• Stocks represent ownership in a company, providing shareholders with voting rights and a residual claim on the company’s earnings through capital gains and dividends.
• Individual and institutional investors gather on stock exchanges to buy and sell shares in a public marketplace.
• Share prices are determined by supply and demand as buyers and sellers place their orders.

How Do Stocks Work?

A stock is a financial instrument representing ownership in a company or corporation, granting a proportionate claim on its assets and earnings. Stocks are also known as shares or equity.

Owning stock means a shareholder owns a portion of the company proportional to the number of shares they hold relative to the company’s total outstanding shares.

For example, if an individual or entity owns 100,000 shares of a company with one million outstanding shares, they would have a 10% ownership stake in the company.

Types of Stock

There are two main types of stock: common shares and preferred shares. Equities are typically synonymous with common shares because their market value and trading volumes are significantly higher than those of preferred shares.

Common shares typically carry voting rights, allowing shareholders to participate in corporate meetings and elections. In contrast, preferred shares generally do not have voting rights. However, preferred shareholders have priority over common shareholders when it comes to receiving dividends and assets in the event of liquidation.

Common stock can also be classified based on voting rights. Some companies have dual or multiple classes of stock, each with different voting rights. In a dual-class structure, for example, Class A shares might have 10 votes per share, while Class B shares might have only one vote per share. These dual- or multiple-class share structures are intended to allow a company’s founders to maintain control over its direction, strategy, and capacity for innovation.

What Is a Stock Exchange?

Stock exchanges serve as secondary markets where existing shareholders can trade with potential buyers. Corporations listed on stock exchanges typically do not directly buy and sell their shares but may engage in stock buybacks or issue new shares, which usually occur outside the exchange’s framework.

Largest Stock Exchanges

The earliest stock markets emerged in Europe during the 16th and 17th centuries, primarily in port cities or trading centers like Antwerp, Amsterdam, and London.

In the late 18th century, stock markets began to emerge in the United States, with notable examples like the New York Stock Exchange (NYSE), which facilitated the trading of equity shares. The NYSE was established in 1792 through the signing of the Buttonwood Agreement by 24 New York City stockbrokers and merchants. Prior to its official founding, traders and brokers would gather informally under a buttonwood tree on Wall Street to conduct share transactions.

The first stock exchange in the United States was the Philadelphia Stock Exchange (PHLX), which continues to operate today.

The emergence of modern stock markets marked a period of regulation and professionalization, ensuring that buyers and sellers of shares can trust that their transactions will be executed at fair prices and within a reasonable timeframe. Today, numerous stock exchanges exist across the U.S. and globally, many of which are electronically interconnected.

The NYSE and Nasdaq rank as the world’s two largest exchanges by total market capitalization of all listed companies. The number of U.S. stock exchanges registered with the U.S. Securities and Exchange Commission (SEC) has nearly reached two dozen, although the majority of these are owned by Cboe Global Markets, Nasdaq, or Intercontinental Exchange, the parent company of NYSE.

Over-the-Counter Exchanges

Additionally, there are several loosely regulated over-the-counter (OTC) exchanges, sometimes referred to as bulletin boards (OTCBB). Shares traded on these exchanges tend to be riskier, as they include companies that do not meet the stricter listing criteria of major exchanges. Larger exchanges often require companies to have a certain operational history and meet specific criteria related to company value and profitability before listing.

In many developed countries, stock exchanges are self-regulatory organizations (SROs), which are nongovernmental entities with the authority to establish and enforce industry regulations and standards.

Stock exchanges prioritize investor protection by establishing rules that promote ethics and equality. Examples of such self-regulatory organizations (SROs) in the U.S. include individual stock exchanges, as well as the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA).

Stock Market Indexes

Indexes represent the aggregated prices of several different stocks, with the movement of an index reflecting the net effect of each component’s movement. Major stock market indexes include the Dow Jones Industrial Average (DJIA) and the S&P 500.

The DJIA is a price-weighted index comprising 30 large American corporations. Due to its weighting methodology and the limited number of stocks included (compared to the many thousands available), it is not considered a reliable indicator of overall stock market performance.

The S&P 500 is a market-capitalization-weighted index of the 500 largest companies in the U.S., making it a more reliable indicator of overall market performance.

Indexes can be broad, like the Dow Jones or S&P 500, or specific to particular industries or market sectors. Investors can trade indexes indirectly through futures markets or through exchange-traded funds (ETFs), which function similarly to stocks on stock exchanges.

A market index is a widely used gauge of stock market performance. Most market indexes are market-capitalization-weighted, meaning the weight of each index constituent is determined by its market capitalization. However, a few indexes, such as the DJIA, are price-weighted. Besides the DJIA, other extensively monitored indexes in the U.S. and internationally include the:

• S&P 500
• Nasdaq Composite
• Russell Indexes (Russell 1000, Russell 2000)
• TSX Composite (Canada)
• FTSE Index (United Kingdom)
• Nikkei 225 (Japan)
• Dax Index (Germany)
• CAC 40 Index (France)
• CSI 300 Index (China)
• Sensex (India)

Why Companies Issue Shares

To move from an idea in an entrepreneur’s mind to an operational company, they must secure an office or factory, hire employees, acquire equipment and raw materials, and establish a sales and distribution network, among other tasks. These resources necessitate substantial capital, which varies based on the business’s scale and scope.

Raising Capital

Numerous corporate giants began as small, privately owned ventures launched by visionary founders, such as Jack Ma of Alibaba (BABA) or Mark Zuckerberg of Meta (META).

