How Stock Market Works and How to Work in Stock Market?

Introduction

Some 400 years ago, the first stock market was created in Amsterdam, Netherlands. Dutch East India Company became the first publicly-traded company in 1611. The New York Stock Exchange was established in the late 1700s. The idea of stock market has played a pivotal role in the evolution of business to where it stands today. Especially, conducting big business was not possible without the existence of stock market.

Please have a look at the featured image on top of this post and continue reading. I will talk about it in the end.

How Does Stock Market Work?

The Original Design

In the 16th and 17th centuries, the shipping companies which used to transport goods across oceans and seas had a very high capital requirement which was not readily available. The companies would borrow money from wealthy individuals and, in turn, share ownership of their shipping business with them.

This practice was gradually adopted by other businesses as well. It was a simple idea that revolutionized the way business was conducted. Big companies needed cash as working capital and for further expansion and individuals with surplus cash, who couldn’t do anything worthwhile with their money, would become part-owners of thriving businesses overnight.

To further refine and improve this model, stock exchanges were created where part-ownerships of various businesses could be traded with ease. In the modern jargon, these part-ownerships are called shares, stocks, or equities. These exchanges or markets also enabled business owners to raise more money quickly for subsequent requirements. Through these markets, small chunks of money under individual ownerships could be easily pooled to create big money that was necessary to start and run big businesses. This had a synergetic effect on the way businesses could be conceived and conducted. In the end, it was a win-win deal for all.

The advent of secondary markets created breathing space and flexibility. Anyone who needed money urgently could sell his ownership immediately and the one who had missed the initial public offering could buy it. It significantly improved the business climate.

The Perversion

The desire for quick and un-earned money is as old as the money itself. Some people saw an opportunity in the way they could easily buy and sell their ownerships in the secondary market. There was a visible change in the prices of ownerships on offer on a daily basis due to the quickly changing sentiments of the people associated with the market. Therefore, they found it quicker and easier to make money through frequent sale/ purchase of shares than how the money was actually made by the business itself.

This had two effects on the market: both liquidity, as well as volatility, increased. Another way of saying the same thing would be that while the secondary market added liquidity and flexibility to the business matrix, it also gave rise to volatility. Parallel to the actual business, a new business model was evolving which entirely hinged on volatility and didn’t have much to do with the actual business.

The ethos of this business model was speculation and information asymmetry rather than fundamentals of the core business.

The Current Structure

Stock markets, the world over, have a well-developed structure now. In majority of the markets, the shares (equities or stocks) have been de-materialized and exist in non-physical form. Trading is conducted smoothly and securely on various counters through online software. Important stakeholders in this structure are as under:

Regulator

Every market functions under a regulator who is responsible to oversee its functioning and implement relevant policies, rules, and regulations. It is also for the regulator to pre-empt, prevent and investigate scams and malpractices and initiate appropriate measures. Stock markets across the world are generally well-regulated entities.

Stock Market

The market is that physical and virtual space where buyers and sellers meet and conduct trading of shares. It is responsible for smooth conduct of trading. It also ensures education and awareness of investors and traders.

Brokers

The brokers are responsible for ensuring a seamless interface between investors and the market. They also carry out research on various companies and maintain data portals for facilitating decision-making by investors.

Individual and Institutional Investors

Investors and traders are those individuals and institutions who participate in the market activity and buy or sell shares of various businesses listed on the stock market.

Custodian of Shares and Record Keeper of Trades

These are two separate entities working under the regulator. Their main job is to ensure safe custody of shares in the name of individuals and institutions and to maintain record of trades.

Structural Difference in How Primary and Secondary Markets Function

Understanding this difference is central to understanding how and why investment and trading are different and why price speculation, devoid of core business analysis, is not good for an individual investor.

Primary Market

The primary market is where you buy brand-new products. The prices of products are determined between the manufacturer and the consumer on a “take it or leave it” basis and there is little room for bargaining. You may also say that the spread within which the prices may move is very narrow.

Secondary Market

As primary markets cannot address all business and consumer needs comprehensively, there is a need to have secondary markets as well. However, secondary markets function in a fundamentally different way. Supply/ demand and human sentiments get added to the pricing mechanism. Not to say that these factors are not relevant in primary markets, their effect in secondary markets is more pronounced.

Here the prices swing quickly and within a wider spread as these markets are auction-driven. Supply and demand, as well as emotions, reign supreme, and the quality of the product may temporarily take a backseat. This is both an opportunity and a threat for an investor. For a speculator, trader or punter, however, this is the entire business model.

Business Models or Styles of Participation

The individuals or institutions who participate in the trading activity have either of the two styles or business models:

Investment

The investment is based on a thorough fundamental analysis (qualitative and quantitative) of the business and the investor expects to make as much money as the business itself makes over time.

Trading

Trading or speculation is distinctly different from investment. It is aimed at benefitting from market volatility. Technical analysis and daily news analysis are employed to inform decision-making process.

How to Work in Stock Market?

