Stock market
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A stock market is a market for the trading of company stock, and derivatives of same; both those securities listed on a stock exchange as well as those only traded privately.
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Definition
Template:Securities Although common, the term 'the stock market' is a somewhat abstract concept for the mechanism that enables the trading of company stocks. It is also used to describe the totality of all stocks, especially within one country, for example in the phrase "the stock market was up today", or in the term "stock market bubble".
It is distinct from a stock exchange, which is an entity (a corporation or mutual organization) in the business of bringing buyers and sellers of stocks together. For example, 'the stock market' in the United States includes the trading of stocks listed on the NYSE, NASDAQ, and Amex, and also on the OTCBB and Pink Sheets.
Trading
Participants in the stock market range from small individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order.
Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor, by a method known as open outcry. (You've probably seen pictures of a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signaling to each other.) This type of auction is used in stock exchanges and commodity exchanges where traders may enter "verbal" bids and offers simultaneously. The other type of exchange is a virtual kind, composed of a network of computers where trades are made electronically via traders at computer terminals.
Actual trades are based on an auction market paradigm where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. (Buying or selling at market means you will accept any bid or ask price for the stock.) When the bid and ask prices match, a sale takes place on a first come first serve basis if there are multiple bidders or askers at a given price.
The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). Just imagine how difficult it would be to sell shares (and what a disadvantage you would be at with respect to the buyer) if you had to call around trying to locate a buyer, as when selling a house. Really, a stock exchange is nothing more than a super-sophisticated farmers' market providing a meeting place for buyers and sellers.
The New York Stock Exchange is a physical exchange, where much of the trading is done face-to-face on a trading floor. This is also referred to as a "listed" exchange (because only stocks listed with the exchange may be traded). Orders enter by way of brokerage firms that are members of the exchange and flow down to floor brokers who go to a specific spot on the floor where the stock trades. At this location, known as the trading post, there is a specific person known as the specialist whose job is to match buy orders and sell orders. Prices are determined using an auction method known as "open outcry": the current bid price is the highest amount any buyer is willing to pay and the current ask price is the lowest price at which someone is willing to sell; if there is a spread, no trade takes place. For a trade to take place, there must be a matching bid and ask price. (If a spread exists, the specialist is supposed to use his own resources of money or stock to close the difference, after some time.) Once a trade has been made, the details are sent back to the brokerage firm, who then notifies the investor who placed the order. Although there is human contact in this process, don't think that the NYSE is still in the Stone Age; computers do play a huge role in the process, especially for so-called "program trading".
The Nasdaq is a virtual (listed) exchange, where all of the trading is done by computers. The process is similar to the above, in that the seller provides an asking price and the buyer provides a bidding price. However, buyers and sellers are electronically matched. One or more Nasdaq market makers will always provide a bid and ask price at which they will always purchase or sell 'their' stock.[1].
Market participants
Many years ago, worldwide, buyers and sellers were individual investors, such as wealthy businessmen, with long family histories (and emotional ties) to particular corporations (think Ford). Over time, markets have become more "institutionalized"; buyers and sellers are largely institutions (e.g., pension funds, insurance companies, mutual funds, hedge funds, investor groups, and banks). The rise of the institutional investor has brought with it some improvements in market operations (but not necessarily in the interest of the small investor or even of the naïve institutions, of which there are many). Thus, the government was responsible for "fixed" (and exorbitant) fees being markedly reduced for the 'small' investor, but only after the large institutions had managed to break the brokers' solid front on fees (they then went to 'negotiated' fees, but only for large institutions).
However, corporate governance (at least in the West) has been greatly affected by the rise of institutional 'owners.'
History
In 12th century France the courratier de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. Because these men also traded with debts, they could be called the first brokers.
In late 13th century Bruges commodity traders gathered inside the house of a man called Van der Beurse, and in 1309 they institutionalized this until then informal meeting and became the "Brugse Beurse". The idea quickly spread around Flanders and neighbouring counties and "Beurzen" soon opened in Ghent and Amsterdam.
In the middle of the 13th century Venetian bankers began to trade in government securities. In 1351 the Venetian government outlawed spreading rumors intended to lower the price of government funds. Bankers in Pisa, Verona, Genoa and Florence also began trading in government securities during the 14th century. This was only possible because these were independent city states not ruled by a duke but a council of influential citizens.
