will trend up. Conversely, if there are more sellers of the stock than buyers, the price will trend down.

The bid-ask or bid-offer spread – the difference between the bid price for a stock and its ask or offer price – represents the difference between the highest price that a buyer is willing to pay or bid for a stock and the lowest price at which a seller is offering the stock. A trade transaction occurs either when a buyer accepts the ask price or a seller takes the bid price. If buyers outnumber sellers, they may be willing to raise their bids in order to acquire the stock; sellers will therefore ask higher prices for it, ratcheting the price up. If sellers outnumber buyers, they may be willing to accept lower offers for the stock, while buyers will also lower their bids, effectively forcing the price down.

Matching buyers and sellers of stocks on an exchange was initially done manually, but it is now increasingly carried out through computerized trading systems. The manual method of trading was based on a system known as "open outcry," in which traders used verbal and hand signal communications to buy and sell large blocks of stocks in the "trading pit" or the floor of an exchange.

However, the open outcry system has been superseded by electronic trading systems at most exchanges. These systems can match buyers and sellers far more efficiently and rapidly than humans can, resulting in significant benefits such as lower trading costs and faster trade execution.

Numerous studies have shown that, over long periods of time, stocks generate investment returns that are superior to those from every other asset class. Stock returns arise from capital gains and dividends. A capital gain occurs when you sell a stock at a higher price than the price at which you purchased it. A dividend is the share of profit that a company distributes to its shareholders. Dividends are an important component of stock returns – since 1926, dividends have contributed nearly one-third of total equity return, while capital gains have contributed two-thirds, according to S&P Dow Jones Indices.

While the allure of buying a stock similar to one of the fabled FAANG quintet – Facebook, Apple Inc. (AAPL), Amazon.com, Inc. (AMZN), Netflix, Inc. (NFLX) and Google parent Alphabet Inc. (GOOGL) at a very early stage is one of the more tantalizing prospects of stock investing, in reality, such home runs are few and far between. Investors who want to swing for the fences with the stocks in their portfolios should have a higher tolerance for risk; such investors will be keen to generate most of their returns from capital gains rather than dividends. On the other hand, investors who are conservative and need the income from their portfolios may opt for stocks that have a long history of paying substantial dividends.

While stocks can be classified in a number of ways, two of the most common are by market capitalization and by sector.

Market capitalization refers to the total market value of a company's outstanding shares and is calculated by multiplying these shares by the current market price of one share. While the exact definition may vary depending on the market, large-cap companies are generally regarded as those with a market capitalization of $10 billion or more, while mid-cap companies are those with a market capitalization of between $2 billion and $10 billion, and small-cap companies fall between $300 million and $2 billion.

The industry standard for stock classification by sector is the Global Industry Classification Standard (GICS), which was developed by MSCI and S&P Dow Jones Indices in 1999 as an efficient tool to capture the breadth, depth and evolution of industry sectors. GICS is a four-tiered industry classification system that consists of 11 sectors and 24 industry groups. The 11 sectors are:

• Energy
• Materials
• Industrials
• Consumer Discretionary
• Consumer Staples
• Health Care
• Financials
• Information Technology
• Communication Services
• Utilities
• Real Estate

This sector classification makes it easy for investors to tailor their portfolios according to their risk tolerance and investment preference. For example, conservative investors with income needs may weight their portfolios toward sectors whose constituent stocks have better price stability and offer attractive dividends – so-called "defensive" sectors such as consumer staples, health care and utilities. Aggressive investors may prefer more volatile sectors such as information technology, financials and energy.

Until recently, the ultimate goal for an entrepreneur was to get his or her company listed on a reputed stock exchange such as the New York Stock Exchange (NYSE) or Nasdaq, because of the obvious benefits, which include:

• An exchange listing means ready liquidity for shares held by the company's shareholders.
• It enables the company to raise additional funds by issuing more shares.
• Having publicly traded shares makes it easier to set up stock options plans that are necessary to attract talented employees.
• Listed companies have greater visibility in the marketplace; analyst coverage and demand from institutional investors can drive up the share price.
• Listed shares can be used as currency by the company to make acquisitions in which part or all of the consideration is paid in stock.

These benefits mean that most large companies are public rather than private; very large private companies such as food and agriculture giant Cargill, industrial conglomerate Koch Industries, and DIY furniture retailer Ikea are the exception rather than the norm.

But there are some drawbacks to being listed on a stock exchange, such as:

• Significant costs associated with listing on an exchange, such as listing fees and higher costs associated with compliance and reporting.
• Burdensome regulations, which may constrict a company's ability to do business.
• The short-term focus of most investors, which forces companies to try and beat their quarterly earnings estimates rather than taking a long-term approach to their corporate strategy.

Many giant startups (also known as "unicorns" because startups valued at greater than $1 billion used to be exceedingly rare) such as Uber (November 2018 valuation = $76 billion) and Airbnb (June 2018 valuation = 31 billion) are choosing to get listed on an exchange at a much later stage than startups from a decade or two ago. While this delayed listing may partly be attributable to the drawbacks listed above, the main reason could be that well-managed startups with a compelling business proposition have access to unprecedented amounts of capital from sovereign wealth funds, private equity and venture capitalists. Such access to seemingly unlimited amounts of capital would make an IPO and exchange listing much less of a pressing issue for a startup.

For reasons unknown, the number of publicly traded companies in the U.S. is also shrinking – from 8,090 in 1996 to 4,336 in 2017 – according to a Financial Times article citing World Bank data.

A market index is a popular measure of stock market performance. Most market indices are market-cap weighted – which means that the weight of each index constituent is proportional to its market capitalization – although a few like the Dow Jones Industrial Average (DJIA) are price-weighted. In addition to the DJIA, other widely watched indices in the U.S. and internationally include:

• S&P 500
• Nasdaq Composite
• Russell Indices (Russell 1000, Russell 2000)
• TSX Composite (Canada)
• FTSE Index (UK)
• Nikkei 225 (Japan)
• Dax Index (Germany)
• CAC 40 Index (France)
• CSI 300 Index (China)
• Sensex (India)

Stock exchanges have been around for more than two centuries. The venerable NYSE traces its roots back to 1792, when two dozen brokers met in Lower Manhattan and signed an agreement to trade securities on commission; in 1817, New York stockbrokers operating under the agreement made some key changes and reorganized as the New York Stock and Exchange Board.

The NYSE and Nasdaq are the two largest exchanges in the world, based on the total market capitalization of all the companies listed on the exchange. The number of U.S. stock exchanges has grown in recent years, with IEX Group becoming the 13th one in August 2016. The table below displays the 15 biggest exchanges globally, ranked by total market capitalization of their listed companies.

Source: World Federation of Exchanges