Through discussing the genesis of markets and their evolution, their present status, and various perspectives people bring to the market, a stage has been set where it should be easy to make considered choices with regard to market participation. Some random thoughts are being shared here:

Participating in a Business

At some stage in your life, you might have thought of starting your own business but then shied away due to the expected risks and challenges. The stock market gives you an opportunity to participate in a business and affords you exactly the same benefits as enjoyed by the business owner.

Therefore, if and when you decide to buy shares, you should think like a business owner. The ease and flexibility with which you can buy and sell shares in the market should be part of your contingency plan and not your basic plan.

Since you are thinking like a business owner, you are actually betting on the value that the business is going to deliver over time. If you are not seriously trying to align your financial commitments with value creation, you are unwittingly incorporating the danger of permanent loss of your invested capital. Getting into and out of the market frequently, on one pretext or the other, is not a good idea.

A good business is worth investing in, even if the stock market doesn’t exist.

Business Analysis

Before buying into a business, you have to know, in detail, about its quality as a franchise, how it makes money, its financial health, how honest and able its management is, the state of solvency, where it currently stands in its life cycle, how various dynamics around it are evolving, how much it is available for relative to the money it is making and will make and much more. All this falls under fundamental analysis (qualitative and quantitative) which must be learned by an investor.

There is another type of analysis called technical analysis. It has nothing to do with the business analysis. It claims to measure market volatility and is mainly used by traders along with other tools to make quick buying and selling decisions. An investor doesn’t need to know anything about technical analysis.

Technical analysis deals with one variable only i.e. market price of the share. Any analysis of a business that is based on its price only, is naive and misleading.

Develop Your Own Thought Process and Own it Completely

If you want to invest in equities directly and don’t want to take the mutual funds route, you have to develop your own thought process, style, and approach to investing and take full responsibility for the results. There is no shortcut. If someone suggests something to you, you should ask him how he arrived at this. You should be interested to know why he says what he says. Analyze it independently and take your own decision. You should exactly know why you are buying a particular share and writing it down is even better.

You cannot afford to act on news feeds, media reports, market buzz, whispers, and rumors.

Micros vs Macros

Micros refer to what is happening inside and around a particular business e.g. its sales data, earnings, growth in earnings, cash flow, balance sheet situation, future plans, how it is performing vis-a-vis the competition, and so on. Macros include the politics, international situation, security situation, news about daily and weekly developments, inflation data etc.

From equity investing point of view, we should focus on micros and leave the macros for the so-called market experts. This is because the impact of macros on businesses is often exaggerated. Good businesses are resilient entities, have their own trajectory and are not affected by the ever-evolving market situation. However, if the prices fall due to market sentiment, it should be viewed as a buying opportunity.

Always Try to be an Investor – Avoid the Temptation of Becoming a Trader

You must have heard various “experts” answering various queries on the business channels like, “Where do you see the market going from here?” or “If the Fed cuts interest rates, how the market is going to respond?” or “The inflation and unemployment data has been released. What do you say about it from the market perspective?” and so on.

Actually, the factors affecting the market at a particular time are innumerable. It is nearly impossible to exactly or even roughly quantify their impact on the market. However, based on these factors, people have a tendency or temptation to try to analyze and forecast the direction the market is going to take. It is only an illusion of analysis as the impact of these factors on the market, especially in the short term, is unknowable. Fortunately, there is a more logical and useful way of addressing this issue. That is to insulate yourself from this 24/7 noise and pay attention to the dynamics of an individual business e.g. the sales, earnings, expenses, and how much a particular business is available for at a particular time.

After having thoroughly analyzed a business, you should invest in it and let the business make money for you. Disregard all market news, trading signals, inflation data, interest rates, fuel prices, etc.

A very useful way of shortlisting businesses for investment is to view businesses as a whole. Hypothetically speaking, do you like a business so much that you would like to own it completely if money is not an issue? If the answer is yes, only then you should buy one or ten or a hundred shares of it. The reason(s) for buying the whole business or a share of it should be exactly the same. If you don’t like the business, don’t buy even one share of it.

Diversify Your Portfolio

For the sake of financial safety, diversify your portfolio across multiple parameters. You may invest in some value and growth stocks. Diversify across various sectors of the economy. Have some high dividend yield stocks. Invest in some low-cap, mid-cap, and large-cap companies. Keep your risk profile in mind while diversifying. Do not over-diversify either.

Ensure time diversification through dollar-cost averaging (aka SIP: systematic investment plan).

Learn Valuation

Learning how to value businesses is at the core of investing. In simple terms, how can you pay a particular price for something you don’t know the value of? Therefore, understand the price-value matrix. The price of any asset, in isolation, is meaningless. Try to know the underlying value for which you are paying a particular price. If you are playing the price game, your feet are not firmly on ground and you should expect from your trades what a speculator should expect.

