If you find the concept of stocks and investments scary, then you are not alone. Most people are scared of planning finances and investments because of the horror stories available on the internet. You may even know a person who lost 50% of their portfolio values or is duped by 'tips and tricks that promise big returns but seldom work. At this stage, it is not surprising that the seed of doubt about investment is planted. 

Realistically, investing in stock markets always carries risks. But if it is approached in a disciplined and strategic manner, it can be one of the most efficient ways to build your net worth. 

So, to understand the mechanisms behind stock markets and investing, let's start by understanding what stocks are and their types.

What is a Stock?

Stocks are financial instruments that represent ownership in a corporate or company and have proportional claims on assets and earnings. These may be known as equity or shares. 

When a person owns stock, it means that they own a share of the company that is equivalent to the shares held as a proportion of the corporation's total outstanding shares. 

For example, let's say an entity or individual owns 100,000 shares from a company that has 1 million outstanding shares. This means they have a 10% stake in that company. Most corporates have outstanding shares that range from millions to billions. 

How Many Types of Stocks are There? 

There are two types of stocks - common shares and preferred shares. If you have heard the term equities, it means common shares, as their market evaluation and trading volumes are much larger than those of preferred shares. 

One of the main distinctions between common and preferred stocks is that common shares carry voting rights that enable the shareholder to have a say in meetings and elections, but preferred shares do not have this option. Preferred shares are named this because they have priority over common shareholders when receiving dividends as well as assets during liquidation. 

Why Do Companies Issue Shares? 

Many corporate giants of today started as small private entities. Jack Ma started Alibaba from his apartment; Mark Zuckerberg started Facebook from his dorm room. But as their companies grew, they realized that they needed massive amounts of capital as investment. So, to make this transition from an idea in an entrepreneur's brain to a functioning operation, they need employees, offices, and a sales and distribution network, among other things. And depending on the scope and scale of the business, they need significant amounts of capital.

1. Raising Capital

Startups can raise capital by borrowing money (debt financing) or selling shares (equity financing). Debt financing is problematic as startups may not have excessive assets to pledge for the loan. Also, the interest on the loan imposes a major financial burden in the early days when a business does not have any earnings or revenue. 

So, equity financing is the preferred route. Entrepreneurs may initially get source funding from personal savings or family and friends to get their business started. When the business expands, and capital requirements become substantial, then they can turn to venture capital firms and angel investors. 

2. Listing Shares

When a business is set up, it may need access to large amounts of capital that are not possible from traditional bank loans. This can be done by selling shares to the public through an IPO or Initial Public Offering. When this happens, the status of the company changes from a private firm, where the shares are held by a few, to a publicly-traded organization whose shares are held by the general public. The IPO also provides early investors with an opportunity to cash out their part of the stake and, in the process, reap the rewards. 

When a company's shares are listed on the stock exchange and trading starts, the prices of these shares fluctuate as investors and traders assess the intrinsic value. Some multiple ratios and metrics are used to evaluate stocks, out of which the most popular is the PE ratio or price-to-earnings. Stock analysis tends to fall into two aspects - fundamental or technical analysis.

What Do you Mean by Stock Exchange? 

Stock exchanges are secondary markets where existing shareholders transact with potential buyers. The important aspect to remember is that corporations listed on stock markets do not buy or sell their shares regularly. So, companies may need to engage in buying back stocks or issuing new shares, but these are not day-to-day operations and occurs outside the exchange framework. 

So when buying shares of a stick in the stock market, you are not buying from a company but from other existing shareholders. Similarly, when you sell your shares, you do not sell them back to the company but to other investors. 

History of Stock Exchanges

Some of the first stock markets appeared in the 16th-17th century in Europe. They were mainly based in the port cities of London, Amsterdam, and Antwerp, as these were trading hubs. 
But the early stock exchanges were similar to bond exchanges as companies did not issue equities. Most corporations were semi-public organizations as they had to have a government charter to conduct businesses. 

During the 18th century, stock markets started appearing in the USA, with the establishment of the New York Stock Exchange (NYSE), where the trading of equity shares started. The NYSE was founded in 1792 with the signing of the Buttonwood Agreement by 24 New York City merchants and stockbrokers. 

The advent of the modern stock market ushered in an era of regulations that ensures buyers and sellers can trust the transaction goes through fair prices and occurs within a reasonable amount of time. Today, there are multiple stock exchanges across the USA and around the world that are linked electronically. This means that the markets are more efficient and liquid. 

How are Share Prices Set?

The prices of shares in the stock market are set in multiple ways. The most common way is through an auction process where sellers and buyers place bids to buy and sell. A bid is a price at which someone wishes to buy, and an offer is a price at which someone wants to sell. When both prices coincide, then a sale is made. 

