How Does a Stock Market Work And Why Consider Investing in a Stock Market?

What is a Stock Market

What is a Stock Market

Most people first become familiar with the world of investing through individual share trading on the stock markets. Companies around the world issue shares to the public for many reasons, primarily to raise capital for expanding their business. Additional benefits for corporations of being publicly traded include generating a higher profile with potential customers and the public at large, the sharing of risk between investors, reducing the company's capital costs, succession planning for founders, among other purposes. The sale of shares from a company's treasury to shareholders is known as the primary market.

Listing Stocks

Listing Stocks

Once a company completes its initial public offering, its shares then usually trade on a traditional stock exchange such as the New York Stock Exchange (NYSE) or London Stock Exchange (LSE). It can also be listed on an over-the-counter exchange such as NASDAQ, where trades are executed directly between brokerages. Both of these are known as secondary markets.

How Stock Market Works

How Stock Market Works

There are two methods to help individuals looking to make money within the stock market. Capital gains through favorable price movement either from the long side (buy low and sell higher) or short side (sell high and buy back lower). Income can also be earned from dividends that companies pay to their shareholders out of net profits.

Investors tend to raise the prices of shares where positive factors are expected to a company, such as improved earnings in the future from increased sales, new contracts, higher dividends, takeover bids or mergers etc. On the other hand, expectations of negative developments, such as a slowdown in the business, regulatory changes, losing contracts and political changes, can lead investors to sell and push down the share price.

Matching Buyers to Sellers in Stock Market

Matching Buyers to Sellers in Stock Market

With a buyer and seller involved in every transaction, at any given time, share prices tend to reflect the balance of the expectations of all market participants. Share prices may change as expectations change.

Factors that impact market expectations can include macroeconomic factors that influence business environments. This includes industry factors such as changing commodity prices, and company-specific factors such as earnings, dividend changes, and other business developments.

One normal development that tends to influence trading is a company's earnings report. The timing of these reports tends to be publicized well in advance, and analysts who follow the company weigh in with their expectations. Many companies also publish their own expectations, known as guidance. How a company's results and future guidance fare relative to expectations can have a major impact on short-term and long-term trading trends.

Risks in Trading Stocks

Risks in Trading Stocks

Once people start trading shares, they often get exposed to certain risks to their capital the particular business that they are trading. For example, someone who trades shares of oil and gas companies may find that, while energy producers in general tend to rise and fall with the price of crude oil and related commodities, their return can also be influenced by how well the individual company performs on the exploration and operation fronts. For example, one company may have significant exploration success, while another may have slow production due to equipment problems.

The primary methods that investors use to mitigate company-specific risks are to trade a group of shares rather than one share, in what is known as having a diversified portfolio. One way to diversify involves trading more than one share within an industry group.

In the oil and gas sector, for example, trading a basket of shares would give you exposure to several company exploration programs, while mitigating the risk of one company's problems. It would also capture general exposure to underlying commodity price movements.

Major Categories of Equity Markets

Major Categories of Equity Markets

There are ten major sectors in equity markets that fall into four major categories.

1. Interest sensitive: financial services, utilities, and telecommunications

These companies tend to have higher debt loads because of which, interest payments represent a significant part of their expense base. These companies tend to outperform in times of falling interest rates and underperform when rates are rising quickly.

2. Defensives: consumer staples and health care

Companies in these areas boast a stable, predictable revenue and a decent earnings stream. They tend to produce or sell goods that people use daily, regardless of economic conditions, such as personal care products, groceries, and pharmaceuticals. They tend to outperform the market during recessions and underperform in stronger economic times.

3. Economically sensitive: consumer discretionary and industrials

These areas tend to do very well in times of prosperity and poorly during recessions as they represent goods and services that can be sacrificed or substituted during unstable times. Some examples within these groups include automobile manufacturers, clothing stores, business services and airlines.

4. Capital spending sensitive: energy, materials, and technology

Growth for companies in these groups tends to come from large scale projects that can take time to implement. Because of this, they can run a little behind the economic cycle as companies usually wait for confirmation that the economy has turned higher before committing to large scale projects. After a top, they complete projects that are underway before cutting budgets.

Note that for technology, this mainly applies to companies that sell hardware, software and B2B services to business customers. There are an increasing number of technology companies that sell primarily to consumers and would potentially fall into the economically sensitive group.

Risk management in Stock trading

Risk management in Stock trading

The risks of trading in share markets depend on your method of trading. If you are buying, holding, or selling shares outright, then the most obvious risk arises when share prices depreciate in value.

Small losses in value will often balance out over time, but it's possible for share prices to crash, or for a company in which you own shares to go out of business. Stock market crashes are also possible.

For example, in 2008, the FTSE 100 nearly halved in value in just a few weeks. Instances like this are generally related to the overall economic outlook.

Example of Risk Management in Stock Trading

Example of Risk Management in Stock Trading

What you invest in can also have an impact on your overall risk. It's, therefore, important to diversify your portfolio. For example, if you invested in the shares of three different energy companies, you are limiting yourself to one sector. If any factor impacts the value of that sector, it's likely all your shares would be adversely affected.

Investors often prefer, therefore, to invest across different sectors to prevent such scenarios from impacting their investments. Established companies such as blue-chip stocks are also likely to be lower risk than new, unestablished start-ups, although this cannot be guaranteed.