The Dutch later started joint stock companies, which let shareholders invest in business ventures and get a share of their profits - or losses. In 1602, the Dutch East India Company issued the first shares on the Amsterdam Stock Exchange. It was the first company to issue stocks and bonds.
International markets
Image:Bombay-Stock-Exchange.jpg The first stock exchange to trade continuously was the Amsterdam Beurs, in the early 17th century. The Dutch "pioneered short selling, option trading, debt-equity swaps, merchant banking, unit trusts and other speculative instruments, much as we know them" (Murray Sayle, "Japan Goes Dutch", London Review of Books XXIII.7, April 5, 2001).
There are now stock markets in virtually every developed and most developing economies, with the world's biggest markets being in the United States, UK, Germany, France, and Japan.
Importance of stock markets
Function and purpose
Just as it is important that networks for transport, electricity and telecommunications function properly, so is it essential that, for example, payments can be transacted, capital can be saved and channelled to the most profitable investment projects and that both households and firms get help in handling financial uncertainty and risk as well as possibilities of spreading consumption over time. Financial markets constitute an important part of the total infrastructure for every society that has passed the stage of largely domestic economies.
The financial system performs three main tasks: firstly, it handles transfer of payments; secondly, it channels savings to investments with a good return for future consumption; and thirdly, it spreads and reduces (local enterprise) economic risks in relation to the players' targeted returns (but note that systemic risk is not thereby reduced— it merely becomes less concentrated and uneven). Moreover, unforseen risks, or catastrophic risks (such as the complete collapse of the financial system or government institutions), may not be capable of being spread, or insured against.
The smooth functioning of all these activities facilitates economic growth in that lower costs and enterprise risks promote the production of goods and services as well as employment. In this way the financial system contributes to increased prosperity.
The stock market is one of the most important sources for companies to raise money. Experience has shown that the price of shares and other assets is an important part of the dynamics of economic growth. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an Argus eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions. Financial stability is the raison d'être of central banks.
Relation of the stock market to the modern financial system
The financial system in most western countries has undergone a remarkable transformation. One feature of this development is disintermediation. A portion of the funds involved in saving and financing flows directly to the financial markets instead of being routed via banks' traditional lending and deposit operations. The general public's heightened interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process. Statistics show that in recent decades shares have made up an increasingly large proportion of households' financial assets in many countries. In the 1970s, in Sweden, bank deposits and other very liquid assets with little risk made up almost 60 per cent of households' financial wealth, as against less than 20 per cent in the 2000s. The major part of this adjustment in financial portfolios has gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance investment of premiums, etc. The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other industrialised countries. In all developed economic systems, such as the European Union, the United States, Japan and other first world countries, the trend has been the same: saving has moved away from traditional (government insured) bank deposits to more risky securities of one sort or another.
The stock market, individual investors, and financial risk
This is clearly a positive social trend. However, such riskier long-term saving requires that an individual possess the ability to manage the associated increased risks. Stock prices fluctuate widely, in marked contrast to the stability of (government insured) bank deposits or bonds. This is something that could affect not only the individual investor or household, but also the economy on a large scale. The following deals with some of the risks of the financial sector in general and the stock market in particular. This is certainly more important now that so many newcomers have entered the stock market, or have acquired other 'risky' investments (such as 'investment' property, i.e., real estate and collectables).
With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all overtalking each other to get investors' attention. At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children's education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly.
This is a quote from the preface to a published biography about the well-known and long term value oriented stock investor Warren Buffet. (1) Buffet began his career with only 100 U.S. dollars and has over the years built himself a multibillion-dollar fortune. The quote illustrates something of what has been going on in the stock market during the end of the 20th century and the beginning of the 21st.
The behavior of the stock market
From experience we know that investors may temporarily pull financial prices away from their long term trend level. Over-reactions may occur— so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. New theoretical and empirical arguments have been put forward against the notion that financial markets are efficient.
