How does the Stock Market Work?

The Stock Market: a large, effervescent group of well-groomed individuals shouting in most unbecoming ways across the huge expanse of the vast ‘floor’, engaged in placing random ‘bets’ on the corporate roulette by shaking menacing fingers at screens and vigorously nodding and shaking their heads at voices streaming out the phone glued to their ear. It can certainly seem that way to the regular Joe. But, in fact, the stock market is a much more systematic and reliable investment vehicle for anyone looking to put some of his money to work.

Basic Structure

As its name suggests, the stock market provides a place where sellers and buyers can trade stocks. Stocks are ownership titles to small shares of a corporation’s assets (everything in its ownership) and earnings (all money from products and services). A company issues stocks when it needs money to either start its operation or expand it. The main advantage of raising capital from selling stocks (known as equity financing) rather than applying for a traditional loan through a bank (called debt financing) is that the corporation does not have to pay interest or even the initial loan back to its lenders. Instead, investors earn their money back (and hopefully more) by selling their stocks at a later point in time to other interested investors at a higher price than they bought them.

Trading At the Stock Market

Before entering the stock market an investor needs to understand what determines the value of stocks (either for buying or selling) at any given time. Stocks prices operate on a basic demand-and-supply cycle: when demand for a stock from potential buyers rises, so does the price of the stock; when demand drops, it drags the stock’s price down with it. In theory, demand rises when a company performs well. In practice, however, demand depends on how well a company is expected to do in the future. Investors buy (cheap) stocks at the expectation that a company will perform well, thus driving the price of the stock up before actual earnings are achieved. Likewise, they sell (expensive) stocks when the company announces its earnings, on the understanding that the stock has reached its peak (at least temporarily), which might cause stock prices to fall as the company’s earnings show an increase. In the event that a company does not performs as expected, the investor stands to lose part of his money, as his stocks will not be worth the price he paid for them.

Investment Strategies

There are many ways to invest in the stock market according a specific investor’s financial goals and risk tolerance, and it is advisable that investors diversify their portfolio well by investing in different types of stocks (and other investments) in order to minimize risk and stabilize returns. One should always investigate well the standing of a company before investing in it, keeping in mind that no investment can ever be absolutely risk-free, as a company’s future growth cannot be guaranteed. The ever-present uncertainty of future projections (even at its slightest degree) means that an investor must take action the minute a trend shifts direction in order to ensure the best possible trade – and it is this inherent urgency of the trade that gives the stock market its well-publicized frenzy that intimidates many would-be investors.