Learn How the Stock Market Works: A Beginners Guide

10 minutes

photo courtesy of www.moneysense.ca/invest/bias-towards-canadian-stocks/
photo courtesy of www.moneysense.ca/invest/bias-towards-canadian-stocks/

What is the stock market?

Did you know that the average daily trades on the S&P 500 is over 700 million? The average for the NYSE is 3.6 billion and the average for the NASDAQ is 10 million! That is a lot of trading. No wonder these guys are tired at the end of the day.

That is an incredible amount of money moving back and forth. The market cap for the S&P 500 is $19 million and for the Dow Jones it is $5.2 million. This indicates the total amount of money the companies that are listed on these exchanges are valued at.

The daily average of trading equates to $134 billion a day. Which is a lot of shekels to be throwing around. The world’s largest financial market currently is the currency market which has an average trading volume of $4 trillion. This dwarfs the U.S. stock market.

The stock market is a place where shares of a company are bought and sold. Back in the old days it was done face to face but now it is done electronically. There were trading floors in places like New York City, London and Tokyo. Prices are basically put up in a bidding type of auction.

Buyers are looking for a certain price as are sellers. They are looking to exchange companies for different prices. An easy way to think of this an Ebay for selling stocks. There are online brokers that are looking to connect buyers and sellers for that particular company.

You must think of stocks as an ownership in a business. When you buy and sell a stock you are really buying and selling a company. Like Apple or Amazon. When you buy 10 shares of Amazon you are purchasing a part of that company. More on this later.

All of these exchanges interact with millions of individuals looking to buy or sell their shares. Because this would be virtually impossible if done face-to-face these trades are now done electronically through stock brokers.

These brokers help manage these purchases and process them thru the different exchanges. These orders are passed down to the floor traders who will go to that specific area on the floor that the stock is trading. They will connect with a specialist at the trading post who will connect buyers and sellers.

According to Warren Buffet “in the short term, the market is a voting machine. But, in the long term, it is a weighing machine.” By this he means that the stock market is fickle and it can a popularity machine at first. Investors will get excited about the latest and greatest new company, CEO or tech. They will pile into this stock irregardless of any analysis or due diligence. Over time the enthusiasm will wane and the popularity will diminish and with it the price of the stock will drop.

The stock market is a very volatile, magical place where millions can be won or lost, sometimes in minutes. But you need to have confidence in your picks, patience and an iron stomach to withstand the ups and downs. And there will be ups and downs.

Brief History of the Stock Market

In 1602, the Dutch East India Company became the first company to issues shares of its company on the Amsterdam Stock Exchange and get traded on a continous basis.

Coffee shops were the first place that stocks were bought and sold. Imagine this taking place at Starbucks today! The stocks were written on paper napkins and traded at other coffee shops in the areas. These coffee shops were the first stock markets.

The first stock exchange was opened in London in 1801. The New York Stock Exchange (NYSE) was established in 1817. But this wasn’t the first exchange here in the US, that prize goes to the Philadelphia Stock Exchange.

Almost every nation in the world has a stock market these days. It has grown incredibly from the humble beginnings of the London Exchange and NYSE.

In 1971 the NASDAQ was born. The main difference between the NASDAQ and NYSE was that the NASDAQ is almost exclusively electronic. The do not have any physical exhanges to make their trades. It is all done via the internet.

Stock Market Crashes

  • Stock market crash of 1973-1974
  • Black Monday of 1987
  • Dot-com bubble of 2000
  • Stock market crash of 2008

All of these pale compared to what happened in 1929.

Of course, I am not forgetting the Grandaddy of them all the Stock Market crash of 1929. Over the course of three days in 1929. Referred to as Black Thursday, Black Monday, and Black Tuesday.

Over the three days the Dow Jones Industrial Average lost over 50% of its value. Imagine the chaos and panic that would have set in in this age of instant knowledge that we have. All the above examples suffered double digits loses but nothing compares to the crash of 1929.

