Investors buy stock for the potential to gain a return on their investment. Companies issue stock (also called shares) to grow their business. There are many stock markets across the globe. There are also many different factors that can affect stock prices.
Understanding how the stock market works can help you with your investing strategy.
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What is the stock market?
The stock market brings together people who want to buy stock and people who want to sell stock. When you buy stock (or equity) in a company, you own a share of the company and become a part owner. That’s why stocks are also called shares.
There are two types of stock markets:
- Primary market – where the first sale (or offer) of stock by a private company to the public happens. This is also referred to as an initial public offering.
- Secondary market – where subsequent buying or selling – often called trading – of a company’s stock takes place.
Stocks may also be referred to as equities. Equities are one of the three main asset classes, or types of investments: equities (stocks), fixed income investments (such as bonds), and cash or cash equivalents (such as guaranteed investment certificates). Learn more about different types of investments.
Where are stocks traded?
What we call the stock market is actually many different markets around the world that trade securities like stocks and bonds. This trading typically happens on stock exchanges but can happen on other kinds of marketplaces.
1. Stock exchanges
A stock exchange is a market where an investor can trade securities in a publicly visible manner. Trading on stock exchanges is governed by rules that apply to all users of that exchange. All stock trades are now done electronically.
If a company is listed on a recognized stock exchange, it must:
- Distribute a certain number of shares.
- File appropriate information about its management team.
- Provide specific financial information.
Some of the most widely known stock exchanges in Canada focus on certain kinds of investments. For example, the Toronto Stock Exchange (TSX) serves the senior equity markets and lists well-established companies.
2. Other marketplaces
Stocks are also traded through other marketplaces including:
- Alternative trading systems (ATSs)– automated trading systems that bring together dealers and institutional investors who trade large quantities of stocks.
- Over-the-counter (OTC) markets –dealer networks where “unlisted” stocks are traded.
How are stock prices set on a stock exchange?
The buyer and seller must agree on a price before a stock can be bought or sold. Here’s how it works:
- People compete to buy the stock if they believe that its price will rise, and they will make a profit.
- Sellers compete to find buyers for their stock at the highest possible price.
- There are usually several investors trying to buy and sell stock in the same company at the same time. It’s like a big, computerized auction.
- Once a stock is bought or sold, the price is posted so that everyone knows the latest price.
For a stock exchange to be successful, it must be perceived as fair and equitable, where information is public and visible.
The stock market is influenced by many factors and is tracked in different ways. Learn more about how the stock market works.
What is an initial public offering (IPO)?
The primary market is made of initial public offering (IPOs). An IPO is the first sale of stock by a private company to the public. It’s often called going public.
There are five main reasons why a company may have an IPO:
- Raise capital – The company can sell shares to raise money to expand and improve its business.
- Get financing – It may be able to borrow more easily and on better terms.
- Attract good people – It will be more likely to offer stock purchase plans or stock options to keep its top employees or attract new ones.
- Create a stronger brand – Going public often creates more media attention so people get to know a company’s brand better.
- Attract other companies – Other companies may evaluate it for potential mergers and acquisitions.
A public company is more closely watched by securities regulators. It also must meet tougher reporting rules.
What should you know before investing in an IPO?
There are advantages and disadvantages to investing in an IPO.
- The main advantage is that, if the company continues to grow, the stock you purchased during the IPO has the potential to yield dividends.
- The main disadvantage is that it is difficult to predict if or when the value of the stock will increase. It’s also possible that the stock value will decrease after the IPO or take a long time to increase at all.
Before you invest in an IPO, it’s a good idea to consider these questions:
- What are the risks? – IPOs are usually riskier than a stock that’s been on the stock market for a while. Before you decide, read the prospectus from the company issuing the IPO. The prospectus describes the business plan and notes important risk factors. Check whether the company is making money or when it expects to become profitable.
- Are there any fees? – In most cases, you won’t pay any commission to buy an IPO. That’s because the company issuing the IPO hires underwriters to price and market the new stock. Underwriters get large fees for their services. Their fees are built into the initial offering price of the stock.
No one can predict how the price of an IPO will change once it goes on sale. That makes it a risky investment.
What factors can affect stock prices?
