What is the stock market and why does it exist?

by Andre Barrett Andre Barrett thumbnail 7 November 2018

#Stock market #Trading #Business
What is the stock market and why does it exist? image

A stock market, not dissimilar to any other market, is a network of buyers and sellers that come together to trade. Unlike other markets, however, it does not necessarily have a physical location. Instead, transactions for the sale and purchase of ownership interest in companies, commodities and other financial instruments take place electronically.

But what does this all mean and why even bother with a stock market?

The best way to explain is by using an example. Johnny Appleseed is a young entrepreneur who solves a need in his local community Pipsvillie. The inhabitants of Pipsville love apples. They can’t get enough of them. Every day a family member goes to the market where Johnny Appleseed has set up a stall and buys apples for the family. Because of the demand, however, by midday, the apples are sold out and lots of the community have to do without. Johnny would love to keep his stall open for longer and sell more apples but unfortunately, the only apples that grow in the town are from a tree in Johnny’s back garden.

Being the entrepreneur that he is, one day Johnny decides he is going to solve this problem once and for all. He knows that there are more apple trees in some faraway towns and he’s heard that these towns have excess apples. If he could somehow get these apples brought in regularly from these other towns, he would have more apples to sell and be able to keep the stall open for longer. He realizes, however, that this is no easy feat so he goes to consult his friend Steve, an elder in the community who has a great deal of experience traveling to some of these towns and setting up successful ventures of his own.

“I understand the dilemma,” Steve says. “You have several problems that need to be solved a few of which have upfront costs and need you to have quite a bit of money in place to get started. The way to solve these problems is to have answered the following questions”

  • Which towns will you get the apples from?
  • Who will go to these towns and transport the apples to Pipsville?
  • How will you transport the apples?
  • What price will you pay for the apples?
  • What price will you sell the apples?
  • How many apples will you need to sell every day to satisfy the demand in Pipsville?
  • Who will work on the stall selling the apples?

“What you will need to do is create a plan which answers all of these questions. If the plan is done correctly, it will forecast how much money can be made from selling your apples. The forecast can then be used to raise the money you will need to solve all your problems. Once the plan is in place, you can take it to Mr. Sachs, the wealthy old man who lives on the outskirts of Pipsville.” Johnny knows Mr. Sachs is a greedy old man who won’t part with his money easily. He is confident, however, that if he can answer all the relevant questions in his plan, he can offer Mr. Sachs a great deal of assurance that he will get his money back.

The day had arrived for Johnny’s meeting with Mr. Sachs. He had sent the plan a few days ago by post so by now Mr. Sachs would have read it and now it was time to see if Mr. Sachs had any further questions and would lend Johnny the money required to get started on his venture. As Johnny arrived at Mr. Sachs' mansion, he was greeted by his staff and shown into Mr. Sachs' office where Mr. Sachs was waiting.

“It’s a great plan,” Mr. Sach’s began. “But I don’t understand why I would lend you any money. Your plan doesn’t highlight any of the risks of which there are many. For example:”

  • What if the apples go bad while they are being transported?
  • What if the transport breaks down?
  • What if the money to buy the apples is stolen or the apples themselves?
  • What if the towns you get the apples from put their prices up
  • What if the inhabitants of Pipsville lose their appetite for apples and decide to buy oranges instead?

“The reason I became this wealthy,” Mr. Sachs continued, “is because I didn’t take silly risks with my money.”

Understanding the greed of Mr. Sachs, Johnny quickly presented Mr. Sachs with an incentive for lending his money. He proposed that if Mr. Sachs funded the venture, he could share in the profits from the sale of the apples. Mr. Sachs began to smile. “Ok, he said, but for taking such a huge risk, I require 45% of the profits and you will have to update your plan to tackle all the risks I just mentioned.” Johnny agreed. “Oh,” he added. We will also need to get our agreement formalized in a contract. I will get my lawyers to put something together which we can both sign." The newly formed partners shook hands and Johnny left to get to work on implementing his plan.

Great story, but how does it relate to the stock market?

Although the story is simple, it illustrates a typical lifecycle of a business or company. A stock, also known as equity, represents part ownership in a company. The contract that Johnny Appleseed signed for his venture to be funded was effectively him selling a stake in his business. The return for owning this stake (or stock) is a share in the profits the company makes from any sales. The purpose of the stock market, therefore, is to provide the public with a place to be able to exchange the ownership of these companies with the potential to make a return from the share of the profits. This behavior is also known as investing (typically when stock is held over a long period) or trading (when stock is held over a short term period).

The real history of the stock market

Stock trading dates back as far as the mid-1500s in Antwerp. Antwerp is a port city in Belgium and towards the end of the 15th century became one of the most important cities for foreign trade in Europe. Sugar, as a raw commodity, was being imported from Spanish and Portuguese plantations, sold to Italian and German refiners which then shipped the refined product to other parts of Europe to be sold. Similar to the story of Johnny Appleseed, the nature of these ventures required moneylenders and financiers who developed a large business lending money all over Europe to finance their operations. The world’s oldest stock exchange building, originally built there in 1531, would have been used to trade the ownership rights in some of these business operations.

The modern-day form of stock trading, however, is recognized as starting with the trading of shares in the East India Company in London, England. Throughout the 1600s, ship voyages to the East such as India or China were undertaken to bring back goods for sale. Each voyage entailed a significant amount of risk due to being threatened by severe storms and pirates. Shipowners regularly sought out investors to offer financing collateral for a voyage. In return, investors received a portion of the monetary returns realized if the ship made it back successfully, loaded with goods for sale. The contracts formed giving rights to part ownership of the sales are the earliest examples of limited liability companies (LLCs), and many held together only long enough for one voyage.

The formation of the East India Company in London eventually led to a new investment model, with importing companies offering stocks that essentially represented a fractional ownership interest in the company, and that therefore offered investors investment returns on proceeds from all the voyages a company funded, instead of just on a single trip. The new business model made it possible for companies to ask for larger investments per share, enabling them to easily increase the size of their shipping fleets. Investing in such companies, which were often protected from competition by royally-issued charters, became very popular because investors could potentially realize massive profits on their investments.

The First Shares and the First Exchange

Company shares were issued on paper, enabling investors to trade shares back and forth with other investors, but regulated exchanges did not exist until the formation of the London Stock Exchange (LSE) in 1773. Although a significant amount of financial turmoil followed the immediate establishment of the LSE, exchange trading overall managed to survive and grow throughout the 1800s.