By: David Stone CFA®
If you don’t understand the stock market, don’t worry because you are not alone. The realm of investing is a globally complex and intricate web of seemingly infinite possibilities that confront investors with finite resources. The stock market is merely one of the strands within this web.
Risk vs. Reward
Before diving into the stock market, an important core tenet to always remember about investing topics is that at their core, a person is always asked to make a decision weighing the possibility of risk versus the potential for rewards. Risk sometimes can mean volatility (how much and often the value of my investment is going to fluctuate) and sometimes can mean outright loss (the concern that my investment can go to zero). Reward on the other hand merely means the return I expect to earn on my investment.
Ultimately, the more risk one is willing to take, the greater the expectation of an equal or greater reward. There are NEVER any guarantees in the world of investing. The future is inherently unknowable and even if something has been successful in the past, that doesn’t mean it will play out the same way going forward. The past, however, can provide a powerful framework to determine your level of confidence of likely future outcomes, and can therefore be a guide to what is a realistic outcome.
Understanding the Spectrum of Capital
The irony for this article is that there is no single definition of a “stock market.” What an investor calls the stock market could change based on their geography or which definition they choose to focus on. Due to this complexity, let’s first start with the definition of what a stock is.
Stocks—which are synonymous with Equity—are a form of capital available to a corporation to fund and run their business. A non-exhaustive list of some other forms of capital include:
- Debt (also called loans or bonds, which can be secured or unsecured)
- Convertible debt
- Preferred equity
Each form of capital comes with different contractual and legal obligations which, should a company happen to go bankrupt, will determine the order of claims by investors—collectively this is called a company’s “capital structure.”
After a company pays their employees’ salaries, their vendors, and rent, then the typical highest-positioned investor in the capital structure is the Senior Secured Debt holder. As the term “secured” implies, this would be debt that is supported by a particular asset, such as a plant or equipment. That debt investor would legally take control of the asset and be allowed to sell it to recoup the money that is owed to them.
In theory, when that bond investor first agreed to lend the company money, they were confident that the value of the secured assets would be sufficient to repay them—that is, the risk is deemed to be lower, and that investor is therefore willing to accept a lower return in the form of a finite amount of annual interest payments.
On the opposite end of that risk vs. reward spectrum is Equity (which, as you remember, is synonymous with Stocks). Equity is the last in line: only after every other employee, vendor, and investor has been repaid what they are owed, will there be any value returned to the Equity investor. If a company goes bankrupt, the likelihood of an Equity investor receiving anything back is very low…this makes it the riskiest part of a company, and so investors will have to expect the highest potential return.
Right now you are probably saying to yourself, “NOPE NOPE NOPE that sounds bad. This isn’t for me.” But keep reading—we promise it gets better!
Where Stocks Fit Into Companies: An Example
Bankruptcies are a very rare scenario when looking at large, established companies. S&P Global is a company that tries to gauge the risk of bankruptcies by assigning their debt a “credit rating.” In 2021, they had over 1 million ratings outstanding, covering $46.3 trillion in debt. That same year, there were only 72 defaults covering $66.3 billion in bonds. Most years are similar to that.
Put another way: bankruptcy is not a normal, base case scenario that an investor expects, and because of that, they can view potential reward and returns in a different light.
In a situation where bankruptcy risk is less likely, Equity investors would look to other factors like the free cash flow produced by a business.
Let’s take a simplified example of a company that makes $100 million a year in revenue. They might pay $40 million to cover employee salaries, rent, marketing, and taxes (always got to pay the tax man!). Then, they might take the next $30 million to reinvest in the business by building new plants, buying new equipment, or investing in innovation via research & development. The next $10 million might go to pay the (finite) interest payments to the bondholders of their debt.
Unlike the bankruptcy scenario, that leaves $20 million left over for the Equity holders (huzzah!). Sadly, this doesn’t automatically mean that you as an Equity investor receive this money.
The CEO and board of the company will decide what is best for this $20 million left over. For example, they could:
- Return $5 million to investors in the form of a dividend (so you do get some money)
- Put another $5 million in buyback stock (providing liquidity to existing investors who will sell their stock back to the company)
- Set aside the remaining $10 million as “retained earnings” (basically making a rainy-day fund—keeping the cash with the company to use in the future)
As an Equity or stock investor, you are legally buying a percentage of the company—and therefore a percentage right to those excess earnings the company makes.
This ownership percentage is represented in the form of “shares.” A single share of a company will equate to a certain percentage ownership of the company: the more shares you own, the larger percent ownership you have.
With these building blocks in place, we can start to get to how the Stock part meets the Market part! Up to this point, we have been describing a single Stock (or Equity) that has risk and return associated with one single company.
Therefore, in its simplest form, you could think of the stock market as every individual stock collectively combined into a larger group encompassing them all to make a market. This most likely is not the definition you came to this article for. Instead, there are two other potential definitions that you may have been hearing about but did not quite understand.
