Stock market

Understanding the Stock Market: A Gateway to Wealth

The stock market is an aggregation of buyers and sellers of stocks representing ownership claims on businesses. Imagine a bustling bazaar where everyone can buy or sell pieces of companies, each piece being a share. This vibrant marketplace has seen its value skyrocket over the years, from $2.5 trillion in 1980 to an astounding $111 trillion by the end of 2023.

With 60 stock exchanges worldwide, and 16 having a market capitalization of $1 trillion or more, it’s clear that this is no small affair. The largest markets are in the United States (59.9%), Japan (6.2%), and the UK (3.9%). These numbers paint a picture of a global financial network where billions of dollars change hands daily.

But what exactly happens at these exchanges? Are you familiar with how stocks are bought and sold?

The Stock Exchange: A Digital or Physical Marketplace

A stock exchange is an electronic network where traders can buy and sell shares, bonds, and other securities. Some exchanges have physical locations with trading floors, while others operate entirely online. When the bid and ask prices match, a sale takes place on a first-come, first-served basis if there are multiple bidders at a given price.

Take the New York Stock Exchange (NYSE), for example. It’s a hybrid market that allows orders to be placed electronically or on the trading floor. Orders are executed by an exchange member who submits them to a Designated Market Maker (DMM) for trading. The DMM maintains a two-sided market and may use their own resources to close any bid-ask spread.

On the other hand, NASDAQ is all about electronic trading where all trades are done over a computer network. A single or multiple market makers provide bids and asks for the stock, which are always available at designated prices.

The Participants: From Individuals to Institutions

Participants in the stock market range from small individual investors to larger investors and institutions. Some exchanges have physical locations with trading floors, while others have electronic networks for making trades. When you buy or sell stocks, you’re essentially buying a piece of ownership in a company.

The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers. It’s like a giant auction where everyone can bid on shares of companies they believe will grow in value over time.

Indirect vs Direct Ownership: A Choice for Investors

Investments are usually made with an investment strategy in mind, but how do you decide whether to invest directly or indirectly? Indirect ownership involves owning shares through mutual funds or ETFs. Direct ownership means buying and holding individual stocks.

According to data, indirect ownership rose slightly from 17% in 2001 to 26% in 2006. In 1992, it was at 8%, but by 2007, it had increased to 17.9%. The median value of direct holdings ranged from $4,000 (bottom) to $78,600 (top), while indirect holdings ranged from $6,300 to $214,800.

Interestingly, the bottom quintile directly owned stock at 5.5%, while the top decile held indirectly at 91.7%. This shows a clear divide in investment strategies based on income levels and financial literacy.

The Historical Evolution of Stock Markets

Stock markets have a rich history, dating back to the 12th century when the concept of “Beurzen” emerged in France. Over time, these exchanges spread internationally, with various countries adopting their own systems. The term “stock” itself comes from the Latin word bursa, meaning money bag.

By the 13th century, Venetian bankers were trading government securities, and Italian companies began issuing shares. This led to the establishment of stock markets in Europe and eventually spread globally, including countries like the United States, Japan, India, China, Canada, Germany, France, South Korea, and the Netherlands.

Even socialist countries had varying degrees of market involvement, but a stock market is a key indicator of capitalism and private property. Companies use these markets to raise money, enabling public trading and raising additional capital through share sales.

The Efficient-Market Hypothesis: A Controversial Theory

The efficient-market hypothesis (EMH) states that asset prices reflect all available information at the current time. However, this theory doesn’t explain events like the 1987 crash when share prices plummeted by 22.6% in a single day.

A ‘soft’ EMH suggests that market participants cannot systematically profit from any momentary ‘market anomaly,’ but it does not require that prices remain at or near equilibrium. Various explanations for large and apparently non-random price movements have been proposed, including changes in estimated risk, psychological factors, and group thinking.

Crashes: A Sudden Drop in Share Prices

Stock market crashes are defined as sharp dips in share prices caused by panic and a loss of confidence among investors. Famous crashes include the Wall Street Crash of 1929, the stock market crash of 1973–4, Black Monday of 1987, and the Dot-com bubble of 2000.

For instance, Black Monday in 1987 was the largest one-day percentage decline in stock market history – the Dow Jones fell by 22.6% in a day. This event raised questions about many important assumptions of modern economics, including the theory of rational human conduct and the efficient-market hypothesis.

The crash led to measures being introduced into the stock market in an attempt to prevent reoccurrences. The Federal Reserve System and central banks worldwide took steps to control the spreading of a financial crisis. In the United States, the SEC implemented several new measures of control into the stock market.

Recent Crashes: 2007-2009 and 2020

The Great Recession, starting in 2007 and lasting through 2009, saw financial markets experience one of the sharpest declines in decades. The housing market, lending market, and even global trade experienced unimaginable decline due to sub-prime lending leading to a bursting of the housing bubble.

The S&P 500 fell by 57% from October 2007 to March 2009 and wouldn’t recover to its 2007 levels until April 2013. The 2020 stock market crash, due to the sudden outbreak of the global pandemic, COVID-19, saw a major and sudden decline in global markets from February 20 to April 7, 2020.

The Future: Electronic Trading and Market Indices

Since the early 1990s, many of the largest exchanges have adopted electronic ‘matching engines’ to bring together buyers and sellers. This has replaced the open outcry system, making trading more efficient and faster.

Stock market indices like the S&P, FTSE, Euronext, NIFTY & SENSEX capture the movements of global, regional, and local markets’ prices. Financial innovation has led to the development of derivative instruments like exchange-traded funds (ETFs), stock index options, equity swaps, single-stock futures, and stock index futures.

Investors can use short selling, margin buying, or derivatives to control large blocks of stocks. Short selling involves borrowing stock to sell it, betting the price will fall. Margin buying involves borrowing money to buy a stock, hoping for it to rise. Both require regulations such as maximum borrowing percentages and maintenance margins.

Conclusion: The Stock Market’s Role in Economic Growth

The stock market plays a crucial role in economic growth by facilitating the movement of funds between units with excess and deficit funds. It allows companies to raise money, enabling public trading and raising additional capital through share sales.

The liquidity provided by exchanges allows investors to quickly sell securities, making it an attractive investment option compared to other assets. Despite occasional crashes and market anomalies, the stock market remains a vital component of modern economies, reflecting both economic activity and social mood.

So, whether you’re a seasoned investor or just starting out, understanding the intricacies of the stock market can be the key to unlocking wealth and financial security. The journey is complex but rewarding, with each crash and recovery teaching us valuable lessons about the nature of markets and human behavior.