What Is The Stock Market?

Answering a question such as, "What is the stock market?" can and should be relatively easy, but it also might be frighteningly complicated as well.

On the surface, a stock exchange enables the trading - buying and selling - of partial or complete ownership in companies. Once upon a time, and not all that long ago in fact, this was a geographical place where people would come together between certain times to make their trades. In this respect, a stock market resembled any other form of market.

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The early stock market history around the world contains many stories of gentlemen gathering in coffee houses and Masonic temples to meet others so that they could buy or sell their holdings.

In some places, stock markets still have a fixed location, but in the modern internet and technological world which we now inhabit, it can be a network of computers all enabling buying and selling at agreed prices. In actual fact, the servers of a stock exchange are hosted in several different locations for security.

The fixed location markets of the past used a system known as 'open outcry'. If you have ever seen pictures on television of a commodities market with vast crowds of people - usually men - waving their arms furiously and shouting, then you have some idea of the open outcry environment.

The modern world, however, enables instantaneous global trading. This possibility has opened up the world to algorithmic trading (information here) which is mainly carried out by very large hedge funds (information here).

These funds trade on very small price differentials or on the imperfections within the market. However, many also trade on the latest stock market news, either relating to specific companies, global prices or the national economy.

Describing the 'stock' element is much trickier however. In the USA, stock is generally considered to be a part ownership in a company. These companies are 'listed' or 'quoted' which means that they are publicly traded and anyone can purchase a part ownership - should they choose to. In other places, the UK for example, this would be known as a share or equities.

These companies are then listed on exchanges (such as NYSE or NASDAQ) so that buyers and sellers can be brought together and trade their holdings. The price at which trades are made will depend upon many factors such as corporate earnings, expectations and supply and demand.

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When issuing stock, it is not all created equally. Depending upon the rules of the company and country, there can be several different types of holding. These are normally referred to as 'ordinary' or 'preference' or class a and b. Issues such as voting rights, dividend payments and preference in case of liquidation are all detailed in the rules. It is well worth checking into these details closely before buying.

Once listed on an exchange, each unit of a companies stock can be bought or sold for the current going price. The latest trade prices are then used as the stock quotes that show on the ticker (for very large companies) and as a guide for future trades for smaller companies.

There are mechanisms which enable stock to be traded privately. This would normally happen between two large companies or fund managers and would involve very large holdings. This is known as block trading on Wall Street.

It would be impractacle for the average investor to privately trade 100 or 1,000 shares with another investor. Such trades are often mentioned in market reports in daily newspapers. This is because such large scale transactions frequently involve either large minority interests or majority holdings changing hands.

This large scale trading is sometimes known as block trading - because the numbers of shares involved will be in the thousands and the total amount will be in the millions. Very few mortals can trade in such volumes which means that the trades happen between institutions. When dealing on such a scale, they are very keen to reduce their transaction fees wherever possible, which is why they trade directly.

A capital idea

Also quoted on most major exchanges are debt instruments. These debts are known as 'bonds' and money will be borrowed by either central or local government and corporations. These debts will have a predetermined term, for example 20 years. At that time, the loan will be repaid at a predetermined price. Until that date, interest will be paid to the bond holder. The price of a bond is not fixed in the market which means that their capital value will fluctuate as will the amount of interest paid (as a percentage).

Government debt prices are often used as a proxy for the health of an economy. As an economy grows or contracts and information about various elements are released, the prices that long- and short-term bonds trade at will fluctuate. The sustainability of government policies can often be judged simply by looking at bond prices.

In recent years, the role of some stock exchanges has changed to include derivatives - futures and options to you and I. These are part of a highly complex world which will not be explained here, but they are an enormous economy unseen by the population at large. In fact, in 2012 the global derivatives market was estimated to be worth 20 times the total value of the world economy (details here).

Peer pressure

The largest companies quoted on an exchange will also be members of an index. Examples are the FTSE 100, CAC40 or Dow Jones Industrial Average. To give an overview of the direcion of the market, this index figure is quoted by news and media and helps to generalise whether the market was or is 'up' or 'down'.

These indices are weighted which means that the largest companies are worth far more in terms of percentages than the smaller firms. By definition, this means that the movement of an index therefore, most accurately reflects the movements of the top few companies. Since these few largest companies have so much weight in the index, their health can often be used as a proxy for the health of a national economy, just as with the bond market mentioned above.

Fund managers (information here) have their performance judged against one or more indices that their portfolio is somehow related to. This makes it possible for a potential investor to judge how the manager has performed relative to that index.

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It is rather depressing to know - especially considering the size of salaries and bonuses - that the majority of fund managers under-perform their index. This relative under-performance is one of the core issues that has helped the hedge fund industry to explode in size - hedge funds are generally tasked with absolute returns rather than relative returns. This means that they are expected to be able to make a profit (alpha is explained here) whether markets rise or fall. Needless to say, it doesn't always work like this, but this is the concept at least.

The biggest fund managers and investment banks are known as 'market participants'. This means that they are considered to be more technically skilled and knowledgeable than ordinary investors. Government regulators apply different standards or care from companies depending upon whom they are dealing with. In financial services lingo this is known as KYC (Know Your Client) and aims to ensure that the less sophisticated are not manipulated or taken advantage of by the professionals.

How to learn

There are many great ways to learn about investing (information here) and financial markets tutorials for virtually everyone. It is best to start by doing some very basic background reading to try and discover whether a certain style of investment, or a type of asset or market appeals to you and then delve much deeper into that specific area. Once that area has been discovered, choosing training courses, products, books or tutorials based around that area will be much easier and probably save you a lot of money by not buying things that with hindsight might not be right for you.

If you decide that medium to long-term equity investment is right for you, then there are a number of useful stock exchange tutorials on this site. Perhaps the difficult element is deciding what might be right for you as a way to preserve and grow capital if not by equity investments of some sort. The harsh reality is that most pension schemes contain significant exposure to bond and stock markets. A range of mortgage repayment vehicles are also designed to invest in markets for their long-term returns. Many people also use equities for growth when saving to pay for the expected school fees of their children. In other words, most modern developed economies are designed to funnel the excess capital of it's citizens into investments that are based on the national stock exchange. Thus, it seems important that we each take the time to learn about the stock market.

Whilst this is only a partial answer to the broad question of, "What is the stock market?" it will hopefully offer enough information to be a beginner guide.