The working principle of stock markets

Share prices are identified by market supply and demand, as buyers and sellers place orders. Specialists or market makers also manage the order flow, and bid-ask spreads to ensure an efficient and fair market. A company’s stocks or bonds reflect the company’s ownership interest, which gives shareholders voting rights and residual corporate earnings, claiming capital gains and dividends. The capital markets are where private and institutional investors come together in a public forum to buy and sell shares. Such exchanges today operate as electronic marketplaces.

If the idea of investing in the stock market horrifies you, you aren’t alone. Individuals with minimal equity investment experience are often terrified by the average investor’s horror stories losing 50% of their portfolio value. In reality, investment in the stock market entails risk, but cautiously, this is one of the most successful ways to up one’s net worth. Most of the rich and very wealthy typically have the majority of their wealth invested in stocks. 

The stock market is an exemplary example of the real-time laws of supply and demand at work. You have to have a buyer and a seller for any stock trade. Because of the uninterrupted supply and demand rules, when there are more buyers for a given stock, the stock price would rise. Conversely, if there are more stock sellers than buyers, then the price will fall.

Many stock markets rely on skilled traders to sustain consistent bids and offers because, at any given moment, a motivated buyer or seller cannot find each other. They are known as market-makers or specialists. A bid and offer consist of a two-sided auction, and the spread is the price difference between the bid and the offer. The smaller the price spread and the more extensive the bids and offers (the number of shares on either side), the higher the stock’s liquidity.

It was initially performed manually to match buyers and sellers of stocks on an exchange, but it is now primarily carried out by computerized trading systems. The manual trading process was based on a mechanism known as “open outcry,” in which traders used verbal and hand signals to buy and sell large quantities of stocks in the “trading pit” or an exchange floor. In most markets, however, electronic trading systems have replaced the open outcry system. Such systems can match buyers and sellers much more effectively and rapidly than humans can, resulting in significant advantages such as lower trading costs and quicker trading execution.

Numerous studies have revealed that stocks produce returns on investment over long periods, which are superior to those of any other asset class. Returns on stocks come from capital gains and dividends. A capital gain arises when you sell a stock at a higher price than the price you bought it. A dividend is a share of income paid by a company to its shareholders. Dividends are a significant component of stock returns — since 1956, profits contributed almost one-third of the overall return on equity, while capital gains contributed two-thirds of the back.

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