There are many methods of valuation used for different types of businesses. For quick valuation, some ratios like PE (price to earnings) and PEG (price to earnings growth) are useful. However, for detailed valuation, DCF (discounted cash flow) and some other methods are used. A very useful general valuation framework, popularized by Aswath Damodaran, is as under:

Any investment thesis that merits consideration should have two important elements: a story and some credible numbers to support it. Stories are sterile without numbers. Insist on the storyteller to bring up some credible and verifiable numbers for analysis. If he fails to, this is the end of it. Conversely, if you are presented with some numbers, like sales, earnings, cash flow, P/E ratio, ROE, ROCE, debt to equity ratio etc, you may start analyzing the investment proposal.

Find Good Wealth Compounders and Stick with Them

Compounding is called the 8th wonder of the world. It is simple but extremely powerful. You should try to find good businesses, with honest and able promoters, the businesses that cannot be easily disrupted and have a long future ahead of them. Invest in these businesses and let them do the rest.

Just have a look at how powerful compounding is:

1 million will become 27.39 million in 20 years at a CAGR (compounded annual growth rate) of 18% only.
1 million will become 143.37 million in 30 years at a CAGR of 18%!
1 million will become 101.72 million in 20 years at a CAGR of 26%.
1 million will become 1025.93 million in 30 years at a CAGR of 26%!!

You may like to open a CAGR Calculator and play with numbers yourself.

Avoid Cyclical Businesses

Cyclical businesses may be avoided because these are not good compounders of wealth. Consistent earnings and steady growth should be targeted.

Significant appreciation in the price of a particular share cannot be the sole reason to sell because price alone doesn’t tell you anything about the business. It has to be seen in relation to earnings, earnings growth, and many other factors. Then what are the reasons why an investor should think of selling his/ her shares? Although if you have bought well, you should seldom sell, some of the reasons could be as under:

When you need money urgently. Although you should not invest in shares that you may need in the next five years at least.
You think that a significantly better buying opportunity is available in the market which did not present itself earlier or you couldn’t spot it and now you don’t have cash available for it.
There is a significant upheaval in the business in question. It doesn’t mean just a negative news or a termporary change but a permanant negative change.

Don’t Ask Your Broker for Advice

If you have your own process of analyzing various investment options in place, you will not need to ask your broker for advice. You should consume research reports and authentic data from credible sources but refrain from being on the lookout for quick buying or selling tips from either your broker or anyone else. Especially, beware of the broker because his interest clashes with yours. He wants you to buy and sell frequently.

Prefer Direct Equity Instead of Mutual Funds

If you have some interest in business analysis, know the basics of finance and accounting, and can spare 3-4 hours per week, you should prefer direct equity. This way you will save 1-2% per annum management fee that you are going to pay to the mutual funds. In the other case, invest through mutual funds.

Prefer Stock Picking Instead of Indexing

Investing in index funds (aka indexing or passive investing) is a solution for those who don’t want to invest through mutual funds but also want to avoid stock picking due to lack of time or expertise. This will spread the risk across but will affect the returns as well.

Indexing is more pertinent to developed markets where it is believed that the value has already been priced in and it is considered that stock picking is not duly rewarded by the stock market. Hence, a preferred approach is to buy an index en bloc. There is an equally strong but contrary view that value investing is still relevant even in the developed markets with a bit of effort.

However, in the developing markets, still, there is a lot of value to be discovered and active investing or stock picking is relevant and extremely rewarding.

Avoid Initial Public Offerings (IPOs)

As a rule of thumb, be wary of any new issue. There is a deliberate marketing and sales effort behind it. Interest of the issuer is protected rather than the buyer.

See the regulations that are applicable to your market with regard to the pricing of the new issues. If the process is de-regulated and the price is going to be decided by the issuer, in collaboration with the investment banker, there is no point in investing in IPOs as the issue is likely to be overpriced. In the other case, you may consider investing in the IPO after due diligence.

Avoid Penny Stocks

Avoid those shares which are selling for a price even less than their face value. These are the shares that represent broken or dysfunctional businesses. Refrain from these at all costs as these are a sure recipe of permanent loss of capital.

Conclusion

In the introduction, I drew your attention to the image featured above. This shows some screens within a touch distance and through the window, the horizon is also visible in the depth. You can understand very well from this image how you should work in the market. You can either get bogged down in what happens on a daily or even hourly basis and become a trader or you can set your eyes on the horizon and have a perspective to become an investor.

Understanding why the stock market was actually created can be very useful. What has been suggested with regard to how one should work in the market may appear daunting, at first, but I am sure, with a bit of effort, if you can understand how various businesses operate, there is a lot of value out there to be harvested. Please go slow and gradual. Learn first and then commit your money. Record your investment decisions along with their rationale for analysis and learning subsequently. I am sure you will be on your way to becoming a skillful investor.

How did you find this content? Please comment and also give suggestions, if any.

My other articles you may find useful are:

How to Make a Personal Financial Plan – Basic Considerations

Personal Finance – A Suggested Checklist

Investment vs Speculation

A Brief History of Money

Why I Started a Blog on Personal Finance

Anatomy of Financial Risk

Debt, Equity, and Real Estate: An Overview

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

Benefits and Challenges of Using a Credit Card