How Do Stocks Actually Work?

The stock market is a huge store of wealth.  As of January 1, 2024, the U.S. stock market was valued at $50.8 trillion (combining the New York Stock Exchange, Nasdaq, and Over The Counter U.S.).  That’s enough money to pay off the federal government’s massive debt burden and still leave nearly $17 trillion left over.  So why does so much money find its way into stocks?

In short, business owners need cash to run their businesses.  The Mom n’ Pop shop down the street might turn to friends and family for some funds.  A company can go to a bank and get a loan or line of credit.  Other entrepreneurs will look to outside investors like venture capitalists or private equity sources.  All of these methods represent a quid pro quo deal, the business owner gets money, and the financier collects interest on debt repayments or provides funds in exchange for ownership of the company.  The latter deal, sharing ownership, introduces the concept of stocks.

Business owners may choose to raise money through an Initial Public Offering (IPO).  “Going Public” is often seen as the last and grandest stop on the fundraising train.  An IPO essentially breaks up the company into pieces called “shares” which are then sold to investors as “shares of stock”.  These investors are then referred to as “shareholders” who literally own a piece of the company and share in the successes and failures of the enterprise as well as rights such as voting on its board of directors and other important matters.

How Stocks Make Money

Investors can make money by owning stocks primarily in two different ways.  First, when a company earns a profit they may reinvest in the business for future growth, pay down debt, or reward their investors in the form of a dividend.  Dividends can provide investors income while they continue to hold onto their stock.  Second, the stockholder can hold their shares for a period of time while the company grows and its stock price increases, then sell it for a higher price in the future, creating a capital gain.  This two-pronged benefit is sometimes compared to being a landlord in real estate, in which the owner can receive rent payments while their investment (property) appreciates in value.

How to Track Stocks

• The Dow Jones- in 1896, Charles Dow added up the closing prices of 12 companies, divided by 12, and came up with an average to track the stock market.  The Dow Jones Industrial Average (DJIA) is still one of the most quoted indexes in the world.
• S&P 500- the Standard & Poor’s Company publishes an index based on 500 leading companies in the largest industries in the U.S. economy.
• Nasdaq- the Nasdaq is most synonymous with the technology sector.  It lists over 3,300 companies.

There are hundreds of other indexes around the world that can help track every sector.  Index funds, which are a collection of stocks meant to track the underlying index, have become a popular investment strategy to participate in the market and easily diversify without the active management usually found within mutual funds.

A Quick History of The Markets

The idea of entrepreneurs pooling money together for a common goal and sharing ownership in its ups and downs is as old as business itself.  Some of the first formal uses of a stock market occurred in 12th century France, when banks charged men with managing and regulating debts in agricultural communities, essentially creating brokers.

In 1602, the Dutch East India Company became the first company to allow investors to buy shares of their company, triggering global stock trading.  Later that century, in 1698, the London Stock Exchange was started by a list of stock and commodity prices published at a coffee house in London.  London quickly became the financial capital of the world.

In 1792, 24 brokers gathered in New York City to establish rules for buying and selling bonds and shares of companies, creating the New York Stock Exchange.  The NYSE is by far the largest exchange in the world.  In 1971, the National Association of Securities Dealers (Nasdaq) starting using an automated quotations system for trading stocks.

Not everyone has the chance to sit at the helm and personally direct a multi-billion-dollar organization, whether it’s creating pharmaceuticals, manufacturing cars, or selling sports apparel.  But, they may have the chance to own it by buying shares of stock in their investment portfolio.

Written by Bryan Kuderna.

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