According to the efficient market hypothesis (EMH), only changes in fundamental factors, such as profits or dividends, ought to affect share prices. (But this largely theoretic academic viewpoint also predicts that little or no trading should take place— contrary to fact— since prices are already at or near equilibrium, having priced in all public knowledge.) But the efficient-market hypothesis is sorely tested by such events as the stock market crash in 1987, when the Dow Jones index plummeted 22.6 per cent— the largest-ever one-day fall in the United States. (However, this was part of a world-wide crash of stock markets which did not originate in the US.) This event demonstrated that share prices can fall dramatically even though, to this day, it is impossible to fix a definite cause: a thorough search failed to detect any specific or unexpected development that might account for the crash. It also seems to be the case more generally that many price movements are not occasioned by new information; a study of the fifty largest one-day share price movements in the United States in the post-war period confirms this.(2) Moreover, while the EMH predicts that all price movement (in the absence of change in fundamental information) is random (i.e., non-trending), many studies have shown a marked tendency for the stock market to trend over time periods of weeks or longer.
Various explanations for large price movements have been promulgated. For instance, some research has shown that changes in estimated risk, and the use of certain strategies, such as stop-loss limits and VaR limits, theoretically could cause financial markets to overreact.
Other research has shown that psychological factors may result in exaggerated stock price movements. Psychological research has demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's self-confidence, reducing his (psychological) risk threshold. (3)
Another phenomenon— also from psychology— that works against an objective assessment is group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority of the group. An example with which you may be familiar is the reluctance to enter a restaurant that is empty; people generally prefer to have their opinion validated by those of others in the group.
In one paper the authors draw an analogy with gambling. (4) In normal times the market behaves like a game of roulette; the probabilities are known and largely independent of the investment decisions of the different players. In times of market stress, however, the game becomes more like poker (herding behavior takes over). The players now must give heavy weight to the psychology of other investors and how they are likely to react psychologically.
We are also liable to succumb to biased thinking. An example is when supporters of a national football team (or a favorite stock), for instance, are overconfident about the chances of winning (or the stock moving up).
The stock market, as any other business, is quite unforgiving of amateurs. Inexperienced investors rarely get the assistance and support they need. In the period running up to the recent Nasdaq crash, less than 1 per cent of the analyst's recommendations had been to sell (and even during the 2000 - 2002 crash, the average did not rise above 5%). The media amplified the general euphoria, with reports of rapidly rising share prices and the notion that large sums of money could be quickly earned in the so-called new economy stock market. (And later amplified the gloom which descended during the 2000 - 2002 crash, so that by summer of 2002, predictions of a DOW average below 5000 were quite common.)
Conclusion
There have been innumerable recommendations about how to make the stock market easier and safer for the casual, non-professional investor. Few, if any, are likely to prove useful or effective. However, in order to minimize the risks of financial market imbalances, it is important that there be a well thought-out legislative, regulatory, and supervisory infrastructure that functions properly, smoothly, and honestly. This is a never-ending task that requires the participation of all concerned.
Today, average individuals face sometimes very difficult risk management decisions that were not required of previous generations. Both opportunities and risks for the individual investor have been amplified many times over. Yet the average investor still lacks the relevant knowledge. Everyone cannot be a specialist in risk management and financial theory.
References:
1) Hagstrom, R.G. (2001), The Essential Buffet, John Wiley & Sons, Inc. New York.
2) Cutler, D. Poterba, J. & Summers, L. (1991), Speculative dynamics, Review of Economic Studies 58, pp. 520-546.
3) Tversky, A. & Kahneman, D. (1974), Judgement under uncertainty: heuristics and biases, Science 185, pp. 1124-1131.
4) Stephen Morris and Hyun Song Shin, Oxford Review of Economic Policy, vol. 15, no 3, 1999.
Stock market index
The movements of the prices in a market or section of a market are captured in price indices called stock market indices, of which there are many, e.g., the S&P, the FTSE and the Euronext indices. Such indices are usually market capitalization (the total market value of floating capital of the company) weighted, with the weights reflecting the contribution of the stock to the index. The constituents of the index are reviewed frequently to include/exclude stocks in order to reflect the changing business environment.
