What is the stock market?

What are capital markets? What are stocks? What are securities? What are we doing here? We’ll be going through these questions so you too can lose all your money in the stock market.

The history of the stock market dates back to the 17th century when the Dutch East India Company issued shares of stock to finance its voyages to Asia. Individuals could fund these ships in exchange for a share of the profits. More money meant that you could grow as a company much faster: here, the company is the ships, and ships had more funds to travel further and do more fancy stuff. But as an investor, there’s a risk of the ships not making more money because of pirate, scurvy, or misappropriating investor funds.

The first stock market was the Amsterdam Stock Exchange, but who cares about what Europeans are doing. In the United States, the first stock exchange was established in Philadelphia in 1790. And the New York Stock Exchange (NYSE) was founded in 1817.  

In the early days, most stocks were traded in person on the trading floor of the exchange, but with the advent of technology, electronic trading became more common. Shares of stock are traded on stock exchanges, and their prices can fluctuate based on a variety of factors, such as the company’s financial performance, news affecting the industry, global economic conditions, or a community of nerds with gambling addictions.

Throughout history, the stock market has experienced many booms and busts, including the stock market crash of 1929 that led to the Great Depression, the dot-com bubble of the late 1990s, and the global financial crisis of 2008. Despite these challenges, the stock market has continued to play a crucial role in financing businesses, creating new industries, and providing opportunities for individuals to invest and build wealth.

The stock of a company represent ownership in a company. When you buy a share of stock, you essentially become a part owner of the company, entitled to a portion of its profits and voting rights in company matters, like electing board members or approving major decisions. Shareholders can also benefit if the value of the company grows and the stock price increases, as they can sell their shares at a higher price than what they originally paid. This profit is called capital gains.

Some stocks pay dividends, meaning shareholders receive some payment (cash or more stocks) for holding the stock, but not all stocks pay dividends and instead reinvest profits back into the business. That little piece of the company can be really valuable to somebody who wants a lot of little pieces for a really big piece.

Voting also becomes important for other major decisions like mergers and acquisitions (taking over or combining companies), financing or buying large assets. The voting becomes important and you can have little proxy wars where a Game of Thrones like whispering happens to sway people to vote in certain ways.

Stocks can be from private or public companies. Private companies have limited ownership, fewer regulatory obligations, and raise funds through private means. They enjoy more privacy and control but may have limited access to capital and less liquidity for owners. Private companies can go public through an Initial Public Offering (IPO).

Public companies are owned by shareholders who trade shares on public exchanges. Major stock exchanges include the New York Stock Exchange and the NASDAQ. They face higher costs and regulatory scrutiny but have access to more capital. Those fancy graphs you see are the prices of the stocks of public companies.

“Securities” is a broader concept, and stocks or shares is one example of securities. Others include bonds, derivatives, mutual funds, ETFs and maybe even cryptocurrencies. We know what stocks are–just partial ownership of a company that gives you certain rights, like profits or voting.

Bonds, on the other hand, are debt securities that represent a loan made by an investor to a company or government. The issuer of the bond agrees to pay back the investor the principal amount borrowed plus interest over a specified period of time. Basically, fancy IOUs.

Derivatives are securities that derive their value from an underlying asset or financial instrument, such as a stock, commodity, or currency. Examples of derivatives include futures contracts, options, and swaps. This is the area where people gamble with each other.

ETFs and mutual funds are just a basket of different securities, however you want to pick and choose securities (stocks, bonds, the biggest companies, tech companies, whatever). But ETFs, exchange traded funds, trade on a stock market, and are not actively management (meaning nobody is really looking at them closely). Mutual funds differ because they are usually actively managed. There are some other marginal difference, but who cares.

Securities are regulated, in the US, by the Securities and Exchange Commission, who are a really fun group of people. SEC v. W. J. Howey Co. (1946) is a landmark case in United States securities law. W. J. Howey Co. sold tracts of citrus groves to investors. Buyers were offered service contracts whereby Howey-in-the-Hills Service, Inc., a related company, would tend to the groves and harvest and market the produce. Most buyers were not residents of Florida, lacked the agricultural expertise, and relied on the service contracts for the success of their investment. The SEC brought an action against W. J. Howey Co., a Florida-based company, for selling unregistered securities. Surprise, surprise, another historic contribution from Florida: securities fraud.

The primary legal issue was whether these transactions constituted an “investment contract” and thus a security under the Securities Act of 1933, requiring registration with the SEC. All securities must be registered or fall under an enumerated exemption. The U.S. Supreme Court ruled in favor of the SEC. The Court established the “Howey Test” to determine what constitutes an investment contract (or what counts as a security):

• An investment of money
• In a common enterprise
• With an expectation of profits
• Solely from the efforts of others

Lawyers like to set up legal tests like these, applying to different cases with different facts, and annoyingly say “it depends” and bill 40 thousand dollars to tell you maybe wont get sued.