The Functional Definition of the Stock Market
First up is the functional definition of the stock market.
As the term “market” implies, the stock market is a place in which different investors can interact to buy and sell shares of different companies. You may also hear of this as a stock “exchange” instead of a stock market. You also may not be surprised to learn that there are multiple different stock exchanges.
The first ever stock offered on an exchange was the Dutch East India Co. in 1602, on the Amsterdam Stock Exchange founded that same year. In the United States, the first market was the New York Stock Exchange, which was founded in 1792. What today is the London Stock Exchange traces its roots back to 1801.
Not every country in the world has a stock market, and unsurprisingly some countries have more than one exchange! For example, another well-known United States exchange is the Nasdaq. Shares of a company will normally trade on only one of these exchanges, but thankfully in today’s technological age, investors don’t need to worry about knowing which one.
Stock Indexes: The Stock Market Definition You’re Looking For
The second—and more commonly known—definition of a stock market is technically a stock “index.” You most likely came to this article in search of this definition because you heard the news talking about the stock market, and citing what happened to the S&P 500 or DJIA (Dow Jones Industrial Average). If you are outside the United States, then it would be referred to in your local version like the FTSE 100 in the UK, or the DAX in Germany.
Stock indexes bundle together a subset of all available stocks to provide a more diversified picture, versus what a single stock would indicate. It is very important to note that there are hundreds of thousands of different indexes in the world. In fact, there are more indexes than there are individually traded stocks!
- Some indexes are designed to capture the performance of a single sector of the economy (e.g., Technology), or sub-sector (e.g., Semiconductors).
- Some are designed to capture a certain theme like Growth, Quality, or stocks that pay High Dividends.
- Some are designed to capture companies in different stages of their life cycle by using a proxy in the form of how large the value of their stock is (Large, Mid, or Small Cap).
- The more commonly cited ones like the S&P 500 are designed to try to capture a cross section of the entire market—with a focus on the largest companies—and therefore provide exposure to a very wide range of businesses.
Why Does the Stock Market Even Exist?
The short answer to why a stock market exists is to provide liquidity both to investors and to companies.
From a company perspective: when they initially begin to trade on an exchange (their IPO, or Initial Public Offering), they are almost always raising brand-new capital from investors that they can use to grow their business or invest in new initiatives. They are even able to sell more stock at any point in the future to raise more capital. But each time they do that, they are usually diluting the current investors’ percentage ownership in the Equity, which diminishes their potential return.
From an investor’s perspective: if I’m given the ability to continually buy or sell shares with other investors, this allows me to not have to wait for the company to decide to return capital to me via a dividend or by selling the entire company.
Why Does the Stock Market Go Up and Down?
Shares are constantly being traded, and those shares represent investors’ perceived value for their percentage ownership in a company. This means that the stock price going up or down on a daily basis symbolizes the investors reevaluating that perceived value on a constant basis.
There are hundreds of different factors that can drive these daily changes, and it is nearly impossible to ever know precisely the combination. The most common reasons are:
- Changes in investor expectations for the economy
- Changes in investor expectations for a company’s earning potential
- Changes in investor outlook for one company’s potential when compared to other investment opportunities
Each individual stock will have different sensitivities to these factors, which will result in them having different daily volatilities (one common measure of risk).
A young tech company that’s growing very quickly will normally see higher daily moves when compared to something like an old, established electrical utility company. Investors are more certain of the potential value of the utility company, since electrical rates are normally regulated and can only grow at a defined, relatively slow rate. The demand for their product is also very high, it’s sticky, and it’s not easily displaced by a competitor.
Compared to the older utility company, the young, high-growth tech company’s prospects are less certain: they could potentially lose clients to a competitor (or be outright replaced—think what the iPhone did to Nokia cellphones), or they could need to lower prices to keep customers and therefore earn less than previously expected.
That uncertainty can cause investors to update their expectations more often, which results in more volatility in the stock.
Putting It All Together
Let’s try to put it all together now within the risk versus reward framework.
When you were imagining the “stock market,” you were most likely thinking of a broad, diversified stock market index like the S&P 500—which, as the name implies, has about 500 stocks in the index. Having 500 stocks together in one basket is designed to provide a smoother ride for most investors.
Effectively, the diversified solution will provide investing opportunities somewhere in between the young tech company and the old electrical utility. The investor focusing on diversifying won’t capture the highest return, but will also avoid the lowest—they won’t experience the greatest volatility but also not the least.
Remember that the stocks and indexes like the S&P 500 are merely one of numerous options in a vast array of investment options. We encourage you to continue to pull on the other strands in the web to make investing choices that make sense for you!
Featured image by Adam Nowakowski on Unsplash
About the Author
David Stone CFA® is an investment professional and Certified Financial Analyst with 15 years of experience. He has spent the majority of his career working with financial institutions to provide advice and support to high net worth investors.
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