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A really fantastic source of educational material on stock markets, trading and traders. They also have a free-to-play stock trading simulation game and other educational tools. Well worth checking out and much of my content on this page has come from them or been double checked against their explanations.
An Introduction to Financial Markets
The basic terms, the concepts and players
Stock Markets
“Stock markets or exchanges are classed as ‘secondary markets’, because owners of shares can interact with potential buyers but the original owner of those share, the company, do not buy or sell their own shares on a regular basis. So when you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from some other existing shareholder. Likewise, when you sell your shares, you do not sell them back to the company, rather you sell them to another investor. A ‘primary market’ is where that firms sell new stocks and bonds to the public for the first time, such as an initial public offering (IPO).
The first stock markets appeared in Europe in the 16th and 17th centuries, mainly in port cities or trading hubs such as Antwerp, Amsterdam, and London. In the late 18th century, stock markets began appearing in America, notably the New York Stock Exchange (NYSE), which allowed for equity shares to trade. The honour of the first stock exchange in America goes to the Philadelphia Stock Exchange (PHLX), which still exists today. The NYSE was founded in 1792 with the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Prior to this official incorporation, traders and brokers would meet unofficially under a buttonwood tree on Wall Street to buy and sell shares.
The prices of shares on a stock market are generally set through an auction process where buyers and sellers place bids and offers to buy or sell. A bid is the price at which somebody wishes to buy, and an offer (or ask) is the price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.
The overall market is made up of millions of investors and traders, who may have differing ideas about the value of a specific stock and thus the price at which they are willing to buy or sell it. The thousands of transactions that occur as these investors and traders convert their intentions to actions by buying and/or selling a stock cause minute-by-minute gyrations in it over the course of a trading day.
A stock exchange simply provides a platform where such trading can be easily conducted by matching buyers and sellers of stocks. For the average person to get access to these exchanges, they would need a stockbroker.
This stockbroker acts as the middleman between the buyer and the seller.”
What can you buy and sell?
The three basic building blocks, Stocks, Bonds & Commodities
Stocks
Shares of stock let investors participate in the company’s success via increases in the stock’s price and through dividends. Shareholders have a claim on the company’s assets in the event of liquidation (that is, the company going bankrupt) but do not own the assets.
Holders of common stock enjoy voting rights at shareholders’ meetings. Holders of preferred stock don’t have voting rights but do receive preference over common shareholders in terms of the dividend payments.
Bonds
A bond is a debt instrument representing a loan made by an investor to a borrower. A typical bond will involve either a company or a government, where the borrower will issue a fixed interest rate to the lender in exchange for using their money (capital).
Bond rates are essentially determined by the interest rates and are considered a safer investment because they are more predictable. The interest rate is a calculation of the risk involved, will the organisation borrowing the money refuse to pay (default on the debt)?
For example US Government Bonds, where they will repay you after 30 years (at the time of writing Oct 2020) is around 1.5% (so considered very low risk, so low in fact that this is less than the predicted rate of inflation, so it will actually cost you money to lend them money!).
If you want an inflation risk free US Government Bond, you can buy a 30yr version of this and it will return -0.33% at the moment. So after 30 years if you buy a US Government bond for $1000 they will give you back $997.
By contrast, 10 year Greek government bonds in 2012 (following the continued fall out of the 2008 financial crisis) had an interest rate of around 35% but today they are around 1%.
Commodities
Commodities that are traded are typically sorted into four broad categories: metals, energy, livestock and agricultural.
In the most basic sense, commodities are known to be risky investment propositions because their market (supply and demand) is impacted by uncertainties that are difficult or impossible to predict, such as unusual weather patterns, epidemics, and disasters both natural and man-made. But they are often seen as a good diversification approach for investors because the movement in their price can be detached from volatility in the stock market.
Traders
Active vs Passive
Active Investments
(Mutual & Hedge Funds)
A Mutual Fund is a type of investment where more than one investor pools their money together in order to purchase securities. This can give them access to assets that might be too expensive for a single investor and so are a good way for small investors to enter a market. Mutual funds are typically managed by portfolio managers who allocate and distribute the pooled investment into stocks, bonds, and other securities. These active fund managers try to pick winners on your behalf and so you pay them fees for their service.
Hedge funds are only allowed to take money from "qualified" investors, in the US it is individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. Unlike mutual funds who can only buy stocks or bonds, a hedge fund can basically invest in anything. They will often use borrowed money to amplify their returns. But as we saw during the financial crisis of 2008, leverage can also wipe out hedge funds. They typically charge a 2% management fee and then a 20% cut of any gains generated ("Two and Twenty").
Passive Investments
(Exchange traded funds (ETFs) and Index Mutual Funds)
Exchange traded funds (ETFs) and Index Mutual Funds are often very similar, but differ on one point, ETFs are traded throughout the day, Mutual Funds instead are revalued at the end of each trading day. For most it’s a minor irrelevant difference.
The key aspect of note is that rather than being managed by active fund managers, they are passive, no one is controlling how much of something is in each fund. Instead the funds contain a basket of different things around a theme; stocks and shares in technology businesses, pharmaceutical companies, or maybe different commodities or even around a whole market place, such as the FTSE100 or the S&P500 for example.
These baskets of things are known as Index’s, the combined value of everything inside them is the value of the index.
What these passive funds do is they buy a small piece of everything in that Index, based on each items share of value. So for example if you buy an index that tracks the S&P500, around 7% of your investment will be in Apple shares, because at the time of writing Apple is worth 7% of the total value of the 500 largest companies in the US. If Apple’s value went down, the amount of Apple you would own would also decrease because your investment passively tracks what’s going on. No one is making any conscious decisions here.
Why do people invest in passive things like this?
It’s unusual for active fund managers to perform better than the benchmark (the index tracker of the market)
Because no one is doing anything the fees are very low (maybe as low as 0.05% compared to perhaps 5% for active funds).
Your risk is diversified because you own a little of a lot of things, if shares in Rolls-Royce go down, but Google go up, you might not lose money and might even have gained that day. You’re not betting on one thing.
Other Traders:
Not strictly part of the stock market like the funds and active managers above, but intrinsically involved on the edges of what the stock market is all about.
Private Equity
Private equity is slightly different to the above because it’s an alternative investment class that consists of investments that are not listed on public exchanges. Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity.
Private equity firms make money by charging management and performance fees from investors in a fund. Private equity can take on various forms, from complex leveraged buyouts to venture capital.
Venture Capital
Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential.
See my section on Growth and Investors for more information on VCs.