How Does the Stock Market Work?

If the thought of investing in the stock market scares you, you are not alone. Individuals with very limited experience in stock investing are either terrified by horror stories of the average investor losing 50% of their portfolio value—for example, in the two bear markets that have already occurred in this millennium—or are beguiled by “hot tips” that bear the promise of huge rewards but seldom pay off. It is not surprising, then, that the pendulum of investment sentiment is said to swing between fear and greed.

The reality is that investing in the stock market carries risk, but when approached in a disciplined manner, it is one of the most efficient ways to build up one’s net worth. While the value of one’s home typically accounts for most of the net worth of the average individual, most of the affluent and very rich generally have the majority of their wealth invested in stocks.

Types of Stock

While there are two main types of stock—common and preferred—the term equities is synonymous with common shares, as their combined market value and trading volumes are many magnitudes larger than that of preferred shares.

The main distinction between the two is that common shares usually carry voting rights that enable the common shareholder to have a say in corporate meetings (like the annual general meeting or AGM) where matters such as election to the board of directors or appointment of auditors are voted upon while preferred shares generally do not have voting rights. Preferred shares are so named because preferred shareholders have priority over common shareholders to receive dividends as well as assets in the event of a liquidation.

Common stock can be further classified in terms of their voting rights. While the basic premise of common shares is that they should have equal voting rights—one vote per share held—some companies have dual or multiple classes of stock with different voting rights attached to each class. In such a dual-class structure, Class A shares, for example, may have 10 votes per share, while the Class B subordinate voting shares may only have one vote per share. Dual- or multiple-class share structures are designed to enable the founders of a company to control its fortunes, strategic direction, and ability to innovate.

What Is a Stock Exchange?

Stock exchanges are secondary markets where existing shareholders can transact with potential buyers. It is important to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis. Companies may engage in stock buybacks or issue new shares but these are not day-to-day operations and often occur outside of the framework of an exchange.

So when you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from some other existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company—rather you sell them to some other investor.

Stock Market Supply and Demand

The stock market also offers a fascinating example of the laws of supply and demand at work in real-time. For every stock transaction, there must be a buyer and a seller. Because of the immutable laws of supply and demand, if there are more buyers for a specific stock than there are sellers of it, the stock price will trend up. Conversely, if there are more sellers of the stock than buyers, the price will trend down.

The bid-ask or bid-offer spread (the difference between the bid price for a stock and its ask or offer price) represents the difference between the highest price that a buyer is willing to pay or bid for a stock and the lowest price at which a seller is offering the stock.

A trade transaction occurs either when a buyer accepts the ask price or a seller takes the bid price. If buyers outnumber sellers, they may be willing to raise their bids in order to acquire the stock. Sellers will, therefore, ask higher prices for it, ratcheting the price up. If sellers outnumber buyers, they may be willing to accept lower offers for the stock, while buyers will also lower their bids, effectively forcing the price down.