The Howey Test became the standard for determining whether certain transactions qualify as investment contracts. The Howey decision has had a lasting impact on securities regulation. It continues to be a pivotal point of reference in various contexts, including modern-day cases involving cryptocurrencies and other financial instruments. Ok, that’s enough law stuff for me. Let’s move onto the finance stuff.

There are a lot of players in the stock market, but let’s focus on the most popular: investment banks, asset management companies, and retail investors.

Investment banks (Goldman Sachs, Morgan Stanley, JP Morgan) are specialized financial institutions that provide a variety of financial services to corporations, governments, and other institutions. They play a crucial role in the financial markets by facilitating capital raising, providing advisory services, and engaging in trading activities.

One of their primary functions is capital raising. This includes underwriting securities such as stocks and bonds, where they determine the pricing, purchase them from the issuer, and then sell them to investors. Additionally, investment banks assist private companies in going public through Initial Public Offerings (IPOs), enabling these companies to raise capital from the public for the first time. In the realm of trading and sales, investment banks engage in market making, buying and selling securities to ensure market liquidity. They’re fancy fundraisers.

Another significant function is providing advisory services, particularly in mergers and acquisitions (M&A). Investment banks offer strategic advice, help identify potential targets or buyers, negotiate terms, and structure deals to facilitate corporate transactions. They also provide financial restructuring services, advising companies on reorganizing their structure, debt, and assets to enhance financial stability and performance. They’re fancy marketers.

Investment banks often have asset management divisions that manage investment funds and portfolios for institutional and individual investors. These divisions provide services such as portfolio management, financial planning, and investment advisory. Additionally, investment banks conduct detailed financial research and analysis on industries, companies, and market trends, which aids in informed investment decisions and supports their trading and advisory activities. They also participate in proprietary trading, using their own capital to trade financial instruments like stocks, bonds, and derivatives for profit. Furthermore, they offer brokerage services, acting as intermediaries to execute buy and sell orders for clients, including institutional investors and high-net-worth individuals.  Finally, investment banks help clients manage financial risks through hedging strategies and derivative products. They offer customized solutions to mitigate risks related to interest rates, currency fluctuations, commodity prices, and other financial variables. They’re fancy traders.

Asset management companies (AMCs) (BlackRock, Vanguard, Fidelity) are financial firms that manage investment funds and portfolios on behalf of individuals, institutions, and governments. The main types are mutual funds, hedge funds, private equity, and pension. Their primary role is to invest clients’ funds in various financial instruments to achieve specific investment objectives. One common way to distinguish them between investment banks (although there are overlaps) is that IB are usually selling and AMC are usually buying.

AMCs select and manage a mix of assets including stocks, bonds, real estate, and commodities to create diversified investment portfolios. Portfolio diversification is a key function of AMCs. By spreading investments across various asset classes, sectors, and geographical regions, AMCs aim to reduce the risk associated with poor performance in any single investment. Research and analysis are critical components of the AMC’s operations. They employ financial analysts and investment managers who conduct in-depth analysis of market trends, economic data, and company performance. Risk management is another crucial aspect of AMC services. They employ various strategies and tools to mitigate risks, ensuring that investment portfolios align with the clients’ risk tolerance and investment objectives. Continuous performance monitoring and reporting are also vital functions; MCs track the performance of investments and make necessary adjustments to optimize returns. In addition to managing investments, many AMCs offer comprehensive financial advisory services which include helping clients develop investment strategies, plan for retirement, manage taxes, and achieve other financial goals. AMCs are weird giant monsters of capitalism and they’re often in the news for a lot of evils, but it’s more like a monster who eats and eats indiscriminately rather than some illuminati Machiavellian prince.

Retail investors are you and me, the non-institutional investors. We have our little brokerage account with a firm like Robinhood or Wealthsimple and try to mimic the research and analysis of billion dollar institutions with Google searches and TikTok astrology courses. Or maybe we’re a bit more sophisticated, finished level 1 of the CFA and watched Aswath Damodaran’s lectures while pretending to know how to read a 10-K.

It is easy to get discouraged and overwhelmed when you’re competing with quantitative traders with PhDs and supercomputers, analysts working 90-hour weeks researching one company, and, frankly, illegal practices. But it’s important not to fall into the hype of stories of windfalls of money, and then try to take shortcuts to gamble away your savings or fall victim to scams. For the vast majority of people, your best bet is to stick all your money into an index and forget about it.

Going off script, I think there are small ways retail investors can try to change the behaviors of corporations and institutions. We can play the game of neoliberalism and vote with our wallets. Buy the stocks of companies supporting greener initiatives, vote in qualified directors of the companies from underrepresented groups, and bring to light any unethical corporate practices. As the great Caesar said, “apes together strong.”