Monday, March 30, 2009

The Stock Market

So, how does the stock market work? To put it simply, companies choose to go public and issue shares because they need money. One of the first types of stocks was issued by traders who wanted to finance expeditions to India and China. Such a project was naturally very risky and really expensive, but if the expedition turned out to be a success and managed to bring silk, porcelain, spices, tea and other rare and valuable commodities to Europe the traders would become immensely rich. If, on the other hand, the ship would sink, be hijacked by pirates, or something similar, all the money invested in the project would be lost. High risk and high potential rewards. In order to gain sufficient founding, a trader could allow wealthy persons to invest in the project. If the expedition turned out to be a success, the investor would receive a specified share of the profit. If the ship sunk or failed in some other fashion, the money invested would be lost. Unlike a normal loan, each investor would take the risk here and if the ship sunk, they could not force the trader to pay back any money. If you can understand this basic concept, you are actually well on your way of understanding how our modern stock market works. How does the stock market work? Like 17th century trading expeditions! (stockmarket.nu)

Okay... I get that. However, I don't really understand all this Dow and points stuff. Why do the numbers drop so drastically and then go back up? Why does all this affect our economy?

3 comments:

Roland Hulme said...

At the risk of pontificating like Two Dogs, I'd say that the stock market is reactionary. There are a few people who make moves based on events in the market - and the rest follow, like sheep.

One Salient Oversight said...

It took me a while to understand the whole numbers thing but I finally understood it.

Read the Wikipedia article first.

The Dow Jones Industrial Average (DJIA) is a "Price weighted index" which basically collates the share prices of the top 30 largest and most widely traded stock.

Essentially it goes like this:

When people are buying, buying, buying, share prices go up and the Dow Jones Index goes up.

When people are selling, selling, selling, share prices go down and the Index goes down.

During a normal day of trading, some share prices will go up and others will go down.

How does this affect the economy?

A company's share price determines its market worth. "Market capitalisation" is when you multiply the share price by the number of shares.

The higher a company's market cap, the more money they can borrow to expand their business and maintain their cashflow.

BLBeamer said...

Why do people buy stocks? Usually, because they believe by doing so they have the likely possibility of future gain.

Why do people sell stocks? Sometimes, but not always, because they believe the money they could get from their sale invested elsewhere (or even buried in the yard) will likely provide higher returns than leaving it in that stock.

The stock market is like any market, with buyers and sellers vying for the attention of those who are interested in their wares. Just like an auction, the price of a stock goes up when more people are bidding for it because they believe they will be better off owning the item than not.

The different indices like Dow Jones are just a way to reflect the aggregated views of those who are participating in the marketplace. When the participants are optimistic about owning stocks, the index goes up because more people expect higher returns there than other alternatives.

So, the stock market doesn't affect the economy so much as be affected by the consensus views of future returns people hold.