The Stock Market: Its Purpose and History

What It's About

It’s the heartbeat of capitalism and is an engine to the world’s wealth creation, but what exactly is the stock market and where did it come from?

The stock market is the place, once a physical location but now an electronic one, where investors can buy and sell stock. It’s also the collection of all the stocks that trade on the market. Stocks normally trade on an exchange, and the most well-known are the New York Stock Exchange and the Nasdaq, though many smaller stocks trade without an exchange on the “over the counter” market. While movies often portray the stock market as a trading floor in New York, virtually all trading is done electronically now.

The phrase stock market has yet another meaning, referring to several stock indexes, or collections of stock. These indexes include the Dow Jones Industrial Average (comprised of 30 stocks), the Nasdaq Composite (100 stocks), and the Standard & Poor’s 500 (500 stocks). The indexes comprise some of the biggest and most successful companies from a wide variety of industries, and they are intended to represent the stock market as a whole.

So that’s what the stock market is, but what does it do and why does it exist?

So what does the stock market do?

The stock market allows companies to raise capital from investors by issuing them stock in exchange for money. Stock buyers want to own a piece of the company and enjoy any gains that come from ownership of it. They’re part-owners of the company — that’s what stock is.

The stock market fulfills a central need in capitalism: to raise capital for businesses that want it and to direct it toward socially beneficial (or at least profitable) enterprises. Raising money from a variety of investors allows the company to fund itself more easily than if it were to raise that money from one investor, and it spreads the risk of investing among many investors. The stock market makes it easier for both groups to participate and fund valuable enterprises.

These days it’s incredibly simple to open a brokerage account, and many brokerages don’t even have a minimum deposit.

So if the stock market helps companies raise money, why does the stock continue to trade after the company has raised money? There are at least three major reasons:

  1. The stock market allows investors with different views on a company to buy and sell their stock. If investors foresee a stock performing well, then they can buy it from another less-optimistic investor. If the company is successful, shareholders will likely see the value of their stock rise as more people want to own it.
  2. The stock market allows the investors to see how any public company is valued, giving new start-ups insight into what kinds of companies can be funded and increasing the number of innovative companies being funded.
  3. The stock market also allows already-public companies to raise even more money based on the strength of their stock, which is determined by investors’ confidence in the company’s performance.

Because it shows investors’ confidence in the economy and their estimate of the future, the stock market tends to be an excellent barometer of the economy’s health. The stock market is like a giant voting machine that counts the votes of all investors, resulting in a prediction about the future of the economy.

A rising market signals that investors are “bullish” and want to own stocks before they become more expensive. The market begins to turn up months before the economy emerges from a recession. Conversely, a falling market suggests that investors fear a slowing economy and want to sell before stocks go down. Usually several months before a recession begins, the market experiences a crash, as investors see signs of weakening business activity.

The history of the stock market

The New York Stock Exchange was founded in 1792, when 24 stock brokers signed the Buttonwood Agreement under a buttonwood tree outside 68 Wall Street, as seen in the depiction of the image above. The agreement limited commissions on trades and specified that the brokers would deal only with each other, cutting out auctioneers and their fees from the process. While the New York Stock Exchange is the most famous American exchange, its founding was preceded by the Philadelphia Stock Exchange in 1790. But sitting at the confluence of so much trade and banking, New York’s exchange became dominant.

Twenty-five years after its founding, the exchange officially moved off the street, moving in to 40 Wall Street. At that time the group also renamed itself the New York Stock and Exchange Board. The exchange expanded beyond stocks and government bonds, especially as the growing U.S needed capital for ventures such as the railroads and gold mining. In 1865 the exchange moved into its current location at 11 Wall Street.

From person-to-person trading, the exchange has had to evolve to electronic trading as rivals such as the Nasdaq introduced the more efficient trading method. To compete better, the New York Stock Exchange acquired the Archipelago exchange, an all-electronic platform, in 2005, as well as the American Stock Exchange shortly thereafter.

The advent of the Nasdaq made trading more efficient, helping reduce costs as well as the bid-ask spread. The Nasdaq was founded in 1971, and it was the world’s first electronic stock exchange and had no physical exchange. The exchange’s name derives from its founders: the National Association of Securities Dealers and its Automated Quotations system. Initially, the exchange traded many of the stocks that had been formerly trading on the “over the counter” market. Now it’s world famous for listing the top names in the technology sector. In fact, it’s so tech heavy that its name has become a synonym for tech stocks. The Nasdaq was the first market to trade online in the U.S., and its continued to push for the efficiency of the exchange.

How do you invest in the stock market?

If you’re looking to invest in the stock market, you’ll need some cash and a brokerage account. The amount of cash you’ll need depends on what stock you want to buy — they’re all priced differently — and whatever minimum deposit your broker requires to open an account.

These days it’s incredibly simple to open a brokerage account, and many brokerages don’t even have a minimum deposit. In fact, you can get started in about 15 minutes and fund your account quickly. From there you can begin placing trades and participating in the market as an investor.

By Mackenzie O'Connor
Wealthbase Contributor

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