How the Stock Market Works

How the stock market works illustration

How does the Stock Market Work?

Most people are afraid of investing in the stock market because they don’t know how the stock market works and traditional media portrays it as a house of Ponzi schemes. In reality, investing in the stock market may carry some risk, but if you make a well-informed decision, then it can be an efficient way to increase your net worth. The wealthiest people manage to stay rich because most of their wealth is invested in stocks. Today we will try to discuss the dynamics of the stock market, but first, we have to understand some important phenomenon.

Stock

A stock is a financial instrument which represents ownership in a corporation or company. It implies a claim on the company’s assets and profits. Owning a company’s stock would mean that you own a portion of that company, which will be equivalent to your number of shares.

Common and Preferred Stock

Common stocks usually give the owner voting rights which enable him/her to have a say in corporate meetings. On the other hand, preferred stocks do not give the owner voting rights, and hence, the owner won’t have a say in corporate proceedings.

Why Companies Issue Shares?

Every corporate giant was once a private startup. For expanding any business, you need capital, and for that, you need investors. So, companies take money from the investors, and in turn, they are given a small part of the company. This small part of the company is called a share. The more money you invest in a company, the more shares you own and the larger your part of the company is.

The companies use this money for buying new assets, hire employees, launch new products, penetrate new markets, and expand operations. Hence, the company grows and generates more revenue.

What is a Stock Exchange?

Stock exchanges are markets where owners of shares can trade with prospective buyers. Corporations listed on stock markets normally do not sell or buy their own shares. So, when you buy a share at the stock exchange then you are not buying it from the company rather you will be buying it from some other existing shareholder. Similarly, when you sell your shares, you won’t be selling them back to the company rather you will be selling it to some other investor.

How Share Prices Are Set?

There are several ways to set the share prices on a stock market. But the most common way is through an auction process where sellers and buyers place offer and bids. An offer is a price at

which a seller wants to sell, and a bid is a price at which a buyer wants to buy. A trade is made when the offer and bid coincide.

Stock Market Supply and Demand

The stock market is a good example of the laws of supply and demand at work. If there are more buyers for a certain stock then there are sellers of it, then the stock price will rise. And if there are more sellers of the stock than its buyers, then the stock price will decrease.

Investing in Stocks

Research studies show that stocks generate greater investment returns than any other asset. Stock returns are either in the form of dividends or capital gains. When a company generates profit, it distributes it among its shareholders; this is called a dividend. If you sell a stock at a higher price than the one at which you purchased it, then the profit you have made is called a capital gain.

When investing in a stock, you should be clear about why are you buying it. Is it for dividends, capital gain, or both? This will allow you to make a better investment decision.

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