When you buy stock, you’ve purchased an investment that could go up or down in value. It can be difficult to predict whether it will go up or down, by how much, and when. It can help to learn more about the factors that can affect stock prices. Specific news about a company’s earnings can influence stock prices. And so can a change in how investors feel about the stock market in general.
If you are a DIY investor, learning more about these factors can help you develop your investment strategy. Along with understanding your own investing goals, time horizon, and tolerance for risk. If you work with an advisor, you may choose your advisor based on their expertise in these areas.
There are four main factors that can affect stock prices:
- Company news and performance
- Industry performance
- Investor sentiment
- Economic factors
1. Company news and performance
The way a company is performing can indicate whether it is growing or declining. There are some company-specific factors that can affect the share price including:
- news releases on earnings and profits, and future estimated earnings
- announcement of dividends
- introduction of a new product or a product recall
- securing a large, new contract
- employee layoffs
- anticipated takeover or merger
- a change of management
- accounting errors or scandals
2. Industry performance
Often, the stock price of companies in the same industry will move in tandem with each other. This is because market conditions generally affect the companies in the same industry the same way. For example, if a product made by one company is reported to be unsafe, then this may affect other companies that produce the same product.
But sometimes, the stock price of a company will benefit from a piece of bad news for its competitor if they are competing for the same market. For example, if a company making a popular product has to halt operations, then other companies that make a similar product would have more demand.
3. Investor sentiment
Investor sentiment or confidence can cause the market to go up or down. This can cause stock prices to rise or fall. The general direction that the stock market takes can affect the value of a stock. There are two types of broad descriptions for the market:
- Bull market – A strong stock market where stock prices are rising, and investor confidence is growing. It’s often tied to economic recovery or an economic boom, as well as investor optimism.
- Bear market – A weak market where stock prices are falling, and investor confidence is fading. It often happens when an economy is in recession and unemployment is high, with rising prices.
4. Economic factors
Several economic factors can influence the value of an individual stock or the stock market in general, including:
Interest rates
The Bank of Canada can raise or lower interest rates to stabilize or stimulate the Canadian economy. If a company borrows money to expand and improve its business, higher interest rates will affect the cost of its debt. This can reduce company profits as well as the dividends it pays shareholders. As a result, its share price may drop. And, in times of higher interest rates, investments that pay interest tend to be more attractive to investors than stocks.
Economic outlook
If it looks like the economy is going to expand, stock prices may rise. Investors may buy more stocks thinking they will see future profits and higher stock prices. If the economic outlook is uncertain, investors may reduce their buying or start selling.
Inflation
Inflation means higher consumer prices. This often slows sales and reduces profits. Higher prices will also often lead to higher interest rates. For example, the Bank of Canada may raise interest rates to slow down inflation. These changes will tend to bring down stock prices. Commodities, however, may do better with inflation, so their prices may rise.
Deflation
Falling prices tend to mean lower profits for companies and decreased economic activity. Stock prices may go down, and investors may start selling their shares and move to fixed-income investments like bonds. Interest rates may be lowered to encourage people to borrow more. The goal is increased spending and economic activity. The Great Depression (1929-1939) was one of the worst periods of deflation ever.
Economic and political shocks
Changes around the world can affect both the economy and stock prices. For example, a rise in energy costs can lead to lower sales, lower profits and lower stock prices. An act of terrorism can also lead to a downturn in economic activity and a fall in stock prices.
Changes in economic policy
If a new government comes into power, it may decide to make new policies. Sometimes these changes can be seen as good for business, and sometimes not. They may lead to changes in inflation and interest rates, which in turn may affect stock prices.
The value of the Canadian dollar
Many Canadian companies sell products to buyers in other countries. If the Canadian dollar rises, their customers will have to spend more to buy Canadian goods. This can drive down sales, which in turn can lead to lower stock prices. When the price of the Canadian dollar falls, it makes it cheaper for others to buy our products. This can make stock prices rise.
Summary
The stock market brings together investors and companies — people who want to buy stock and people who want to sell stock.
- Stocks, bonds, and other securities are traded on the stock market.
- The primary stock market is composed of initial public offerings or IPOs — where companies ‘go public’ for the first time.
- The secondary stock market is where investors buy and sell stock from companies which have already gone public. This is often called trading.
It is hard to know whether the price of a stock will go up or down. Many different forces can affect stock prices, including company news and performance, industry performance, investor sentiment, and economic factors.
