Investing 101: The Stock Market, how it works and why it exists.

So, you’ve picked up an interest in the stock market and financial systems, you’ve read about it and, yet, still don’t have a clue? It sure might seem complicated, awfully complex and so full of technicisms and topic-specific jargon that you will never, ever, learn it.

But, let me tell you: Economics and finance have been long developing fields of study. We already posess large vocabularies to describe concepts which coexists in this abstract theoretic fields and still, if you read any very old book about Economics, you might be surprised by how simply everything can be expressed in simple words once you learn the basics.

So, what’s the stock market anyways?

The stock market is defined, primarly, as the set of all markets and exchanges in which buying and selling occur regularly, and where companies perform issuanse of publicly priced shares.

It sure is a mouthful, but can be undestood simply. We first need to understand the difference between a market and an exchange.

Exchange:

We generally refer to a market as the location or specific system/organization in which assets are traded. An obvious example are marketplaces.

This is a technically incorrect conception, for such a place is, in economics, an exchange. That’s what you call that specific system or place in which transactions occur and goods are dealed. The sine qua non requisite for an exchange to exist is for it’s type of goods to be traded somewhere else.

Market:

Now, a market is but the collection of all exchanges that deal a particular good. Commodities are a very undestandable example.

There are many companies from which you can buy a given commodity, coffee beans, for example; tons and tons of them. These transactions will have a price primarly determined by quality of usufruct (The coffee beans), any operating costs (Like water and insecticides) and how much profit the business owners want (Which is, of course, infinite).

The only thing stoping any company from selling it’s product at exhorbitant prices is competition. They want infinite revenue, but as any potential customer will compare prices between companies, then, obviously, business owners are now interested in having a ‘fair enough’ price. This allows them to make some profit per unit of product and atract costumers with prices that may seem ‘low’ if other companies can’t afford such prices; thus creating the ‘coffee beans market’, the set of all coffee beans exchanges that exists.

Now you can apreciate the important role of varied markets in an economy, in contraposition with that of single exchanges (Monopolies).

So, let’s clear up our definition now.

By stock market we refer to the collection of all markets (Commodities, stocks, bonds, etc) and exchanges (N.Y.S.E., B.Y.M.A., and any exchange not officially recognized where the aforementioned goods trade) that exists in the world right now and that affect prices.

The issuance of shares by companies is necessary for stocks to exists. But…

Why do companies emit shares?

Share issuance has a simple purpose: Financiation. This works as follows.

A company divides it’s net worth into many bits (Shares), which then are, in a sense, auctioned to as many people as possible. Only a proportion of the shares will be publicly traded, though. For example, 75% of them will go into the stock market, and the other 25% will be sold and bought privately. The cash generated by this will be used to generate more revenue for the company, investing with it. As the company grows, given that the number of shares in the market has stayed the same, then the value of each share increments.

Such process makes a profit for those investors who bought the shares initially and kept them, and generates demand for this particular company’s shares in the market, which financiates the company even further.

Let’s say, for example, that company X has a net worth of $25.000.000 and wants to enter the stock market. The company issues 1.562.500 shares total, of which 1.171.875 go into the public market, and the rest into private markets. Company’s X net worth ($25.000.000) will be divided by the total amount of shares (1.562.500) to gives us the price per share ($16), which is the price every investor buying shares of the issuance will have to pay for each one. Given that every share destined to the public market is bought, now the company is available for public trading.

Primary & Secondary Markets

What we first defined is called the Primary Market. This is the market in which securities are created and first bought.

As soon as the securities are issued they enter what’s called the Secondary Market. This is the stock market we all hear about in the news, where traders make GameStop shoot up and crypto never seems still enough to think about buying it without having a heart attack.

The only difference between Primary and Secondary Markets is that, in the secondary market, securities circulate and are bought and sold constantly, with no intervention by the company in the process like we see in the primary market whatsoever. It’s pretty much like a second-hand security market.

This is all wonderful and so on, and so on, but may still be wondering: Why does the stock market even exist?

T’is but a gambling table!

Many people nowadays still think that the role of the stock market is that of… well, a gambling table. That it’s a place where Wall Street speculators go to make or lose millions.

And while that might be true to some extent (Wall Street is, after all, a place of speculation, not of investing), the role and purpose the stock market serves in the economy is much broader and different; and very rarely is it talked about.

First things first, what we already stablished:

• Companies recieve financing:

This is a plus for the economy, and one of the main reasons the stock market exists. Anything you do (Within the legal frame of reference!) that increases the country’s GDP is, and will be, a plus for the economy. Maybe not a plus for the country per se; GDP isn’t a measure of citizens’ quality of life; but it surely is better for the upper-middle and high classes for GDP to be greater.

• It benefits professional and institutional investors:

It’s not just a favor done to the powerful. The sole idea of benefiting them is quite simple; they end up spending more. And this, in turn, results in greater GDP.

This is not to say that retail investors don’t benefit with it and end up spending more; they do. But it’s only a minority.

• Any free-market economy needs it:

The stock market keeps the money business as public as possible, which, essentially, means that markets have the possibility of becoming high in liquidity.

This is good news, as it has been shown that greater liquidity in markets bring income inequality down, benefiting lower classes greatly without having to undermine higher classes’ businesses.

Although there’s the other side of the coin, of course: Various studies have found that, while liquidity might bring down income inequality, markets with rising prices everywhere actually aggravate inequality.

Yet this is not surprising, for higher class individuals invest much more in the stock market than middle and lower class individuals do, and so when the markets are bullish (That is, prices rise) those who’ve invested accumulate wealth, while those who didn’t stay the same, or even worse.

Finally

It isn’t difficult, as you’ve seen, to understand the basic stock market mechanisms. It only takes a while to get used to thinking in financial and monetary terms as ‘supply and demand’ or ‘compound interest’, and you’re all set.

Who knows, maybe in a while you’ll be the next Warren Buffet.