How Does the Stock Market Work? Shares, Prices and What Moves Them

A company that wants money to grow can borrow it or can sell part of itself. Selling part means issuing shares: a company divided into ten million shares has sold ten million equal claims on its future profits and on a vote at its meetings, and someone who owns a hundred of them owns a hundred ten-millionths of the business. Profits paid out to shareholders are dividends; profits kept and reinvested make the company, and so each share, worth more. The first sale of shares to the public is a flotation or initial public offering, and it is the only time the company itself receives the money.

Everything after that is trading between investors. When one person buys shares in a company on the market, the seller is another investor, not the company, and the company gets nothing from the transaction; what it gets is a public price for itself, which it can use to raise more money later, to pay staff in shares and to buy other companies.

An exchange, such as those in London, New York or Tokyo, is a place where buyers and sellers post the prices they will accept, and a share's price at any moment is simply the last price at which a buyer and seller agreed. If more people want to buy than sell at the current price, buyers must offer more to find willing sellers and the price rises; if more want to sell, it falls. Nobody sets the price, and the only thing the price certainly means is that someone was willing to pay it a moment ago.

What people are willing to pay depends on what they expect the company to earn, discounted for how far away those earnings are and how uncertain, and compared with what they could earn elsewhere. That is why prices move on news: a better than expected profit, a new drug approved, a competitor's failure, a change in interest rates that makes the safe alternative more or less attractive. It is also why prices move on nothing, when enough people guess that other people are about to buy or sell.

The market that rises or falls in the news is an index: a basket of shares whose combined value is tracked as a single number. The main ones are chosen to stand for a whole economy:

• •FTSE 100: the hundred largest companies listed in London, weighted by size
• •S&P 500: five hundred large American companies, the broadest common measure of the US market
• •Dow Jones Industrial Average: thirty large American companies, one of the oldest indices and the least representative, weighted by share price rather than company size
• •Nikkei 225: the main Japanese index; DAX, the main German one
• •MSCI World: about 1,500 companies across developed countries, used by global funds

Most shares are not held by individuals but by pension funds, insurance companies, mutual funds and the index funds that simply buy every share in an index in proportion, on behalf of millions of savers who own them indirectly. Alongside them are hedge funds betting on particular outcomes, companies buying back their own shares, and high-frequency traders whose computers hold a share for a fraction of a second. Retail investors trading on phone apps are a small share of the volume but a noisy one. The mix matters because the large, patient holders damp swings while the fast, leveraged ones amplify them.

Over long periods the market has rewarded patience. A broad index of American shares has returned about seven percent a year above inflation over the last century, including the crashes, because it is a claim on the profits of a growing economy. Over short periods it is close to a random walk, which is why most professional fund managers fail to beat the index they are paid to beat and why the cheapest advice, to buy the whole market and wait, has been so hard to improve on.

The market falls sharply when expectations change all at once or when forced sellers, such as funds that borrowed to buy, must sell whatever the price. The crash of 1929 wiped out nearly ninety percent of American share values over three years and turned a downturn into the Depression; the 1987 crash took twenty-two percent off in one day, partly through automated selling; 2008 halved the market as the banks that underpinned it failed; and March 2020 fell a third in a month and recovered by the summer. Circuit breakers, which now halt trading for a period if prices fall too far too fast, exist because of 1987. None of this has stopped crashes, because the market is made of people guessing about the future, and the future occasionally arrives.

It is possible to profit from a share price going down, through a trade called short selling. An investor borrows shares from someone who owns them, usually arranged through a broker for a fee, and sells them at today's price. Later they buy the same number back and return them to the lender. If the price has fallen in the meantime, they keep the difference; if it has risen, they must pay the higher price and take the loss. Borrow and sell 100 shares at 10 pounds, buy them back at 7, and you make 300 before fees.

Short selling carries an unusual risk. A share bought in the normal way can lose at most what was paid for it, but a share sold short can rise without limit, and so can the loss. If many short sellers rush to buy back at once to cut their losses, their buying pushes the price higher still, which is called a short squeeze. That happened to GameStop, an American video game retailer, in January 2021, when small investors coordinating on online forums drove its price up many times over and several hedge funds betting on its decline lost heavily.

One common way to judge whether a share is cheap or dear is the price-to-earnings ratio. Imagine a company with 10 million shares that made 50 million pounds of profit last year. Its earnings per share are 5 pounds. If the shares trade at 100 pounds, the ratio is 100 divided by 5, which is 20, meaning buyers are paying twenty years of current profit for each share. Multiply the price by the number of shares and you get the market capitalisation, here one billion pounds, which is what the market values the whole company at.

Turn the ratio upside down and you get the earnings yield, 5 divided by 100, or 5 percent. That is a handy figure to set against the interest paid on safe government bonds. If bonds pay 4 percent, a share earning 5 percent on its price looks only modestly better for the extra risk; if bonds paid 1 percent, the same share would look far more attractive, which is one reason share prices tend to rise when interest rates fall. A ratio of 40 is not necessarily foolish, because buyers may expect profits to grow quickly, but it leaves less room for disappointment.

Professional fund managers spend their careers trying to choose shares that will beat the market, yet regular studies comparing their results with the indices they aim to beat find that most actively managed funds fall behind over long periods, especially after their fees are taken into account. Even managers who do well for a few years rarely keep it up.

That evidence drove the rise of index funds, which simply buy every share in an index in proportion to its size. John Bogle launched the first index fund for ordinary investors in 1976, and it was mocked at the time as settling for average. Because index funds trade little and charge low fees, they have since attracted enormous sums, and many individual investors now hold the whole market rather than trying to outguess it.

Behind every share price on an exchange sits an order book: a list of the prices at which people are offering to buy, called bids, and those at which others are offering to sell, called asks. Suppose the highest bid is 9.98 pounds and the lowest ask is 10.02. The four-pence gap between them is the spread. A market order to buy says you will pay whatever it takes right now, so you are matched with the cheapest seller and pay 10.02. Sell straight back and you would get only 9.98, so an instant round trip costs you the spread.

A limit order works differently. You name your price, say 10.00, and the order waits in the book until a seller is willing to meet it, which may be never. Limit orders build the book; market orders consume it. Depth matters too. If only 500 shares are offered at 10.02 and you want 5,000 at once, your order eats through the cheapest offers and fills the rest at 10.03, 10.05 and higher, moving the price against you. That is why spreads are narrow for big, busy companies and wide for small, rarely traded ones, and why large investors split orders into many small pieces.

The stock market is where shares, equal slices of ownership in companies, are traded between investors at whatever price the last buyer and seller agreed, which rises and falls with expectations of the companies' future profits and with the returns available elsewhere. Companies raise money only when they first issue shares; the indices in the news track baskets of them; most shares are held by funds on behalf of savers; and over long periods the whole market has grown with the economy while over short ones it is close to unpredictable.