The overall industry is made up of millions of traders and investors who have different ideologies about the value of stocks and what prices they should buy and sell at. The thousands of transactions that occur when these sellers and traders convert their intentions to actions by selling or buying cause minute-by-minute changes in a trading day. 

Stock exchanges provide platforms trading can be easily conducted by matching sellers and buyers of stocks. But for the average Joe to get access to such exchanges, they need a stockbroker. These stockbrokers act as middlemen and are most commonly found when a person creates an account with a well-known retail broker.

[ Related Article: What are the Rights and Duties of a Shareholder ]

The Demand and Supply in a Stock Market

The stock market offers a perfect example of the laws of supply and demand in real-time. For stock transactions, buyers and sellers must exist. Because of the immutable laws of demand and supply, if there are more buyers for specific stocks than sellers, then stock prices will go up and vice versa. 

When bidding, the bid-offer spread - the difference between the bid price of a stick and the offer price represents the difference between the highest price that a buyer is willing to bid for a stock and the lowest price that a seller offers for the stock. 

Trade transactions occur when the buyer accepts the asking price or when a seller takes the bid price. If buyers outnumber the sellers, then they are willing to raise the bids to acquire the stock. But when buyers lower their bids, then they can force the price down.

Matching Buyers with Sellers

When stock markets rely on professional traders to maintain continuous bids and offers, motivated buyers or sellers may not find these at that moment. These professional buyers are known as market makers or specialists. 

These two-sided markets are made of bids and offers, while the spread is the difference in prices between the offer and bid. The narrower the price spread, the larger the size of the bids and offers, and the greater the liquidity of the stock. Also, if there are multiple buyers and sellers at subsequent higher and lower prices, the market has good depth. 

Previously, matching sellers with buyers in the exchange was done manually, but now it is increasingly carried out via a computerized trading system. The manual method of trading is based on the outcry system, where traders use verbal and hand signal communications to buy and sell a large number of stocks on the exchange floor. 

But the open outcry system has now been changed to the electronic trading system. These can match buyers with sellers more efficiently and result in significant benefits such as faster execution of trades and lower costs. 

Market Capping and Sectors

We know that there are two basic types of stocks, but those can be divided into two categories - based on market capitalization and sector. 

Market cap is the total market value of a company's outstanding shares and is calculated by multiplying these shares by the current market price of 1 share. But the exact definition may depend on the market. Large-cap businesses are generally those with a market capitalization of $ 10 billion or more, mid-caps are between $2-$10 billion, and small caps are between $250million and $2 billion. 

The industry standard for classification based on sectors is the Global Industry Classification Standard (GICS), developed by MSCI and S&P Dow Jones Indices in 1999 as efficient tools for capturing the evolution, depth, and breadth of the sectors. This four-tiered industry classification system consists of 11 sections and 24 groups. The 11 sectors are: 

• Energy
• Financials
• Healthcare 
• Industrials
• Materials
• Consumer Staples
• Information Technology
• Consumer Discretionary
• Real Estate
• Communication Services
• Utilities.

Sector classification makes it easy for investors to customize their portfolios according to the level of risk tolerance and preferences in investment.

List of Stock Exchanges by Market Capitalization

How Does Inflation Affect the Stock Market?

Inflation refers to an increase in consumer prices and occurs either due to an oversupply of money or a shortage of consumer goods. Inflation effects on the stock market are highly unpredictable. In some cases, it can lead to an increase in higher share prices. As there is an influx of money in the market and an increase in job growth, the higher the input prices, the more restricted corporate earnings, and this cause profits to fall. Overall, the value of stocks tends to perform better growth in stocks in times of high Inflation. 

[ Check out What are Options Trading? ]

How Much Does the Stock Market Grow Every Year?

The S&P 500 has grown by about 10.5% per year since it was established in the 1920s. Xo, using this barometer for market growth, the only estimate is that the stock market can grow in value in the same amount every year. However, the probability of having an increase in stocks in the coming years has been growing less. Additionally, some stocks grow faster than others. 

How Do People Lose Money in the Stock Market?

Most people lose money in stocks due to reckless investments when considering high-risk securities. But these score high returns when they are successful, but they are likely to lose money. An element of psychology is also involved in this; when an investor sells during a crash, it locks in due to their losses, which is why those who hold any stocks have a chance of seeing a reward when patient. Finally, margin trading makes the stocks even riskier; only then can one magnify the potential loss or gain. 

Wrapping Up

Stock markets have become the backbone of the market, and experts use them as a thermometer of economic health. But the importance of stock markets goes just beyond mere speculation. By allowing businesses to sell their shares to millions of retail inventors, stock markets represent a major source of capital for public businesses.