How Does The Stock Market Work?

Most caricatures of the stock show groups of men in suits screaming buy and sell orders to no one in particular on the floor of the New York Stock Exchange (NYSE). While trading floors still exist, this is an exaggeration of what the stock market really is. For starters, most trading is done via computer now, with many automated systems trading based on their programming with little input from humans.

But how does the market actually work? We know cliches like ‘buy low, sell high’ and ‘don’t put all your eggs in one basket’, but not everyone understands the difference between public and private companies, let alone debt vs equity financing. Today, we’ll go under the microscope and examine the inner workings of the market. First, let’s cover the basics.

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

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Debt vs Equity

No business begins as a multinational conglomerate. In reality, most of the high-flying stocks that make up the core holdings of a portfolio began their existence in a small apartment or garage. Businesses start with ideas and move on to physical components later.  But physical components cost money and since new businesses don’t have sales, they need to raise money another way.

Debt financing is something most consumers have experience with. If you take out a loan for college and pay it back after graduation, you’re using debt to finance your education. Businesses can do the same, either by issuing bonds or taking loans from banks. But debt financing requires collateral – the lender needs assurances that the debt can be repaid, or they won’t issue the funding. And new businesses often don’t have much in the way of collateral to offer lenders (other than pledging the founders’ personal assets).

The other method of financing is through equity. Equity is just a fancy word for ownership and businesses can sell off little pieces of themselves in the form of shares of stock. When we buy stock, we are claiming tiny little shards of ownership of the underlying company. Now buying 100 shares of Apple won’t get you into a meeting with Tim Cook, but it does entitle you to a little piece of Apple’s profits. When shares appreciate or pay dividends, you reap those benefits. The company issuing the shares doesn’t have to put up any cash or financial collateral for the shares either – investors understand that stocks carry more risk than bonds and shareholders are at the bottom of the totem pole should the company be liquidated.

Buying and Selling Stocks

Companies need a public place to offer their shares. In most cases, this is a stock exchange like the NYSE. Stock exchanges are run by brokers and market makers who attempt to pair investors seeking shares with investors looking to sell shares. Brokers facilitate this trading through the stock exchanges, matching up the parties who wish to transact.

The bid/ask spread is the difference between the seller’s price and the buyer’s price and is how the brokers make their money. The bid is the amount the seller receives for the sale of stock, while the ask if the amount the buyer pays, with the broker pocketing the difference. Highly liquid stocks have low bid/ask spreads since matching up buyers and sellers is easier at high volumes. If minimal shares are available or the trading volume is low, spreads will be higher since the broker has to work harder to facilitate the trade.

Buying stocks is inherently risky since there are no guarantees of future profit. When you buy a bond, you can calculate how much you can expect to receive in returns based on the maturity of the bond and the coupon rate it pays. With stocks, there are no such guarantees. Even the dividends paid out by mature companies can be slashed if sales goals aren’t met or the company is struggling with debt.

Putting It All Together

When buyers and sellers come together to trade shares of stock, we have a stock market. That’s really all it is – one group transacting with another on an exchange facilitated by a broker. For every stock buyer, there must be a stock seller. Sometimes this can be the company issuing new shares directly, but most stock trades involve two different investors buying and selling for reasons completely independent of one another.

It’s important to remember that each investor is playing their own individual game when it comes to the stock market. You might have a deeper understanding of the market’s plumbing, but you’ll never understand the rationale for why each investor buys or sells a security. You’ll need to create your own investment rulebook and set goals for your investments because following the crowd is often a path to the slaughterhouse. Stocks are risky. Minimize those risks in a way that’s most efficient for you.

Work With an Experienced Financial Advisor

We hope you better understand how the stock market works, and when you are ready to buy or sell stocks, come to us for financial advice. The goal of personal finance isn’t to amass large sums of money—it’s about getting more mileage out of the money we earn. If you’d like to learn more or need assistance creating a financial plan that suits your needs, contact the team at Good Life of Mount Pleasant today.

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Disclosures

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

Stock investing includes risks, including fluctuating prices and loss of principal.

Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.