Startups can raise capital by selling shares through equity financing or by borrowing money through debt financing. Debt financing can be challenging for a startup, as it may have few assets to offer as collateral for a loan.

For many startups in need of capital, equity financing is the preferred option. Initially, the entrepreneur might use personal savings, along with contributions from friends and family, to launch the business. As the business grows and requires more significant capital, the entrepreneur may seek funding from angel investors and venture capital firms.

Listing Shares

Companies can raise larger amounts of capital than they can obtain from ongoing operations or a traditional bank loan by offering shares to the public through an initial public offering (IPO).

An IPO changes the company’s status from a privately held firm with shares owned by a limited number of shareholders to a publicly traded company with shares held by a wide array of individuals from the general public. The IPO also allows early investors in the company to sell part of their stake, often realizing significant profits in the process.

How Share Prices Are Set

Share prices on a stock market can be determined in various ways. The most common method is through an auction process, where buyers and sellers submit bids and offers to buy or sell. A bid represents a price at which someone wants to buy, while an offer (or ask) is the price at which someone wants to sell. When a bid matches an offer, a trade occurs.

Stock Market Supply and Demand

The stock market provides a compelling demonstration of the principles of supply and demand in action. Every stock transaction requires both a buyer and a seller. According to the unyielding laws of supply and demand, if there are more buyers for a particular stock than there are sellers, the stock price will rise. Conversely, if there are more sellers than buyers, the price will fall.

The bid-ask spread, also known as the bid-offer spread, is the difference between the highest price a buyer is willing to pay (bid price) and the lowest price at which a seller is willing to sell (ask or offer price) a stock.

Matching Buyers to Sellers

Certain stock markets utilize professional traders, known as specialists or market makers, to ensure continuous bids and offers. This is because a buyer or seller may not always find a match at any given moment, and these specialists help facilitate trading activity.

A two-sided market comprises the bid and the offer, with the spread representing the price difference between them. The narrower the spread and the larger the size of the bids and offers, the higher the stock’s liquidity. When there are many buyers and sellers at progressively higher and lower prices, the market is considered to have good depth.

Advantages of Stock Exchange Listing

• An exchange listing means ready liquidity for shares held by the company’s shareholders.
• It enables the company to raise additional funds by issuing more shares.
• Having publicly tradable shares makes it easier to set up stock options plans that can attract talented employees.
• Listed companies have greater visibility in the marketplace; analyst coverage and demand from institutional investors can drive up the share price.
• Listed shares can be used as currency by the company to make acquisitions in which part or all of the consideration is paid in stock.

Disadvantages of Stock Exchange Listing

• Significant costs are associated with listing on an exchange, such as listing fees and higher costs associated with compliance and reporting.
• Burdensome regulations may constrict a company’s ability to do business.
• The short-term focus of most investors forces companies to try and beat their quarterly earnings estimates rather than take a long-term approach to their corporate strategy.

Many giant startups choose to get listed on an exchange at a much later stage than startups from a decade or two ago.

While this delayed listing may partly be attributable to the drawbacks listed above, the main reason could be that well-managed startups with a compelling business proposition have access to unprecedented amounts of capital from sovereign wealth funds, private equity, and venture capitalists. Such access to seemingly unlimited amounts of capital would make an IPO and exchange listing much less of a pressing issue for a startup.

Investing in Stocks

Numerous studies have shown that, over long periods, stocks generate investment returns that are superior to those from every other asset class. Stock returns arise from capital gains and dividends.11

A capital gain occurs when you sell a stock at a higher price than the price at which you purchased it. A dividend is the share of profit that a company distributes to its shareholders. Dividends are an important component of stock returns. They have contributed nearly one-third of total equity return since 1956, while capital gains have contributed two-thirds.11

While the allure of buying a stock similar to one of the fabled FAANG quintet—Meta (formerly Facebook), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Google parent Alphabet (GOOGL)—at a very early stage is one of the more tantalizing prospects of stock investing, in reality, such home runs are few and far between.

Investment often depends on an individual’s tolerance for risk. Risky investors may generate most of their returns from capital gains rather than dividends. On the other hand, investors who are conservative and require income from their portfolios may opt for stocks that have a long history of paying substantial dividends.

Market Cap and Sector

While stocks can be classified in several ways, two of the most common are by market capitalization and by sector. Market cap refers to the total market value of a company’s outstanding shares and is calculated by multiplying these shares by the current market price of one share.

Large-cap companies are generally regarded as those with a market capitalization of $10 billion or more, while midcap companies are those with a market capitalization of $2 billion to $10 billion, and small-cap companies fall in the $250 million to $2 billion range.12

The industry standard for stock classification by sector is the Global Industry Classification Standard (GICS), which was developed by MSCI and S&P Dow Jones Indices in 1999 as an efficient tool to capture the breadth, depth, and evolution of industry sectors. GICS is a four-tiered industry classification system that consists of 11 sectors and 24 industry groups. The 11 sectors are:13

• Energy
• Materials
• Industrials
• Consumer discretionary
• Consumer staples
• Healthcare
• Financials
• Information technology
• Communication services
• Utilities
• Real estate

This sector classification makes it easy for investors to tailor their portfolios according to their risk tolerance and investment preference. Conservative investors with income needs may weigh their portfolios toward sectors with constituent stocks that have better price stability and offer attractive dividends through so-called defensive sectors such as consumer staples, healthcare, and utilities. Aggressive investors may prefer more volatile sectors such as information technology, financials, and energy.