How the stock market works

How do stocks work?

What’s the one thing a stock market needs to operate? Why stocks, of course! So before we tackle the real edge-of-your seat topic of how the stock market operates, let’s start by defining our terms.

What the heck’s a stock? A stock represents a share in a company’s ownership, and those who own stocks can claim a percentage of the company’s assets and earnings. Exactly what percentage depends on how many shares you own relative to how many currently exist — or in the finance speak, the “outstanding.” With some simple division, we learn that a stockholder who owns 100 shares of a company with 5 million outstanding shares owns .00002 of the company. (Don’t let it to go your head, Mr. Bigshot.)

A company will issue stock in order to raise money for various business-y reasons— the most prevalent of them being expansion the company wouldn’t otherwise have the cash to undertake. When the company first issues shares, they often do so through what’s called an initial public offering, or IPO. Since it’s the first time they’re sold, this is called a stock’s “primary market.” Once the shares have been sold that first time, stockholders will need a place to resell them, kind of like a used car lot for stocks. This is called the stocks’ “secondary market,” but it’s more familiarly referred to as just “the stock market.”

How does the stock market work?

The stock market works pretty much the same that it’s always worked, but it looks a lot different today than it did 50 years ago. Since computer automation now represents the vast majority of trading activity, markets like the New York Stock Exchange, which was once a mosh pit of blue-coated traders shouting and gesticulating, are now relatively sedate. Working stock exchanges are rapidly going the way of drive-in theaters and video stores;the markets continue to trade online, but the actual physical stock exchanges in London, Hong Kong, Tokyo and Singapore have shut down altogether. This video on how the New York Stock Exchange works is about as technical as an episode of Paw Patrol and provides a decent overview of what happens today on the NYSE.

Regular folks can’t just show up at the NYSE to buy a share or two of Apple. They have to employ the services of licensed middlemen — brokers — to buy stocks. In all likelihood this broker is not a living, breathing stock broker named Tony who lives with his family in Hoboken, but rather an electronic institution like E*Trade, TD Ameritrade, or Wealthsimple. A few brokers still exist on the floor of the NYSE, and they buy their stocks from Designated Market Makers, or DMMs, people who preside over the orderly selling of a specific list of publicly traded companies.

Trading sessions vary according to country. Regular trading hours for the NYSE and the Toronto Stock Exchange are Monday through Friday, 9:30 AM to 4:00 PM; by operating from 8:00 AM to 4:40 PM, the London Stock Exchange makes both its North American cousins look sloth-like.

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How is the price of a stock determined?

Like any other free market, the stock market works according to the laws of supply and demand. Supply refers to how much of something is available, and demand is how much of it consumers want to buy. Excess demand will drive prices up and excess supply will push prices down.

Investors may determine the price of a stock based on a number of factors, which include:

  • Revenue growth
  • Historical price
  • Earnings per share
  • Price/Earnings Ratio
  • Dividends

Have no earthly idea what these terms mean and care enough to find out? Check out this beginners’ guide to buying stock.

How stock picking works

It’s not easy picking stocks by simply researching how they’re priced as it relates to their revenue growth, historical price, etc., and attempting to pick up some underpriced bargains. Buying stock is nothing like walking into a store and finding a gorgeous $1,000 suit on sale for $200 dollars. Through the law of supply and demand, the market has already worked all its special price discounting magic and all of the information the market knows is already baked into a stock’s price. So unless you get some inside information from someone inside the company—a practice called insider trading, which will land you in the poky and get you featured among the unsavories on a list like this one — understand that in stocks, you get what you pay for.

Two parties are required for a stock market sale: a buyer and seller. At the time of a sale, sellers are trying to sell stock for as much as they can, and buyers hope to pick up the stock dirt cheap. Sellers decide on the absolute lowest price they’d accept to part with the stock and buyers the highest they’d pay to buy it. The amount that divides these two numbers is called the bid-ask spread. Naturally, the closer the bid-ask spread is to 0, the more the stock will be traded, a condition called liquidity. (How much a stock is traded on a particular day is referred to as its “share volume.”)

If you’re the buyer, how sure are you you’re smarter than the seller? Here’s the tricky, philosophical quandary that makes buying stocks a difficult business, and one of the reasons that the vast majority of those who are paid handsomely to pick stocks fail to outperform the stock market as a whole. You, person who wants to buy a stock, are doubtlessly super smart (and, may we add, easy on the eyes to boot.) But when you buy a stock, you have to buy it from someone. That person might be super smart too, and she has access to exactly the same information you have (or, if she’s breaking the law, and engaging in insider trading, significantly more.) She has decided the stock is worth selling at say, $10 a share because it’s definitely going to go down, and you’ve decided it’s worth buying at that price because it’s definitely going to go up. Who’s right? How sure are you that you’ve synthesized all the available information better than other investors? No offense, but what makes you so darned special?

