• 26Nov

    What is the stock market?

    In simple words the stock market is a place where different kinds of people are buying and selling their stocks under determined rules to make a profit.  Although this definition is correct, it’s very simplified. We need to explain what is the essence of this mechanism and how it works.




    Let’s assume that 100 people have $10,000 and they want to do something with that money to make a profit. Individually, they are limited by their money, and they need to think how to deal with the business strategy that will bring them a return. If these people go to the stock market and invest their money in the same company or the same project, they invested together one million dollars in the same goal, which is the sum that gives them much better perspectives on the market – and so the most important thing about the stock market is the concentration of capital.

    Roots of the stock markets

    If we want to find the roots of stock markets, we need to move back to the XVI century. The first stock market was founded in town of Bridge in Flanders (Belgium) where some traders and business people were gathering to buy and sell tulip bulbs. The trades were not as institutionalized as they are today, but it was the first known, organized trading market. Its principles remained exactly the same until today. Even the first speculations were present and they eventually led to the first bubble as well. As more and more people were trading and the market seemed to be quite stable, everyone behaved as if the trading had no limits and the profit was guaranteed. That caused the market tendency to overvalue the goods and it had to lead to a dramatic end. That happened in 1637. The prices suddenly dropped and the real panic began. As a result, all the people started to sell everything in panic and the more they were selling the worse the situation became. The prices were fell, and, as with each bubble, many people ended bankrupt and  a few became very rich in a short time.

    Evolution of the stock markets

    The times changed and the stock market changed: the building, the rules of trading, institutions charged for supervising, arbitrage etc. Since the Great Depression (1927-1933), which was caused by a crash on New York Stock Exchange in October 1927, the state took a part in organizing and supervising the stock market, to prevent speculations and other violations that can cause damage to its normal functioning. Speculations are not forbidden, but they are strictly controlled, and the investors with hazardous activities are sanctioned by the state.

    By the mid-70’s many financial instruments were developed (futures, options), and the volume of trading rapidly grew. The top of trading was in 1987 when Dow Jones index reached 2700 points in a very short time. Suddenly, on Black Monday, the index dropped by 508 points (about 500 billion dollars). Everyone was scared. The new Great Depression was to come. Fortunately, the progress in technology brought us new products that refreshed the market and raised the level of trading and eventually prevented the great panic. Especially, computerization, informatization and electronization play a big role in the stock markets. They have not only raised the amount of trades, but they’ve completely changed the way of trading. Today, we don’t have to go on the stock exchange to buy or sell stocks. We can do it from the comfort of our home. All we need is a computer and Internet access. Trading on the classic stock exchange occurs in the building, where traders are yelling when they want to buy or sell the stocks. An electronic model represents computerized trading where people are buying and selling stocks in quiet.

    Stock Exchange in New York

    Stock Exchange in New York

    Risks of trading

    The risks of trading on the stock markets are determined by the quality of stocks. It has been considered that the papers emitted by the state are the stocks with the highest level of security. Of course, that also varies from country to country and so US or German obligations are regarded as more stable than Greek or Mexican. Corporate stocks are not in that rank of quality, so it depends what information is provided by certain corporate stock on the market. In principle, the investments with high risk have high interest rates and should bring bigger profit. On the opposite, the investment with low risk has smaller interest rates and smaller profit per share. What the investors are buying is quite often the safety of their money, and they are willing to receive less but a guaranteed amount. That explains why US obligations can be sold with a smaller interest rate than Greek ones. It is just that the United States is certain not to go bankrupt, and the money invested is sure to be returned.

    Big investors rarely invest in one stock only. In order to maximize their profit, they make portfolios, which are combinations of two or more stocks. They control the risk by buying stocks with high and low risk and putting them together into one portfolio. While taking that approach, total risk is lower and of course the expectations are bigger. Beside corporate stocks with high interest rates, investors have to consider other risks on the market.  There is a risk of bankruptcy, which means that a company can lose all of its assets. Another very important risk is interest rate risk, which assumes that under different circumstances,the  level of interest rate can be changed. Purchase power risk is a kind of risk that is caused by inflation.  Money is worth less under inflation, and the assets of investors can get into a more dangerous position. Of course, every investor who invests in many different countries has to consider political risks. There are countries with a high level of risk caused by possible war, dictatorship, corruption or simply a bad market rating.

    Rating agencies

    One of the best known agencies for estimating credit risk and rating bonds is Moody’s Investors Service. The stocks with the best quality and high level of protection are marked as Aaa, Aa and A stocks. The speculative stock and the middle risk stock are marked as Baa, Ba and B stocks. And finally, the stocks marked as Caa, Ca and C, bring highest profit, but theses stocks are of the highest risk and the lowest level of protection.

     

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