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Pragmatic Capitalism

Practical Views on Money, Finance & Life

Understanding the “Stock Market”?

The financial markets are actually comprised of many different smaller markets for certain types of financial assets, but in order to understand how these markets work it’s probably easiest to start with the more prominent of these markets – the stock market.  The stock market isn’t the largest market in the world, but it is the one we most often hear about.  That’s because the stock market represents the market value of all publicly listed corporations in a certain country.  For instance, the S&P 500 is 500 of the USA’s largest publicly listed companies.  But what does it mean to be publicly listed?

When a corporation is first formed it exists on what is called the “primary market”.  This is just the private market.  In general, the owners of a business on the primary market are the people who started that company.  So, if I start XYZ Corp by investing $100 in making widgets for the company then I am the sole owner of the corporation on the primary market.  As XYZ Corp grows I might need access to funding if I have products or services that I want to initiate, but don’t presently have the cash flow or revenues to fund these operations.  If I do this I might go to a venture capital firm who will provide me funding in exchange for a percentage of ownership in the company.  Bear in mind, I could also sell bonds which are just a form of debt as opposed to selling a portion of ownership in the firm.  There are different trade-offs and costs involved in whether a firm will fund itself by selling bonds, stock or borrowing funds in other ways (such as from the bank).

Now, the “stock market” comes into play when firms grow large enough that they can sell their ownership share to the public.  The public markets give companies the opportunity to raise huge sums of money so they can fund future operations.  So, if XYZ Corp were to grow substantially I might be able to sell my ownership shares to the public which will again help my company raise funds so we can expand even further.  Selling shares to the public raises funds so the company can spend for future production.  This is real “investment” (spending for future production).  And real investment is always done on the primary market where companies receive funding for future production.

Once those shares are issued and trade on the market they trade in what’s called the “secondary market”.  The secondary market does not involve real “investment”.  It simply involves private parties exchanging ownership of existing shares of outstanding stock.  So, if you buy 100 shares of XYZ corp at $100 then you are exchanging $10,000 worth of cash for $10,000 worth of XYZ corp stock.  There is someone else on the other side of the trade who is the recipient of your cash.  It’s a simple exchange and the actual corporation is not involved and does not receive funding from this “trade”.

The financial markets exist in large part to help us interact in the economy in various ways.  The stock market is just one way that firms can access funding for future production by selling shares to the public.  It also provides us with the opportunity to diversify our savings by buying and selling existing financial assets on the secondary market.

There are many different “markets” in the world and all exist for similar purposes though with differing legal arrangements and financial instruments.  But understanding the basics of the stock market will hopefully help you establish a better understanding of how markets function in general.