Finance 2: How the stock market works (v1.1)
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.
How corporations and securities work
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 bondholder loans money to the company for an agreed‑to
interest until maturity when the principal is returned. It is much safer than
stocks. Bondholders get paid before stockholders. The debt‑to‑asset ratio is an
important number. Rating agencies grade a company on its ability to repay
bondholders.
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.
Stock exchanges
There are two major stock exchanges in the US:
- The New
York Stock Exchange (born in May 1792)
- The NASDAQ
stock exchange (born in 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
- very
high trading volume
- low
transaction costs
- total
confidence that trades will be honored and contracts enforced
- publicly
available information (insider trading is illegal)
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.
Efficient Market Hypothesis (EMH)
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:
- News
trading strategy is trading based on news and market expectations.
- End‑of‑day
trading uses trading at the end of the day.
- Swing
trading trades on both sides of a movement.
- Position
trading holds a position for months or years, ignoring minor
fluctuations in favor of long‑term trends.
Why humans cannot compete with institutional trading
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 at 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 tails 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.
What retail investors typically do
Retail investors rarely opt for active trading. Common
recommendations often made to retail investors are to:
- invest
for the longer term
- diversify
- 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 ratio diversified index mutual funds 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.
Want to Read on?
NEXT: Using Plaid
Comments