Understanding the Stock Market

Don’t panic - I’ll give you a simple definition: it’s a market for stocks. Stock markets exist worldwide, and they vary significantly in many respects.

A Brief Introduction

I must have been five when I first encountered what I later came to learn was ‘the stock market’. I remember walking into our lounge and being utterly perplexed; my parents had taken the decision to sit and watch, or even study as it appeared, flickering blue and red numbers on what used to be Teletext, instead of watching a film!

I had always loved numbers as a child, and so I wasn’t too keen to berate their decision, despite always having had a lot to say for myself. I did, however, delve a little deeper.

One outstanding memory of mine is the moment at which I spotted ‘Cadbury’ on the television screen. Immediately, I started to ask questions, and quickly established that there appeared to be a link – a link between two things I loved: numbers, and chocolate. How did that work, then? My parents, and later my grandfather, introduced to me the concept of ‘shares’ and all became clear.

My interest blossomed, and I continued to ask questions in the months and years that followed. I was fortunate enough in that I was always encouraged to do so by my every mentor. I remember during my first work placement in a Stockbroking firm in 2009, I was told, “Believe only 10% of what you’re told and question the other 90%.” I live by this saying to the day, except I also question 90% of that 10%.

The Basics

In a roundabout way, I have already introduced the fundamental concept regarding stock markets to you already. Any given product, be that chocolate or otherwise, is likely produced by a company. This company is very probably publicly-traded.

What this means, is that anyone may own a stake in that company. Taking the example of Cadbury, later acquired by Kraft, in order that they may finance their chocolate-producing operations, they issue ‘shares’, which come to ‘float’ on the stock market. This stock issuance is a method by which a firm may raise capital in order that they may grow.

Regular consumers, such as yourself and myself can come to own these shares, and a slice of the pie, so to speak. Most sensible investors would then be keen to follow the price of the shares, which reflect the value of their stake in the company, just as my parents were doing all those years ago.

But the question is, how do we, prospective investors, come to get a slice of the pie? How can it be that we can own a stake in Cadbury? I certainly don’t have the owners on speed dial, but I’d quite like to gain some exposure to their profitability. Their chocolate is flying off the shelves, and I guess, that must mean that they’re doing well!

This is the point at which the stock market enters the picture. Don’t panic – I’ll give you a simple definition: it’s a market for stocks. It is any place, or virtual platform as it has come to be, where buyers and sellers of these ‘shares’ may come together in order to trade.

The Nitty-Gritty Stuff

Just like in any market, high demand for a good (a share in this case), will lead to a rise in its price. This will be reflected on the stock exchange, where all share prices are quoted. Lower demand for a share will lead to a decrease in the price.

The beauty of trading is that opinions differ. One individual’s opinion of Cadbury’s share price may differ significantly from that of another. Hence, trading occurs, and a fair value for the stock is determined based upon prevailing market conditions and investor sentiment.

Needless to say, Cadbury isn’t, or wasn’t (before its takeover) the only stock on the exchange. There are hundreds, thousands, dare I say millions of publicly-listed companies which anyone can own thanks to the medium of the stock exchange.

When these companies are compiled, maybe based upon the fact that they operate in a similar sector, or more likely are in close proximity to each other (usually at a country level), they form an index.

There are many methods as to how indices are constructed. The basic principle is that a number of public companies will become members (constituents) of a stock index, if they meet certain criteria, and the movement of this index reflects fluctuations in the underlying value of the constituents, as represented by their share price, at any given time.

If an index moves upwards, it suggests that on average the constituents have risen in price. Therefore, in the market, there are more buyers than sellers for these particular stocks. If the index drops, there are more sellers in the market. Thinking again about Cadbury, if their share price dropped, one possible reason could be that their chocolate just doesn’t taste as good anymore, at least relative to that pesky rival over in Switzerland.

Regardless of the reason, shareholders may reconsider their ownership of Cadbury shares, and may be keen to act by selling their stake in the company on the stock exchange.

Ultimately, via the interaction of demand and supply, an equilibrium will develop for any given share, and the share price at any given time is simply a reflection of this economic law. This shares performance, which will result from changes in demand and supply patterns, will affect the value of the index within which it is a constituent.

To Conclude…

I very much expect that you will have heard of a few of these such indices. Does the FTSE 100 ring a bell? That’s the primary UK stock index, which comprises companies such as BP, Shell, Tesco and Barclays; a whole host of firms with which I expect you will be familiar.

Stock markets exist worldwide, and they vary significantly in many respects. If this article has whetted your appetite for the subject, why not have a look at some of the larger stock exchanges out there? You may well be surprised at what you find.

Would you have put the stock exchange of Frankfurt above that of Mumbai, Seoul or Sao Paulo, in terms of size?

I hope that this article has provided you with at least some insight into the workings of a ‘stock market’. Given the current volatility in global stock markets, now is as good a time as any to further develop your interest in what truly is a fascinating field of study.

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