Stock Market: What is It And Why is it Important?

May 3, 2023
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People have traditionally used investment options like regular deposits and fixed deposits. However, recent times have witnessed a shift from these towards stock investment because stocks are better placed to beat inflation. The stock market has a set of benefits that the participants can leverage.

But before getting started with the stock market, you need to understand what it is and how it works. Contrary to popular opinion, you are not always guaranteed success in this industry unless you do it the right way. Despite the risks, there are various benefits to investing in the stock market that can motivate you to keep going.

What is the stock market?

The term stock market refers to exchanges used for buying and selling publicly held companies. These exchanges have predefined regulations that govern the conduct of all the participants. Financial activities on these exchanges are executed over the counter.

An alternative term to the stock market is the stock exchange. These are used interchangeably and should not confuse you. The bottom line is that you have traders who buy or sell shares on exchanges that form the overall stock market.

We mentioned that in a stock market, traders buy or sell shares of a publicly traded company. You may wonder what type of company this is. A public company is a corporation in which the shareholders claim part of the company’s profits and assets. Ownership, in this case, does not belong to particular individuals but rather is distributed to the general public shareholders.

In a public company, ownership is achieved via shares of stock that are normally freely traded in a stock market or over-the-counter markets.

In the stock market, buyers and sellers get to meet, interact and transact their securities. Such markets enable the discovery of prices and shares of corporations. Furthermore, they are a baseline for measuring the overall performance of the economy.

There are stock exchange operators globally. The New York Stock Exchange is the largest in the world. As of December 2022, it registered an equity market capitalization of 23 trillion USD. Other leading stock markets include the Shanghai Stock Exchange, the NASDAQ, and Euronext.

Basics of stock market

To better understand a stock market, you need to know what makes it up. In general, a stock market comprises exchanges like the New York Stock Exchange, the Shanghai Stock Exchange, the NASDAQ, and Euronext. These exchanges create the meeting point for buyers and sellers within which shares are traded. They track the supply, demand, and price of each stock.

The stock market also has individual traders, who are represented by registered brokers. Thanks to the Internet, you will typically work with an online broker. Traders place their orders through the broker, who then deals on their behalf.

The stock market exchanges have varying operational hours. For instance, the Nasdaq and the NYSE run from 9.30 a.m. to 4 p.m. Eastern time. Some brokers may also access pre-market and after-hours trading sessions.

Various factors directly affect stock trading. Issues such as inflation, supply-chain challenges, war, and rising interest rates can negatively affect even the most experienced investors. That’s why you need to always have a diversified portfolio of stocks that take you through both bad and good times.

How does the stock market work?

The stock market gives companies an opportunity to raise capital by selling equity or shares of stock to investors. On the other hand, the stocks empower shareholders with voting rights and claim on the corporate earnings, which are shared in the form of dividends and capital gains.

An investor in the stock market can be an individual person or an institution. These investors meet on the stock exchange to buy or sell shares. Whenever you purchase shares on the stock market, you do not buy them from the company but rather from an existing shareholder.

Similarly, when you sell your shares, you do not sell back to the company. Instead, you sell these shares to another investor operating on the stock market. The forces of supply and demand normally influence share prices.

The bottom line of how the stock market works is that it entails transferring and acquiring stock through brokers. A stock, in this case, is a financial instrument that represents ownership in a company or corporation.

Functions of a stock market

  • Gauges economic performance. The stock market can be used to gauge how the country’s economy is performing. The general and economic changes that the country goes through directly affect the price of shares. Rising prices show that there is a boom, while a decline point toward recession. Therefore, the stock market is rightly the mirror of a country’s economic status.
  • Enforces safe transactions. Listed companies are well-regulated. These companies must follow the existing legal framework if they are to retain their status. An important part of this regulation covers transactions. You can be certain that your transactions are safe because they are well protected through strict regulation.
  • Encourages savings. The journey toward financial freedom starts with settling your debts and saving money. Saving at an individual level and later investing your savings empowers you to accumulate wealth. Similarly, country-wide saving culture is an important source of economic growth. The stock market mobilizes public savings through investment trusts, mutual funds, and other securities. These options favor even those that may have ordinarily not managed to invest in a huge amount of securities.
  • Measure company performance. In the same way that the stock market measures the performance of a country, its function starts at the basic level of gauging company performance. That can be seen in the price of securities of each company. You get to see an effective combination of demand and supply which is then used to measure the stability of companies. Investors can use this information to direct their investment decisions.
  • Mobility of funds. The circulation of funds in a country is key to its economic growth. The stock exchange helps achieve this by buying and selling securities, ensuring funds are always available. Doing so also strengthens the money market, which ensures the availability of short-term funds. Similarly, banks get involved by providing funds needed to participate in the stock exchanges.
  • Facilitates capital formation. Companies rely on the stock exchange to help with capital formation. Listed firms can raise funds through issuing of shares in the form of rights shares or bonus shares. And when there is a need for diversification, a company has the option of issuing shares to raise more funds. The capital generated in this process promotes economic growth in the country.
  • Capital allocation. Apart from forming capital, the stock market can also guide capital allocation. Profit-generating companies are often attractive to investors on the stock market. On the other hand, investors will typically shy away from loss-making companies. Thus, the stock market guides the general public on the best way to allocate their capital and generate maximum profits.
  • Liquidity. The stock market provides a simple and secure platform for trading securities. Furthermore, it builds up investors’ confidence which gets them to convert their investments into cash. For instance, banks could invest their idle funds and make funds, even in the short term. The securities can always be sold to raise funds whenever the need arises. Therefore, the stock market gives liquidity to investments.
  • Keeps companies under control. Companies listed on the stock exchange have an obligation to submit annual reports and audited balance sheets. Failing to provide this information can be ground for blacklisting. In this case, the stock market is used as a tool of control over the companies. The information provided measures the ability of these companies to transact.
  • Safeguard public interest. If a company wants its securities listed on the stock exchange, it must adhere to certain rules and regulations. These regulations have a central element of keeping the public safe from fraud. As such, the investing public can count on the stock market to protect its investment.

