Investing 101: How Does the Financial Market Work?

How Does the Financial Market Work

The following is an excerpt from our ebook, “A Minimalist’s Guide to Financial Markets,” which you can download by clicking here.

Financial markets are complex. They contain an almost infinite number of moving parts that all play off of each other. To make sense of it all and make it work for you, you need to have a basic framework in place that helps you understand the world of investing. This is by no means an exhaustive description of how the markets work. We want to focus on the fundamentals here.

We’ll begin with a fairly basic concept: There is no such thing as a single financial “market.”

The word market refers to a network of millions of people trying to make as much money as possible by buying and selling pretty much anything you can think of.

Beyond Right and Wrong: A Secret to Understanding the Market

Up close, the market appears to be total chaos. However, take a step back and an internal logic – known as efficient market hypothesis (EMH) – begins to appear.

EMH says that all available information is factored into a security’s price almost immediately, so you can’t predict what the market will do next. By the time you hear about a new development in the market, it’s already been factored in.

How Does the Financial Market Work?

That’s not to say all prices are “right.” In fact, it might be more accurate to suggest that all prices are wrong. We just don’t know if they’re too expensive or too cheap.

Think about it from the perspective of a trader on the floor of the New York Stock Exchange. If she catches sight of a stock that is underpriced, she’ll swoop in to buy it. As soon as she buys it, her purchase will push the price up.

Reciprocally, if she feels one of her stocks is too expensive, she’ll sell it immediately. By selling it, her action pushes the price down – that’s basic supply and demand driving market prices.

But it’s not just one trader on the floor of the Exchange. The market moves swiftly. High frequency traders use computers to trade huge sums of money in fractions of a second, and the market is continually adjusting according to these trades.

So here’s the secret: The core purpose of the stock market is to allocate capital. In other words, the stock market exists to designate a price to a stock based on how much people are willing to pay for a slice of a company.

Chances are you’re using the stock market to fund your retirement. That’s great, but it is not the market’s intended purpose. The market does not exist to help you fund your retirement and it does not owe anyone a retirement fund. The market exists to allow companies to raise capital, which then allows you to raise money for retirement.

How Does the Market Help Companies Raise Capital?

Companies raise capital by selling shares to the public. You’ve probably heard of IPOs, or Initial Public Offerings. An IPO is the first time a company comes to the stock market to raise money. Companies can raise money after their IPO, too, through subsequent sales of stock called “secondary offerings.”

When a company hits the market, the market tries to figure out how much it is worth using a fairly familiar method.

Imagine two people strut into a bank looking for a loan: one has a credit score of 832 and the other’s is 510. Who will get a lower interest rate?

The person with the higher credit score, obviously. The bank will assign a lower interest rate to the person it deems more reliable because there’s less risk of not being paid back.

In the same way, the market assesses the risk of a company and is willing to buy the “safer” companies for more money by assigning its stock a higher price. The riskier the company, the lower the price and the higher the demanded return.

Click here to download the ebook “A Minimalist’s Guide to Understanding Financial Markets.”

 

McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.

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