How do modern stocks work? - April 29, 2018

How do modern stocks work?

Stocks have been around for 400 years and they are still among the favoured investments. But how did they change during this long period and how do they work nowadays? We will answer this question for you!

We already wrote about the history of stocks: they appeared approximately 400 years ago in Amsterdam. The reason the first stocks were released was simple: merchants needed capital (and risk sharing) for their long journeys. In exchange, they shared the profits. Now stocks serve a similar, yet very different purpose.

How are stocks born?

These days, stocks are issued by companies when they try to raise money for expanding. This is called an IPO (Initial Public Offering) and it’s a rather difficult process. It’s often helped by an investment bank and always monitored by authorities. In the US, the latter is handled by the U.S. Securities and Exchange Commission (SEC). The company must provide information to the SEC about its financial and legal status, background and plans on how to use the money from the IPO.

If every information provided checks out, the SEC approves the IPO. Before the IPO, the company (and the investment bank if there was one) decides on the IPO price, which will be the starting price of the stock. After the IPO, the company becomes publicly traded and their stocks can be bought and sold in an exchange. The company itself only receives money after the stocks were sold during the IPO (or the ones it owns). Stocks bought and sold by investors later make no money for the company.

Why do investors buy them?

There are several answers to the question of why people buy stocks. When investors buy stocks, they buy a part of the company. This is the reason why stocks are also called shares. Having a share in a company can mean several things. If someone has enough shares, they can have the power to influence (or run) the company. If a company pays dividends after their shares (not all of them does) the owner may also profit from that.

Dow Jones' inflation adjusted rise in the 100 years

Click on the image to see it in full resolution

However, investors usually buy shares to sell them later as the price of shares tends to rise over time. In the chart above, for example, we can see that Dow Jones has constantly risen in the last 100 years, and not even history’s biggest crises were able to stop it. This means that if someone has the capital and is patient enough, they can realize profit just by holding on to a share. In the last 5 years, S&P 500 and Dow Jones has risen more than 84%, which is the minimum suggested time of a long-time investment. Investors also tend to diversify their stocks, creating a portfolio, which can have even better performance. Some investors also try to predict the market movements and buy and sell shares accordingly, but for that, serious understanding of the market is needed. Common investors are usually better off with a portfolio and patience.

Are they safe?

Stocks are safe, but no investment is without risks. The legal procedure before an IPO guarantees a great level of safety. Even after the initial offering, authorities are monitoring trading. Still, prices can change: they can rise and, yes, fall. This is, however, not connected to safety, but to what the market (basically the sum of investors) thinks of a company and what investors expect. Stocks also have companies behind them therefore real economic performance is connected to them.

It’s also important to mention that even after huge falls, like the one we’ve seen during the financial crisis of 2008, prices crawl back up. Now they are even higher than they were back then. Shares also recovered faster than real estate did, according to some papers. Stocks also tend to have relatively high returns compared to their risks. If an investor wants lesser risk, they can still choose government bonds, which are considered among the safest investments albeit they usually have smaller returns.

Disclaimer: This analysis is for general information and is not a recommendation to sell or buy any instrument. Since every investment holds some risk, our main business policy is based on diversification to minimize threats and maximize profits. Innovative Securities’ Profit Max has a diversified portfolio, which contains liquid instruments. This way, our clients can maintain liquidity, while achieving their personal investment goals on the long term.