Derivative instruments
Financial innovation has brought many new financial instruments of which the pay-offs or values depend on the prices of stocks. Examples are exchange traded funds (ETFs), stock index and stock options, equity swaps, single-stock futures, stock index futures, etc. These latter may be traded on futures exchanges such as Euronext.liffe (which are distinct from stock exchanges— their history traces back to commodities futures exchanges), or traded over-the-counter. As all of these products are only derived from stocks, they are sometimes considered to be traded in a (hypothetical) derivatives market, rather than the (hypothetical) stock market.
Leveraged Strategies
Stock that a trader does not actually own may be traded using short selling; margin buying may be used to purchase stock with borrowed funds; or, derivatives may be used to control large blocks of stocks for a much smaller amount of money than would be required by outright purchase or sale.
Short selling
Template:Main In short selling, the trader borrows stock (usually from his brokerage which holds its clients' shares or its own shares on account to lend to short sellers) then sells it on the market, hoping for the price to fall. The trader eventually buys back the stock, making money if the price fell in the meantime or losing money if it rose. Exiting a short position by buying back the stock is called "covering a short position." This strategy may also be used by unscrupulous traders to artificially lower the price of a stock. Hence most markets either prevent short selling or place restrictions on when and how a short sale can occur. The practice of naked shorting is illegal in most (but not all) stock markets.
Margin buying
- Main article: margin buying
In margin buying, the trader borrows money (at interest) to buy a stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks the trader owns outright, it can be a maximum of a certain percentage of those other stocks' value. In the United States, the margin requirements have been 50% for many years (that is, if you want to make a $1000 investment, you need to put up $500, and there is often a maintenance margin below the $500). A margin call is made if the total value of the investor's account cannot support the loss of the trade. Regulation of margin requirements (by the Federal Reserve) was implemented after the Crash of 1929. Before that, speculators typically only needed to put up as little as ten percent (or even less) of the total investment represented by the stocks purchased. Other rules may include the prohibition of free-riding: putting in an order to buy stocks without paying initially (there is normally a three-day grace period for delivery of the stock), but then selling them (before the three-days are up) and using part of the proceeds to make the original payment (assuming that the value of the stocks has not declined in the interim).
New issuance
Global issuance of equity and equity-related instruments totaled $505 billion in 2004, a 29.8% increase over the $389 billion raised in 2003. Initial public offerings (IPOs) by US issuers increased 221% with 233 offerings that raised $45 billion, and IPOs in Europe, Middle East and Africa (EMEA) increased by 333%, from $ 9 billion to $39 billion.
Investment strategies
Template:Main One of the many things people always want to know about the stock market is, "How do I make money investing?" There are many different approaches; two basic methods are classified as either fundamental analysis or technical analysis. Fundamental analysis refers to analyzing companies by their financial statements. One example of a fundamental strategy is the CANSLIM method, which aims at finding companies with superior earnings growth and heavy buying demand from market participants, although there are some people who would classify its philosophy a combination of fundamental and technical analysis. Technical analysis studies price actions in markets through the use of charts and quantitative techniques to attempt to forecast price trends regardless of the company's financial prospects.
Additionally, many choose to invest via the index method. In this method, one holds a weighted or unweighted portfolio consisting of the entire stock market or some segment of the stock market (such as the S&P 500 or Wilshire 5000). The principal aim of this strategy is to maximize diversification, minimize taxes from too frequent trading, and ride the general trend of the stock market (which, in the U.S., has averaged nearly 10%/year, compounded annually, since World War II).
Finally, one may trade based on inside information, which is known as insider trading. However, this is illegal in most jurisdictions (i.e., in most developed world stock markets, more or less).
See also
- Balance sheet
- Shareholders' equity
- Stock exchange
- Stock investor
- Stock market bubble
- Stock market crash
- Stock market boom
- Stock Market Regulation in the United States
- Trader (finance)
Lists
- List of accounting topics
- List of economics topics
- List of economists
- List of finance topics
- List of management topics
- List of marketing topics
- List of stock exchanges
- List of stock market indices
- List of stock market slang terms
External links
- Yahoo! Finance - Stock Screener - Market Cap
- ECB: Statistics pocket book
- the compelling Real DJIA, 1924-now
- the 3 Fed Chair warnings, Real DJIA
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