How The Stock Market Really Works
Most people understand what the stock market is and that a bunch of suits driving fancy sports cars use it to make lots of money. At least I think they do, I know I do. Unfortunately, the complexities of the system often intimidate the rest of us without suits or fancy sports cars (damnit) into avoiding it altogether. Hopefully I can help by providing a simple overview of how it all works without all the stupid nuances that I am convinced exist solely to make it complicated.
It helps to look at it from a company’s point of view so imagine you’re just starting a business and you need to buy supplies, equipment, advertisements, and if you’re lucky maybe an employee or two to help you out. The first place people typically turn is their credit card which sort of works but it has its limits. Ideally though, they persuade an investor to give them a ton of money in exchange for partial ownership of the business so that if it ever takes off they will all make even more money. Usually they fail and lose the money but occasionally the business gets lucky and starts making truckloads of cash and the lucky investor who decided to take a chance with them wants to collect his reward.
Time to go public
The money the business is making is nice, but they want more and the best way to do that is to sell a larger portion of the business to even more investors. Finding these other investors also allows the original investor to sell his stake to them and buy a fancy sports car (he probably already had the suit). To get these other investors they approach an ‘exchange’ which is essentially just a private company that helps them sell parts of their company. If they were selling old furniture they’d list it on Craigslist or eBay, but since they’re selling parts of a company they’ll list it on The New York Stock Exchange or the NASDAQ. These companies work very similiarly to eBay: people bid on what they want to buy and the host takes a commission for faciliating the transaction.
Shares
To make these transactions easy, the company cuts itself up into pieces called shares. If they decided to cut themselves into 1,000 pieces each share would be equivalent to 0.1% of the company and owning 10 of them would mean you own 1% of the company. Every company cuts itself up differently and can change the size of the pieces pretty much whenever they feel like it. Microsoft, for example, is currently split into 9,306,980,000 pieces and Google is split into 236,750,000. For the most part, these numbers mean nothing as they are set by an executive writing a number on a piece of paper and signing it. What this means is that while 1 share of Google may sell for 20x more than 1 share of Microsoft, it would take 40 Microsoft shares to own the same % (which happens to be .000000004%) of Microsoft as 1 Google share would own of Google.
The fact that the number of shares a company has is up to the company itself leads to a lot of misconception about the share price of that company. People often mistakenly compare companies by the price of the shares. Though a Google share currently sells for about $600 and a Microsoft share sells for about $30, there are a LOT more Microsoft shares out there than there are Google shares, and when you add them up, Microsoft is worth almost twice as much as Google. This value can be found on any finance site under the label ‘Market Value’ or ‘Market Capitalization’ and is exactly equivalent to the ‘Number of Shares Outstanding’ (the number of pieces the company is cut into) multiplied by the current price per share (Here: roughly 9 billion * $30 for MSFT vs $600 * 230 million for GOOG).
Why do I want a share of a company?
The general understanding is that stocks (equivalent to ’shares’ here) go up in value overtime as the company makes more money. While that is generally true, it doesn’t provide any explanation for WHY they go up. Remember that shares are sold in the exact same way any other item is sold in our economy, and accordingly, the price is set by the laws of supply and demand. When few people are selling a certain kind of stock and a lot of people want it, people bid more for it and the price goes up. When a lot of people are selling a stock and few people want to buy it, the price goes down. The reason to buy a stock now then is solely because you think someone will buy it from you later for more than you paid. When they buy it from you, they will be buying it solely because they think someone will buy it from them for more than they paid, and so on. However, the only reason to sell it is if you think it is NOT going to be worth more in the future which is exactly the opposite of the person buying it from you thinks. Only one can be right, the other is losing the money that the former gains.
Since the people selling are predicting that less people will be interested in the stock in the future than in the present and the people buying are predicting the opposite, the price they settle on reflects the present consensus opinion of all buyers and sellers of what the future consensus opinion will be. If that seems a bit pointless, you’re following along well! The process repeats itself continuously with only three possible endings (that may never come in your lifetime): 1) Another company eventually buys all the shares in order to acquire or merge with the original company, 2) The company starts giving some of its earnings to the share holders (in which case the shares have value beyond the predicted future price) in the form a dividend, or 3) The whole thing blows up. The only reason the amount of money the company makes or how fast it is growing or what its plans are or what its competitors are doing or any other piece of information about the company affects the stock price is because it affects the probabilites of the specifics in scenarios #1 and #2.
Your success in the market depends not just on finding companies that are likely to do well, but even more so on finding people that are likely to perform that task poorly.
[...] Original post by Gibybo’s Money [...]