How does the stock market actually work?Easy

Two markets wearing one name: the one where a company raises money, and the far larger one where investors trade with each other and the company gets nothing.

4 min read · 661 words

The short answer: there are two markets and they are usually confused. In the primary market a company sells new shares and receives the money. In the secondary market investors buy and sell those shares from each other, and the company receives nothing at all. Almost everything called "the stock market" is the second one.

The primary market: where the money reaches the company

This happens rarely for any given company — at a listing, and occasionally afterwards. An IPO is the first time; a rights issue is one of the ways it happens again. The desk that arranges it is equity capital markets.

The secondary market: where the price comes from

When you buy a share, the money goes to whoever sold it. The company is not a party to the trade and does not know it happened until the register updates. The price is simply the level at which a buyer and a seller last agreed.

Mechanically it is an order book: everybody willing to buy, listed with their prices, against everybody willing to sell. The highest bid and the lowest offer face each other, the gap between them is the spread, and a trade happens when one side crosses it. Market microstructure is the page on how that actually behaves, and what happens when you press buy follows one order through it.

Who is on the other side

Usually not somebody who disagrees with you. Most of the volume is people with no opinion about the company at all: a fund tracking an index that has to hold whatever the index says, a market maker quoting both sides for the spread, somebody rebalancing, somebody meeting a redemption. Who is on the other side is the page on why that matters.

Which leads to the fact that explains more short-term price moves than any other: a price is set by whoever has to trade, not by whoever has the best argument. An index fund at a rebalance, a fund meeting redemptions, a leveraged position being closed out — none of them is expressing a view, and all of them move prices.

What you actually own

A share is a vote, a claim on whatever is left after everybody else is paid, and no promise of anything. What a share really is is the page. And you almost certainly do not hold it directly — there is a chain between your statement and the company's register, and who actually holds your shares follows it link by link.

Why the price does not equal the value

The price is what the last two people agreed. What the business is worth is a separate estimate that reasonable people disagree about, which is why valuation is a whole discipline rather than a lookup. Over long periods the two tend to meet; over short ones they need not, and nothing forces them to by any particular date.

What actually decides a long-run return

Not the trading. Over years it is what the businesses earn, what they pay out, what you paid to begin with, and what was deducted along the way — what drives returns takes the four apart. Two of the four are decided before you own anything, and one of them, cost, is the only one entirely within your control.

What can go wrong that is not the market falling

• Your broker fails — a different question from the shares falling, with a different answer.
• You do not get the price you saw — the screen showed one side of a two-sided market, for a size, at a moment that had passed.
• 2010 — what happens when the order book empties for a few minutes.

The one sentence to take away

When you buy a share you are buying it from another investor, not from the company — which is why the price tells you what somebody else would pay today and nothing directly about what the business earned.