BASICS OF THE STOCK MARKET
Learning about stocks and how they work is essential to achieving strong investment returns and will allow for significant financial advantage.
The Financial Industry
So you want to learn about the stock market…but where do you start?
The financial industry is really complicated. There are investors, brokers, traders, lenders, borrowers, advisors, companies, banks, stocks, shares, funds, prices…the list goes on and on and on. It can really make your head spin! But it’s important to have a “big picture” understanding of all these elements because together they bring this thing we call the “stock market” to life. It’s true; the stock market is like a living, breathing organism. And it’s always changing and evolving. But at some point, we’ve got to slow things down a bit and take a look inside.
That’s what we’re here to do today.
This course will put a magnifying glass to the financial world. We’ll go through the history of the financial industry and work towards understanding its basic structure. We’ll then zoom in and take a deep look at the stock market and how it functions. Finally, we’ll touch on the major U.S. stock exchanges and their participants to get an idea of how it all comes together in the real world.
So buckle up, because we’re about to jump on in and demystify the world that all those big wigs on Wall Street – with their jargon and their freshly pressed suits – don’t want you to understand.
Why does the Financial Industry Exist?
From bartering, metals and gold to paper bills and credit, money has always been around, albeit in many different forms.
Money was created out of a need to trade goods and services between one another. People always have needs. They need food to eat, clothes to wear, and shiny sports cars to look cool. OK, some of our “needs” are more like “wants”. But either way, people look for ways to staisfy their demands.
Way back when, people traded goods in order to get what they needed, by giving up what they had. Let’s say, I trade you a goat for a gallon of milk. But not all products and services are trade-able. For instance, you wouldn’t trade wheat for electricity. So, we turn to money.
Money is the middleman. Money takes care of the transaction between buyers and sellers.
But as our world has developed and grown more complex, so has the meaning and purpose of money. We’re no longer dealing with shepherds bartering sheep. Today we have multinational corporations that handle millions and billions of dollars. In order to handle this evolution, we needed a way to organize it. Enter the financial industry.
In a nutshell, the financial industry is all about managing money: investing it, growing it, saving it and ultimately spending it. The stock market is at the center of all this, where people (investors) and businesses meet to make transactions and respectively manage their money.
Why Does The Stock Market Exist?
The real birth of what we think about today as the stock market started way back in 1602, with the Dutch East India Company. Historians claim it to be the first company to ever offer shares to investors in exchange for a portion of its profits.
The stock market exists so that companies can raise money without incurring any debt (such is the case of a loan). They issue shares of their company to the public in what is known as an Initial Public Offering (IPO). Investors buy and sell these shares (or stocks) to one another on the stock exchange, thus making stock prices move up and down. If there are more people buying a stock than people selling it, the price goes up with the demand. If more people are selling than there are people buying a stock, that’s a sign that the company is unfavorable to own and the stock price drops.
- The stock market is mutually beneficial to businesses and investors because:
- Companies raise money to (try to) make their businesses grow
- Investors invest in businesses to (try to) make their money grow
An Over-Simplified Example: Starbucks
Let’s say you really love Starbucks coffee. You have a demand for a daily cup of Starbucks coffee. In order to buy your daily cup of coffee, you need money. You make a pretty nice income from your job as a Coffee Critic, but you’d like to have some extra disposable income so that you can afford your daily cup of Joe (You’d think as a coffee critic, they’d supply you with free coffee. But such is life…)
You decide to grow your money by investing it in the stock market.
Starbucks understands that you (and millions of other people all around the world) have a demand for a daily cup of coffee. In order to satisfy that increasing demand, Starbucks needs to grow; and they need money to do that. The company needs to buy more beans, hire more employees, open new stores, etc. So, in order to raise this money, they issue stock to investors on the stock market.
This means that they cut up the company into millions of (figurative) pieces. They sell these little pieces of the company, known as stocks, to people like you and me. If you own a stock, you own a little piece of the company.
Since you love Starbucks coffee so much, you believe that they’ll be able to successfully grow and satisfy more peoples’ demand for coffee. You think they’ll buy fresh beans, hire skilled employees, and open beautiful new stores. So you decide to buy Starbucks’ stock. This means that you own a little piece of the company. If Starbucks grows and makes more money, your money grows along with it.
Now let’s look at the places where millions of these transactions take place each and every day: stock exchanges.
Remember when you were a kid, and your mother would drive you over to the local card store to trade baseball cards with your friends? Well stock exchanges are like those card store, but for adults (if you can call them that).