Guide on stock market regulation

Most countries normally appoint a monetary authority or local financial regulator to regulate their stock market. For instance, the U.S. stock market is regulated by the SEC.

The Securities and Exchange Commission (SEC) runs independently of the government and does not experience political pressure. Its main mandate is split into three categories:

  1. Safeguard investors
  2. Maintain fair, orderly, and efficient markets
  3. Enable capital formation

To achieve this mandate, SEC creates rules and regulations for the U.S. stock market that are normally categorized into “Parts.” For example, Part 200 covers Organization; Conduct and Ethics; and Information and Requests, while Part 204 focuses on Rules Relating to Debt Collection.

Any company listed on the stock market is regulated, and its dealings are under watch by SEC or the respective country’s regulatory body. More importantly, exchanges operate based on particular requirements like timely filing financial reports and notifying important corporate developments. The importance of this requirement is to ensure all participants get a clear picture of what’s happening.

Companies that do not follow stock market regulations can be suspended and/or face additional disciplinary actions.

What does stock trading mean?

As we talk about the stock market, it is essential that you also understand stock trading, the primary activity on exchanges. Stock trading is one of the many investment opportunities to consider. It concentrates on short-term profits rather than long-term gains. Jumping into stock trading without proper knowledge can lead to massive losses.

When getting involved in stock trading, you should be able to time the market correctly. Those who successfully do so can bring quick gains. However, you should not forget that you carry the risk of making big losses due to small mistakes. In the same way that a company’s fortunes can rise more quickly than the market, these can easily fall.

Two things that you should never forget about stock trading:

  • It is not for the faint-hearted
  • Do not invest the money that you need

You can start by learning stock trading online from a computer or smartphone. Just ensure that you have set aside the money for this purpose.

There are two types of stock trading to consider:

  1. Active trading entails buying and selling securities for quick profits as prices move in the short term. The trader holds their position for a shorter duration. Active trading does not have a precise time measurement. Day traders making tens or hundreds of trades per day fall within this category. Similarly, swing traders who open and close positions every few days can also be said to perform active trading.
  2. Day trading involves buying and selling stocks on the same day as you entirely focus on short-term price changes. As a day trader, you will typically leverage capital daily to buy more assets. However, doing so significantly increases your risk. This level of trading is sophisticated, and you need to meticulously monitor the market and news. It moves fast and involves a significant amount of speculation.

How to trade stocks

If you want to make your way into the stock market, remember that successful investors keep things as simple as they can get. Follow these steps to get started with trading stocks:

Step 1: Create a brokerage account

You will need a broker to engage in stock trading. You can search online for reputable brokers to create an account with one.

Step 2: Define your trading budget

Without a budget, you risk trading funds that you need for other pressing matters. Remember that there are risks involved, and if you do not clarify your budget, you risk landing in financial problems. You may set aside something like $200 per month for stock trading, nothing less, nothing more.

Step 3: Learn about market orders and limit orders

These are trading strategies that can significantly enhance your chances of success. There are many others to consider, but market orders and limit orders are the most common.

Step 4: Set a benchmark to gauge returns

Measuring results is an important part of your investment. As a serious investor, you need to have a benchmark that you are working towards outperforming.

Step 5: Focus on your end-goal

A lot happens in the stock trading world. Thus, if you do not have a specific goal, you can easily be swayed and potentially face more risks. By the time you hear about a certain breakout stock, thousands of other professional traders have likely already heard. Thus, jumping on this new trend could easily spell doom.

Conclusion

The stock market creates an avenue for buying and selling shares of publicly traded companies. It is significant because it is part of the free-market economy where companies raise funds and investors participate in the financial achievements of these companies via capital gains and dividends. The stock market is equally an important savings and investment platform that plays a central role in the economy of a country. You can safely participate in stock exchanges due to existing regulations that protect your investment.