Many think this was the beginning of the Great Depression as it plunged the US into the depression as well as losing millions for people.

An interesting tidbit is the fact that stock markets have been in existence here in the States since 1817. In that time there have been only 5 major drops with one complete collapse. I wanted to point this out to help alleviate the fear that the market is always crashing and you could lose everything.

Keep in mind that some of this fear is created by the talking heads on TV. Their job is the entertain and they can do this best by creating controversy and stirring the pot. Try your best to ignore the noise and focus on what you know and be strong.

Interesting stats for those stat geeks like me.

Biggest Gain in one day

March 15, 1933                   15.3%

Biggest loss in one day

October 19, 2007                -22.6%

Original Black Monday

October 22, 2012                 -13.5%

 

What are the Big Three Indexes?

There are three major indices here in the US. These indices are comprised of some of the most powerful, influential companies in our economy. You could say they drive our economy.

One of the great features of these indices is that you can buy them as a whole which would allow you to own all of these companies in one place without having to spend time evaluating each company.

Dow Jones

The Dow Jones Industrial Averages is agruably the most important index in the world. It was created by Wall Street Journal Editor Charles Dow and notable investor Edward Jones. Yes, that Edward Jones. It was first published in 1885 and it comprises 30 of the most important companies in the US economy. They are all large publically traded companies who play a key role in the economy. It started as a listing of industrial companies but today it has morphed into quite the menagerie of companies, with tech leading the way.

Examples of companies in the Dow Jones

Apple

American Express

3M

Coke

General Electric

IBM

Recent expulsions from the Dow would be Bank of America and Hewlett-Packard. This occurred in 2013. The longest running stock in the Dow would be General Electric which was introduced back in 1907.

The Dow has become the number that most investors think about when they are thinking about the stock market. So, if you hear that the market was up or down today. They are typically referring to the Dow Jones, which includes trading solely in this index.

These are the 30 largest companies in the US and they do have a pretty big influence on the economy, but they are not the whole economy and this can be a little misleading on the overall state of economy.

I point this out because the talking heads on TV will point this number out on any conversations regarding the overall economy of the US. This can of course skew people’s view on the state of the economy, either in a positive or negative way.

S&P 500

The S&P 500 was introduced in 1957 as a market index to track the 500 largest companies in the US. It was intended to represent the overall makeup of stock market. It includes companies from the both NYSE and the NASDAQ.

Its exact composition is a constantly evolving thing with companies being added or removed all the time.

It has performed remarkably well since its inception. It has outperformed other asset classes such as bonds and commodities.

The S&P is considered the bellwether of the US economy. Because of its varied makeup, it gives a great indication of the status of the economy. It is not referred to as much outside of financial circles.

It is also one of the leading sources of independent credit ratings.

You will find a crossover of companies listed on both the Dow Jones and the S&P. Such as Apple, Amazon, Walmart, etc.

The S&P 500 Index is one of the most popular indexes to buy for investors as it provides great diversification with all the mix of different industries included in the index. It is also a great indicator of the overall economy.

Nasdaq

Currently, the NASDAQ is the second largest stock market in the world by market capitalization. The NASDAQ is considered a stock market, not an index like the Dow Jones or S&P 500.

The NASDAQ was created in 1971 and it was the first all-electronic stock market. Today the NASDAQ is the world’s largest electronic market with over 3000 securities listed.

The NASDAQ is a little more obscure in the public eye. It is very well known in the financial world but you will notice that it is very rarely referred to in the financial media.

It will always be listed with the Dow Jones and S&P but it is not as common to have it referred to as an indicator of financial health. Check it out the next time you look at a listing of the stock market on any financial site like Yahoo Finance or Morningstar for example.

Where do stock tickers come from?

A stock ticker is the report of a price of a current stock or security. It is updated continuously throughout the day through various stock exchanges such as the NYSE. A “tick” is any change in price, either up or down.

