How Does the Stock Market Work? Shares, Prices and What Moves Them
By the BrainSnail editorial team. How these articles are written and checked, and how to tell us when one is wrong.
When a news bulletin says the market fell two percent, it is reporting the changing price of ownership in a few hundred companies, traded by millions of people who mostly never meet. The stock market is at bottom a second-hand shop for slices of businesses, and once that is clear most of what happens on it, including the crashes, follows from the ordinary behaviour of buyers and sellers who are trying to guess the future and each other.
What a share is
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.
How a price is set
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.
Indices and the market as a whole
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, the oldest index 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
Who is trading, and why
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.
Crashes
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.
The takeaway
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.