The Stock Market And How It Works

The things you need to know to make your money grow.

Words by Simone Ubaldi

By Simone Ubaldi, 8/2/2017

While it might conjure images of pin-stripe suits and Wall Street wealth, everyone has a reason to have some understanding of the stock market – even if you don’t have a suit in your wardrobe. It’s an important part of our global economy and you will be affected by it, directly or indirectly. It can change your financial circumstances significantly, so you should understand how it works. Here’s your introduction.

If you work a job for a wage or salary, your income is mostly fixed. There are only so many hours of work you can do and those hours are paid at a fixed rate. Investing is one way to potentially grow your wealth that doesn’t rely on physical man-hours.

If you want to build wealth there are a few options you could consider. You can educate yourself and get a higher paying job, you could start a business or you could invest your savings in a way that could potentially provide a return over time. One of the most common ways people invest is by buying property which they rent to other people. Another way of investing is through the stock market. Here’s what you need to know.

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Jimmy’s Old Timey Lemonade and the power of perception

As the title implies, the stock market is a market where people buy and sell stocks. Let’s think of a simple example to illustrate how it all works.

Jimmy is an entrepreneurial kid who starts a business selling lemonade from a roadside stall next to his house. He calls the business ‘Jimmy’s Old Timey Lemonade’. People love Jimmy’s lemonade and he makes a lot of money.

It occurs to Jimmy that he’d make a lot more money if he could expand the business and open roadside lemonade stalls all over the city. Unfortunately, he doesn’t have enough money to pay for all the new stalls and employees, let alone the increased lemonade production. Jimmy needs investors to provide money for his expansion.

The stock market brings together investors with the business owners who need investment. A business owner sells tiny parcels in the business (shares) in exchange for investment funds. The business owner does this by “listing” their company on the stock market.

In this lemonade business scenario, Jimmy decides to list his company on the Australian stock market – the Australian Securities Exchange (ASX). He registers his business as a limited liability corporate entity and hires a board of directors. Jimmy then heads to the market with an initial public offering, offering a set number of shares and a price-per-share for people to buy into his lemonade business.

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Jimmy is giving up some of his ownership in exchange for investment capital, which is called equity financing. This process – listing your company on the stock exchange to raise money for your business – turns a privately-owned business into a publicly-listed company with strict oversight and reporting requirements. Jimmy is legally required to provide quarterly financial reports for his shareholders (and basically anyone else who wants to read them). These financial reports allow investors to find out how the business is performing.

Once the shares are sold in the initial public offering, they will be bought and resold on the secondary stock market, as long as the company exists.

Meanwhile, Jimmy’s shareholders have acquired a slice of both the assets and the earnings of Jimmy’s Old Timey Lemonade Ltd. Jimmy’s shareholders aren’t interested in running Jimmy’s company, that’s the job of Jimmy’s board of directors. The shareholders are primarily interested in the earnings of the company and the price of the shares.

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Share prices are all about the estimated (or perceived) future value of earnings from a company. The perception of the future profitability of Jimmy’s Old Timey Lemonade Ltd affects how many people want to buy shares in the company and therefore the price of those shares. Before Jimmy even starts to expand the business, a rumour goes around that a popular fast food chain wants to start selling Jimmy’s Old Timey Lemonade in their restaurants and investors get really excited. If it’s true, his lemonade business will go through the roof! Everybody wants a share. But the number of shares in Jimmy’s Old Timey Lemonade Ltd is limited. The more demand there is for those shares, the higher the price-per-share, or share price. When the share price goes up, Jimmy’s original investors can sell their shares at a profit (a capital gain).

Conversely, if a rumour that a global soft drink company is looking to launch a new Old Timey lemonade of their own, this could cause Jimmy’s share price to fall (a capital loss for shareholders).

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Bears, bulls and other basic concepts

The vast majority of the world’s major businesses are listed on the stock market – or stock markets, as there are many, with each representing a different cluster of companies. Founded in 1792, the New York Stock Exchange is the world’s largest, representing more than $30 trillion worth of publicly listed businesses. Also based in New York, the NASDAQ lists companies worth more than $11 trillion. A small regional player, the market capitalisation of all companies listed on the Australian Stock Exchange was worth a mere $1.7 trillion at the end of 2016.

The performance of the market from day-to-day is indexed, or tracked over time, and reported in the nightly news all across the globe. In Australia, the S&P/ASX 200 measures the movement in share prices of the top 200 companies on the Australian Stock Exchange (ASX).

If the economy is going gangbusters, companies tend to be more profitable and therefore share prices tend to rise en masse, which is known as a bull market. When things get tough and prices drop across the board, a bear market is in effect. Other factors can also influence share prices. These include politics, foreign investment, industrial relations, international conflicts, natural disasters and government stability.

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So why you should care about any of this?

Superannuation payments are compulsory for (almost all) employed Australians. Your employer will make the payments into your superannuation fund, on your behalf. Most people can choose their superannuation fund. There are different options, but most Australian superannuation companies have at least some of their superannuation invested in the stockmarket. If that is the situation with your super fund, you’re already an investor, you’ve got skin in the game, so it doesn’t hurt to be more educated.

Consider how your retirement funds are being invested. You get a superannuation statement every year and the money has hopefully increased, but do you know how that actually happened? What businesses has your fund invested in to increase your wealth?

If you decide you want to develop a stock portfolio outside of your super fund, you have the potential to invest well before retirement. You could invest in a series of stable equity stocks that pay out dividends, so that you can earn an income outside of the salary paid to you in your job. Alternatively, you can invest in stocks which you think have the potential to grow in value, hopefully giving you a capital gain over time. Either way, there are stockbrokers, investment managers and financial planners who can help you get started.

If you want to get involved in the stock market and start investing, knowledge up and find a financial adviser near to you, follow this link to the BT financial adviser tool.