This is done automatically and will only display a certain amount of stock tickers throughout the day. It will also display other information such as volume. This is done to help investors keep track of their investments as well as give them information to help base their possible trades on.

Stock symbols have an interesting history. After the Civil War, Thomas Edison invented the ticker tape machine to help speed news about stock transactions all over the company.

To help speed up the transmissions, some of the most common referred companies were assigned single-letter abbreviations to represent those companies.

Thus was born the stock symbol. Among the first were US Steel which was appreviated with an X? Not sure why X, but hey we’ll go with it. Some of the older companies still have held onto their single letter designations. Among them would be AT&T(T), Ford(F), Sprint Nextel(S) and Kellogg(K).

These days you can use up to 4 letters in your symbol. And it is us up to the company to choose what they would like. Some are no brainers liker General Motors(GM), General Electric(GE) or Anheiser-Busch(BUD).

Before the standardization of today. Each company would have to decide which exchanges they would like to be listed on as well as what their symbols would be. They used to have one to three letters per company per the NYSE and the NASDAQ required four letters. This prevented companies from being able to move across exchanges freely. They would have to have different symbols per each exchange, which obviously got to be very cumbersome.

In 2007 this rule was changed which allowed the companies to move across exchanges freely and made things less confusing for the investors.

What is the difference between stocks and commodities?

In the commodity markets, you are buying and selling raw materials that can be used for manufacturing other goods. Some examples of these would be oil, steel, electricity, beef, natural gas and orange juice.

If you remember Trading Places, a movie from the eighties featuring Eddie Murphy. They were trading orange juice in that movie.

Stocks are the buying and selling companies that will use these commodities to manufacture those products that they sell. You can buy or sell individual shares of the company.

Commodities have their own markets and are bought and sold just like a stock would. Their financial headquarters is in the Windy City, Chicago. They are typically traded in the futures market.

One big difference between commodities and stocks is that commodities prices are driven by supply and demand. As opposed to the stocks which have their prices set by the exchanges they are traded in.

An example in today’s world would be the price of oil. In the last year or so the price of oil has plummeted because of several factors. First being that there is a glut of oil in the world today. There is too much supply. OPEC has kept pumping out the oil hoping to drive the new American producers out of business as the price has dropped.

Another factor in the decline has been the drop in demand for oil, with the slowdown of the world’s economy there has been less demand for oil. Places like China, Europe, and the US have seen a slowdown in manufacturing which has driven down the demand.

I am simplfying this example to make it more understandable, but trust me it is much more complicated. As you can see commodities markets are going to be much more volatile to invest in, as opposed to the stock market which is a little bit more stable. Sometimes.

Final Thoughts

My goal with this post was to try to educate you on what the stock market its and how it operates. I tried to demystify it a little bit for you.

We have talked about the many aspects of how the stock market started as well as how the trades are executed.

Remember that it is comprised of exchanges where the stocks are actually traded. There are exchanges all over the world but some of the biggest to be aware of are New York Stock Exchange, London Exchange, and the Tokyo Exchange.

The Dow Jones and S&P 500 are considered indexes which contain some of between 30 and 500 companies. These are some of the biggest and most important in our economy. There is some overlap between indices so it can get a little confusing. But just keep in mind that Apple is Apple, regardless of which index it is included in.

The prices of stocks are set by the exchanges and they are bought and sold on their floors. The orders are called in by brokers who execute the trades and are the go-between the consumer and the traders.

I hope I have been able to answer some of your questions and take a little of the mystery out of the stock market. I have found in my life that if you take the time to learn something about a thing that may make you a little leary, it helps reduce the uneasiness and makes me much more comfortable.

Thanks as always for taking the time to read this post.

Please share this with your friends who you think might benefit from this information.

Until next time,

Take care,

Dave

 

 

 

 

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