A stock exchange is where investors trade their shares of companies to one another. That’s why stock prices are constantly changing. If more people are selling (and therefore trying to get rid of) a stock than those buying it, the stock price will drop. If more people want to buy a stock than people selling it, the stock price will rise. Stock exchanges bring all these investors together, so that trades happen in a central and regulated place.
There are hundreds of stock exchanges all over the world. In the U.S., the top stock exchanges are the New York Stock Exchange (NYSE), the NASDAQ, and the American Stock Exchange (AMEX). Each of these exchanges have different companies trading on them. For example, NASDAQ is known for technological companies. Most of the tech stocks out there trade on the NASDAQ stock exchange.
A lot of today’s trading takes place online, rather than on trading floors on Wall Street. But that doesn’t mean stock exchanges lose any importance. Even though it all takes place online, each and every trade placed has to go through a stock exchange in order to match buyers and sellers together. This is called the Electronic Communication Network (ECN), which connects traders and brokers over the Internet instead of on the trading floor.
Next we’ll go through the different type of investors that are trading on these stock exchanges…
Types of Investors
There are two types of investors out there: Institutional and Retail.
Institutional investors are large firms like banks, investment companies, mutual funds or hedge funds that invest pools of money on behalf of their investors. They make up the majority of the volume (number of shares traded) on the stock market. Because some of these firms are so large, their trades have a significant impact on the share price of a company. Institutional investors are sometimes referred to as “smart money” (but usually only by other institutional investors).
A Retail investor is…well…you. It refers to someone who puts money in the market for themselves: an individual investor. Since the financial crash in 2008-2009, there has been an emergence of “retail investors”. People have stopped trusting big investment banks and funds with their money, and choose to learn how to become financially independent and in control of their own money (kind of like what you’re doing right now!).
Another reason for this surge of retail investors is that online discount brokerages such as E*TRADE and TD Ameritrade make it easier and cheaper for the individual than ever before, in terms of learning, in terms of trading, and in terms of handling one’s shares in a way that feels direct, real-time – and fun.
The following step will break down the services of a broker or brokerage firm, and tell you about some of the top online brokerages out there.
Intro to Brokers and Brokerage Firms
Buying a stock is a tad more complicated than buying something like… say…a used guitar. To do that, you could just jump on Craigslist and put up an ad, find a seller, and meet up to get the guitar yourself. You’d be killing riffs in no time.
Buying a stock is more like buying a house. Most people don’t go on Craigslist to buy a house. They hire a real estate agent who knows the housing market and works with other real estate agents to find houses for sale.
Stockbrokers and brokerage firms are like the real estate agents of the stock market. Brokers buy and sell stocks on behalf of investors on the stock exchange.
There are a number of types of brokers. Full service brokers will not only perform the trades for you but will also manage your portfolio for you and give you trading advice. Other brokers, such as discount brokers, won’t give you any advice at all. They’ll just do what you ask of them.
The most important thing to look at when choosing a broker is the structure of their commission fees. Brokers charge investors in various ways, depending on the type of services you’re looking for.
Let’s take a look at an example of a broker’s cost structure:
Take Janet Wall, a fictional broker that offers a full service to her clients. This is how her costs break down for managing your portfolio:
- She makes 1.5% annually of the value of the stocks that she manages.
- She also gets a quarterly fee, which is $750 per account.
If she sells your stocks and makes you a lot of cash, she earns 2.5% of that profit. This gives her more incentive to perform well and make you more money.
Here’s what her year with your account might look like:
- If your shares are worth $100,000, she makes $1,500 (1.5% x $100,000) annually to manage it
- Plus $3,000 (4 x $750) annually for her fee.
- She later sells your stock holdings for $150,000, for a nice profit of $50,000. Janet gets a cut of $1,250 (2.5% x $50,000 profit) more.
- So Janet’s total fee is: $1,500 + $3,000 + $1,250 = $5,750
Janet’s made a nice profit of 50 large, but you’ve got to give up $5,750 to her for her services. You’re still walking away with a pretty penny.
Not all brokers or brokerage firms offer such a full service. You can also get a discount broker or brokerage to simply conduct the trades for you at a set fee. They won’t offer you any trading advice, but you’ll also save a bunch of money on fees if you make these decisions yourself.
Next we’ll take a look at discount brokerages, and give you some options of online brokerages that’ll get you started in the real world of investing when you’re good and ready.
Make sure you understand your brokers’ compensation and be sure that the services you’re paying for are aligned with your interests.