Finance 2: How the stock market works (v1.0)

 A key reference is prof Ramon P. DeGennaro of the Univ of Tennessee at Knoxville. It is not to be considered professional financial advice from me. Please consult a financial planner for advice that suits you. This blog is oriented more towards people who want to understand concepts than people looking for an investment flowchart. 

Corporations in this blog will be thought of as a collection of goodies (or assets) – both tangible like corn and trucks and intangible like branding or steady customer base or patents (there are other dimensions of looking at a corporation too).  These goodies are valuable. A common stockholder in the company is the owner of a proportional share of the goodies. A common stockholder gets any gains/losses in the market value of the goodies after expenses are deducted. This is the risk premium for stocks. A bond holder loans money to the company for an agreed to interest until maturity when the principal is returned. It is much safer than stocks. Bond holders get paid before stockholders. The debt to asset ratio is an important number. Rating agencies grade a company on its ability to repay bond holders. The price earnings ratio is also an important number. When a company issues new stocks, the ownership proportion represented by your stock holding decreases. A cash payment to stockholders is called a dividend and some companies do that, typically slower growing companies. A stock dividend is payment in additional stocks, but the stock dilutes. A stock split is also a form of stock dividend. Private equity and preferred stocks are beyond the scope of this blog. Both stocks and bonds can be traded in an exchange.

There are two major stock exchanges in the US. The New York Stock Exchange (born in May 1792) and the NASDAQ stock exchange (born more recently on Feb 1971 and computerized). The Chicago Mercantile Exchange (CME) group trades in commodity futures and options (derivatives). There are other regional small exchanges which will not be discussed. CME and exchanges in other countries will not be discussed further either. Some companies list in multiple exchanges. The vast majority of the trading is in the secondary market (where neither the buyer nor the seller is the company in question). A well-functioning market has very high competition, and very high trading volume, low transaction costs, and total confidence by the traders that the trades will be honored, and the contracts enforced by law. Also, insider trading is highly illegal, and trades are assumed to occur in an environment where all relevant information is public. Computerization makes stock markets much faster and cheaper. These days much of the trading is program trading that occurs in the blink of an eye.

Let us look deeper into why it is so hard to beat the market consistently. The efficient market hypothesis (EMH) states that when new information comes into the market, it is immediately reflected in stock prices and thus neither technical nor fundamental analysis can help an investor generate returns greater than those of a portfolio of randomly selected stocks. There are many studies that support this hypothesis although there are many critics. For example, investors such as Warren Buffett have consistently beaten the market over long periods, which by definition is impossible according to the EMH. I will not go into these studies for or against. Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security's future price movements. Fundamental analysts search for stocks currently trading at prices higher or lower than their real value. If the fair market value is higher than the market price, the stock is deemed undervalued, and a buy recommendation is given. There are other strategies used too. A news trading strategy is trading based on news and market expectations. The end of day trading strategy uses trading at the end of the day. A Swing trading strategy does trade on both sides of a movement. Position trading strategy is a very popular trading strategy where a trader holds a position for a long period of time, usually months or years, ignoring minor price fluctuations in favor of profiting from long-term trends.

Today, although trading on the floor is still possible, the vast majority of the trading is done by institutional investors using sophisticated program trading that constantly look for opportunities and react in less than a second to put in large trades. A software bug or poor algorithm either in the trading platform or these program trading systems would be monumental in the degree of damage. But given good software, there is no way any human can compete against that. Even most professional money managers are not able to match the market return consistently. The winners in one year likely are the losers in the next. The reason is intense competition. There are millions of investors going to it. Because of this, the stock price tends to be fair. As an example of ‘fair’, tossing a coin to determine who bats first in a game is fair, but the outcome may be heads or tail randomly. Stock returns tend to be somewhat close to random. They move up and down unpredictably. Picking winners for a retail investor in the stock market is extremely hard.

Retail investors rarely opt for active trading. Common recommendations often made to retail investors are to invest for the longer term, diversify, and if mutual funds or ETFs are picked, pick ones with low expense ratios. Another common recommendation for a retail investor is not to waste time and money trying to beat the market or time your trades. Historically stocks have given good returns over the long term although a significant downturn at any point may delay that. You could pay an investment manager to invest for you to better align with your risk profile, time horizon, desired strategy or goals (the manager decides what and when to buy/sell in consultation with you and has access to a lot of market intelligence and analysis and employs various strategies). But there are no real good odds it will perform better than investing in a few low expense ratios diversified index mutual fund by yourself and hold for a long time.  Few retail investors can really perform technical analysis or fundamental analysis which might improve the odds on stock trading, or read reports on that by analysts.