Understanding the stock market

In the second article of our investing series we discuss what stocks are, how the stock market works, and why people invest in stocks.

As we explained in this article, people invest to grow the value of their savings because otherwise their money will lose value over time due to inflation. 

Perhaps the most reliable way to beat inflation is by investing in the stock market. However, unless one studies finance or economics, the stock market is something most of us need to research in order to properly understand. In this article, we explain what stocks are, how the stock market works, and what causes the price of stocks to fluctuate.

What are stocks and shares?

Put simply, a stock or a share (also sometimes called an “equity”) is a slice of a company that gives its owner certain legal rights, such as the right to a share of the company’s profits, known as a dividend. Shares are first “issued” by companies when they are first formed to their initial owners or founders.

Investors who buy shares directly from a company are called “primary investors”. Primary investors can then sell these stocks/shares to other investors in order to realise the profits from these investments. Investors that purchase shares from primary investors are called “secondary investors”. 

Large, established companies tend to be listed on a public stock exchange, which is where primary investors can sell their shares to secondary investors (and where secondary investors can sell their shares to other secondary investors, like you or me. When people refer to “the stock market”, this is what they refer to. 

How does the stock market work?

Although stock markets are governed by complex laws and regulations that are designed to promote an efficient system and protect investors, they are fundamentally the same as any other market.

When there are more investors buying a particular stock than there are selling it, the price of the stock in question will go up (due to supply and demand). On the other hand, when more people are selling a stock than are buying it, its price will fall.

It is important to note that there is a distinction between a stock’s price and its value. Price is what a particular investor is willing to pay for the stock at a point in time, whereas value refers to a stock’s inherent—or intrinsic—worth. Investors, particularly professional investors, may look at a company’s financial performance and other indicators in order to determine what they feel a stock’s value is.

Meanwhile, a stock’s price might move up or down as investors react to short-term news about the company. For example, if a company releases financial results that are disappointing then investors might sell its stock because they believe that their money is better invested elsewhere, causing its price to fall. However, other investors might view the reduced stock price as an opportunity to buy if they believe the company’s long-term value remains sound. 

As such, a company’s stock price does not change due to the news itself; instead, news relating to that company will impact investors’ judgements of that company, which may cause them to buy or sell, which can lead to price fluctuations. 

How do you profit from shares?

There are two ways that investors can make money from shares. The first is through selling shares at a higher price than you bought them at. The second is through dividends, which, as mentioned earlier, are a share of profits that companies can pay out to their shareholders in proportion to the number of shares that each shareholder owns.

However, it is generally best to buy and hold shares over the long-term in order to benefit from compounding. Gains on the stock market compound, which refers to the fact that they generate returns on returns.

This concept is best understood through a simple example. If you invest £10 into a company that gains 10% a year, the investment is worth £11 after year one; the following year it will be worth £12.10, and the year after it will be worth £13.31. In this example, the annual return is 10% of both the initial £10 as well as 10% of all gains since the initial investment. 

Over longer periods of time, the effects of compounding can be staggering. In the next article in our investment series, we will illustrate this concept using investment examples that ordinary investors like you and I can relate to.

This is the second article in our series on investment. You can read the first article on the inter-relationship between interest rates, inflation and investment here. The third article in this series will discuss how ordinary people can get started with investing and why passive index investing might be the most effective way to do so.