You hear a lot about the stock market in the news and on TV. And it can seem confusing—even a little nefarious—but it doesn’t have to be.
First thing to know is there isn’t one stock market, there are many stock exchanges and markets. The second is that a stock is just a share of a company. Stocks can be bought, sold, or traded. (There are also more complicated financial configurations, such as a futures contract, which is an agreement to buy or sell a stock at a predetermined point in the future at a predetermined price.)
The reason this all works is because the people buying and selling on the market have different theories about how things are going to work out down the road. For example, I might think the value of a certain company is going to go up, and you might think it’s going to go down. Market crashes happen when everyone is trying to sell at the same time.
Stock exchanges are a big part of the overall economy. Understanding what a stock exchange is and how it works will help you understand how it affects you and your investments.
What Is a Stock Exchange? How Does It Work?
A stock exchange is simply a market where stocks are traded, sold, and bought. Exchanges are generally organized by an institution or association that hosts the market. Those who want to buy or sell stocks or bonds commonly go through a broker, who is licensed to trade on the exchanges.
There are a growing number of online brokers, where you can choose to make many of the trades yourself or opt for a diversified fund that has a makeup designated by what kinds of stocks, bonds, and commodities you want.
Or you can work with a traditional broker or financial advisor, who will advise you on your overall retirement investments and wealth planning. Even they, however, do much of their trading electronically at this point.
If a company is “listed” on an exchange, it means that the company can be traded on that exchange. Not all companies are listed because each exchange regulates which companies meet their requirements. Companies not listed on the exchange are traded “over-the-counter,” or OTC for short.
Even now, you don’t have to buy or sell stocks on an exchange, even if they are listed there. You’re allowed to sell your official stocks on your own, but it isn’t particularly convenient. It was the need for convenience and some rules that led people to form stock exchanges in the first place.
Regulatory authorities set U.S. regulations that stop insider trading and dictate who can legally trade. Buyers and sellers are able to trade at the exchange when it’s open during business hours.
You might think you don’t personally make trades or need to know about stock exchanges, but odds are a portion of your retirement savings are actually in a portfolio of stocks and bonds. In the long run, the market typically offers an average 10% return when inflation is taken into account —though obviously, it can go up and down in the short run.
Different Types of Securities
Securities are any financial asset that you can trade, which includes:
Stocks: Represent an ownership percentage in a company and often pay dividends to stockholders.
Bonds: Long-term debt. Earnings come from the interest being paid on the debt. Bonds typically pay interest in set intervals.
Commodities: Goods like corn, oil, and gold. Sold on a commodity exchange.
Why Do We Have Stock Exchanges?
Dating back to the 1400s and 1500s, there have long been exchanges or markets where individual, government, and business debts were traded, sold, and bought.
But it wasn’t until the Dutch East India Company started selling shares in its company with its multiple shipping ventures, to offset the risk of any one individual expedition, that stocks and bonds came into existence.
Almost all companies need to raise capital. One way they do so is by selling shares in their company. But the people who buy those shares need to know they’ll also be able to sell or trade their shares in the future. (Fewer people would want to own a portion of a company if they knew they’d be stuck with it forever and ever, regardless of circumstance.)
The lack of rules early on led to lots of companies issuing shares they couldn’t back up, and then going out of business or leaving shareholders high and dry. London banned companies from issuing shares until 1825. Although the New York Stock Exchange (NYSE) wasn’t the first—it wasn’t even the first in the U.S.—it officially became the New York Stock & Exchange Board in 1817 and traded stocks from its very first day.
What is the New York Stock Exchange? Also known as the NYSE, it’s just one of many stock exchanges in the world. It’s also the biggest one in the world, valued at almost $23 trillion in market capitalization. But there are 16 other exchanges valued at over $1 trillion, like the NASDAQ, which is also based in New York, the London Stock Exchange, and the Tokyo Stock Exchange (also known as the Japan Exchange Group).
How Does the Stock Market Work?
The stock market is a term that encompasses all trades made through avenues like stock exchanges, over-the-counter venues, and computerized trading methods.
It facilitates the buying and selling of shares between:
• Companies and investors via IPOs (primary market).
• Investors and investors via stock exchanges like the NYSE or NASDAQ (secondary market).
Prices in the stock market can fluctuate with supply and demand for different shares. For example, if there’s high demand for a stock, its price will likely be higher.
How a Stock Exchange Factors Into The Overall Stock Market
Even if you don’t trade stocks—and the vast majority of stocks are owned by the top 10% of richest people—the stock exchanges and stock market still affect you. That’s because they affect the overall market. How?
When people talk about “the market” what they’re typically referring to is the trends of all stocks, bonds, commodities, and futures across multiple exchanges. To this end, stock market indices are important.
An index weights a selected set of stocks to create an average. For example, the S&P 500 calculates 500 of the largest U.S. companies’ market capitalization. The Dow Jones Industrial Average is made up of 30 large publicly traded U.S. companies. By watching the value of these indices each day, investors can get a sense of the overall markets’ trends.
The reason you should care is that the overall market can be predicted by, but also influenced by, the stock market. There are a number of reasons a given stock price could go up or down, and the stock market overall simply reflects the aggregate of all those individual stock prices.
That means that stock market rises and falls do not necessarily cause the economy to rise or fall. But, often a stock market drop or crash can precipitate a recession. In some cases, this is because the drop in stock prices reflect larger economic issues, like during the 2008-09 recession. In some instances, it is because the stock market drop erodes consumer confidence, which then leads to less consumer spending and causes an economic decline.
When the stock market goes down, stocks and funds may mirror the dip. But you don’t need to necessarily worry. Sometimes it can make sense to invest when the market is down. To understand what stock exchanges mean for your personal investments and retirement funds, it can help to get some advice.
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