Advantages of investing in the stock market

Depending on which source you consult, you’ll hear a variety of numbers quoted of how much the stock market has grown on an annualized basis. The S&P has a mean return of 11.4% and compound annual growth of 9.5% of the S&P 500 since 1927. Some sources may run a bit higher, others may be lower, but all of them will show that over the long haul, the stock market has provided very good returns on investments.

So naturally the advantage of investing in the stock market is you have the potential to make quite a bit of money if you invest over a long period of time, a lot more than if you invested in safer bets like fixed income (government bonds). A compound return calculator will show that if $100,000 is left alone for 30 years, based on a 9.5% rate of return, it would grow to about $1.7 million. Be warned though: investments are speculative and it’s important to understand that past results should never be understood to be guarantees, but rather imperfect predictors of future performance. While you have the potential to make money on stocks, you could also lose money (that’s the not so nice part).

We provided lots of sobering information above on the difficulty of stock picking, about how investing in stocks is risky and it’s quite possible that you could lose not only your shirt, but your socks and underwear investing in a stock that tanks. But risk also happens to be the reason why stocks make a lot more money than “safer” investments like government bonds. There’s a concept called the “equity risk premium” (ERP), which is the percentage over the so-called “risk free rate,” or the current interest rate you could get by putting your money in risk-free government bonds. Over the long term, investors will expect to be rewarded for taking on risk. This concept keeps stocks viable; if a stock wasn’t expected to outperform the risk-free rate, investors would just stick with the safe money and a stock price would crater. So one of the most important responsibilities of a company CEO is to do everything she can to make sure that investors get bigger rewards in exchange for their risk than they would parking their money in something safe like bonds.

There happens to be a pretty good alternative to picking individual stocks to harness the growth of the stock market while limiting the crushing loss that happens when a stock tanks. Harry Markowitz, the Nobel Prize winning economist who championed an investment strategy called Modern Portfolio Theory. He posits that the key to effective investing is diversification–acquiring not just a big holding in one or two stocks, but rather buying dozens, or even better, hundreds of smaller holdings in many, many stocks. Diversification is the cunningest strategy of all.) By investing widely, the theory goes, you’ll enjoy robust stock market results while protecting yourself from crushing downside when a specific stock or sector falls precipitously.

How do I invest in the stock market?

You have a number of choices when it comes to investing in the stock market. The main choices are an online brokerage, a human stock broker, a financial advisor or a robo-advisor.

Online brokerage

The absolute easiest, cheapest way to buy stocks is through an online discount brokerage. Accounts can be opened in ten minutes if you have a social security or social insurance number, a home address, and an employer’s address (don’t freak, freelancers—it’s totally AOK if your office happens to be five feet from your bed.) Discount brokerages normally charge a fee for each stock, mutual fund, or ETF you trade. Most will assess a flat per-trade commission fee for any stock purchase, big or small, that generally range from $5-$10 per online trade but increasingly, a few investment providers have started offering commission-free trading, so every cent you pay goes directly into your stock investment, not into the brokerage’s coffers.

Human stock broker

Most brokerages do employ humans to execute stock trades, but they’ll charge a lot more if you need to use one, so do your best to crack the system without the assistance of a warm body. If you’re nervous, you’ll find dozens of how-to videos for buying stocks on all the major online brokerages on YouTube (https://www.youtube.com/).

Financial advisor

If you have a financial advisor, you may choose to execute trades through him or her. Some advisors are “fee-only,” meaning they’ll either charge you a flat fee or take a small percentage of the value of your portfolio every year. If you don’t have a financial advisor, it might not be best to hire one specifically to make a single trade. Advisors generally specialize in creating financial plans that help with the bigger picture. They are particularly useful for people with a high net worth or complicated tax situation. If that’s you — then you’ll be well served getting a financial portfolio review with an advisor.

Robo-advisor

Generally, automated investing services will put together a diversified basket of ETFs for their clients based on their investment goals rather than individual stocks. (Our Patron Saint, after all, is Harry Markowitz.) The advantages of robo-advisors come in the form of low fees and a diversified portfolio that’s likely made up of a bunch of different stocks, bonds and real estate. Robo-advisors generally aim to track the market rather than beat it. They follow the exact same advice that Warren Buffett gave to his heirs. It’s generally straight forward to sign up for an account with a robo-advisor, everything is done online and you can start investing in minutes.

Eager to find someone who finds nothing more exciting than talking stocks? Give us a ring. Wealthsimple is one of the only automated investing services to offer all of its clients unlimited human support. Every Wealthsimple client gets state of the art technology, low fees and the kind of personalized, friendly service you might have not thought imaginable from a low-priced investment service. Sign up here.

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