This is Part 1 of a series. I am not claiming to be an expert by any means, this is just an effort for me to internalize things I’ve learnt.
I recently got into short-term investing via Robinhood with the monetary spoils of my summer job. And I was reading The Hard Thing about Hard Things by Ben Horowitz. While Horowitz’s book isn’t specifically about the stock market - it does talk about IPOs and shareholders and dividends and the such quite a bit. Words that used to go over my head not too long ago. I realized I would have loved to read an article like this, didn’t find one, and so set out to be the change I wished to see in the world (you can laugh if you get the joke).
The thing about the stock market, I realized, is that most people know something about it, and some people know a lot about it. But for the most part, a lot of people are pretty in the dark about how it all works.
As Harari writes in Sapiens, the stock market is a second degree chaos system. Predictions about the stock market influence the stock market. So they necessarily cannot be spot on. There are still tons of people who try and make predictions about the market anyway. Algorithmic traders and quants make predictions. Traders on Wall Street make predictions. Pundits make predictions. By buying a stock or fund, you are effectively attempting to make predictions about the stock market.
It’s often useful to think from first principles. Let’s apply it to the stock market.
Why was the stock market started?
Precursors to stock trading existed in France, where certain people purportedly traded with agricultural debts. According to Wikipedia, bankers in 13th century Venice traded government securities.1
But the exigency for stock markets was when traders in the New World wanted to raise a lot of capital quickly. Raising a fleet was not cheap. Begging the monarchy or the rich to invest in businesses was not efficient and not something people without connections could do. So traders realized that they could be funded by the people. It’s a lot like modern-day crowdfunding in theory.
The Dutch East India Company2 issued paper shares in the early 1600s - which means they printed tons of sheets of paper, each representing ownership of a certain fraction of the company, and sold these to investors. Regular people could be investors. People who bought these paper shares sold them to other people, effectively transferring ownership. The first stock market was born. It seemed like a great way to raise money quickly.
To this day, one of the most common reasons for a company wanting to “go public” is so that capital can be raised quickly. In many ways, it’s liberating for a company to IPO - they don’t have to borrow from a bank at a high interest rate, long-term projects can be prioritized, there’s more a company can do with an influx of capital that they don’t necessarily have to return to anybody.
Now that we understand why stock markets are a thing, let’s talk about how they affect governments, agriculture and industry. And then we can talk about trading on an app like Robinhood.
How do markets affect governments?
Bond markets most definitely affect governments. It’s how they raise capital. Just like the Dutch East India Company wanted money for expeditions to plunder the New World and their other territories - the government from time to time wants money to build highways and ports. They can’t just print more money for this,3 they need to ask people for this money. And we’re dealing with billions of dollars here.
Let’s say the government wants a $100 million to build a new freeway. Instead of straight up asking for a $100 million dollar loan at a 7% interest rate, the government “asks” for 200,000 loans at a 7% interest rate of $500 each. This is a small, approachable quantity - even I could loan the government $500. These bonds are then traded on the secondary market. So my friend Jack could buy the bond off me.
Depending on what the Fed’s interest rate is, you could conceivably buy a bond off of somebody for lesser than the principal. Sal does a great job of explaining it here.
When you hear about the S&P 500 or the NASDAQ being on a 52-week high, that is a reflection of a section of the stock market performing “well”, in the sense of investors making money4 on their stock investments.
The New York Stock Exchange is a company that maintains a database that is a one-stop shop for people who want to trade stocks and other financial instruments. In the past, stocktraders would go to the physical building in Wall Street, and make trades there. Now we all use our computers, but still trade through the NYSE’s database. The NASDAQ and the Bombay Stock Exchange are equivalents of the NYSE.
Just like how taking the derivative of a function gives you the slope, a derivative in finance is a bet on the rate of change of the value of a stock, or a bond, or an index. Things get fairly meta. You can also bet on sugarcane harvests or oil prices.
You could bet on the direction of the price of a particular stock or Exchange-traded Fund (an index that is an amalgamation of various stocks and commodities).
Brokers are middlemen. They take money from one party and hand it to the other, and often take a commission in doing so. Robinhood, my broker of choice, does not take a commission.5 Brokers arrange for a transaction to occur, and help you execute a trade at the best possible price. They interface with, and pay, the NYSE, in order to do this.
The actual trading is often more than just plain vanilla buying and selling. You could automate the buying and selling. There is STOP LOSS, which is a method wherein you limit your losses by automating the sale of your stocks when the price touches a predetermined low point. There are LIMIT orders, which are orders which help automate the buying of stocks when they hit a certain low price, and selling stocks when they hit a predetermined minimum price you’re willing to sell them at.
Take the Vanguard Total Stock Market ETF. The ETF is cap-weighted, which means its components are weighted in proportion to how valuable the companies in question are.6 The volume is the number of shares traded on a given day. Price-Earnings Ratio is the ratio between the price of a share and the earnings (or profit - dividends7) per share. The dividend yield is the ratio between the dividend and the price of the share. Highs and lows are self-explanatory. These are all just numbers at the end of the day.
Wall Street firms trade stocks/bonds/securities/fancy-financial-instruments for a profit. A lot of them use the money of clients, and take a cut from the profits. Most firms hire analysts to make intelligent guesses, many like Jane Street Capital and Hudson River Trading hire quants to use math and programming to make intelligent guesses.
Day trading, for the most part, is a zero-sum game. The economy as a whole, however, isn’t necessarily that way. Companies create value, and the economy has grown over time. There don’t have to be losers everytime there are winners.
(To be continued)
[UPDATE: I just realized Buzzfeed News had an article with the same headline, but this is the sentiment I wished to convey.]
what’s a security, you ask? Government securities, or government bonds (they are essentially the same thing) are one of the important ways governments raise capital. Think of it like this, instead of the US government sending a guy to the Wells Fargo on Pennsylvannia Ave to ask them for a loan to build a highway in Alaska, they instead take a loan from the general public. They issue “bonds”, small pieces of their loan, that all yield a certain interest rate, and people like you and me can go buy pieces of their debt, and receive the interest. ↩
which ended up ruling Indonesia and committing atrocities there, whole other post about how companies can become like governments when we let things go too far. ↩
well they could, but that’s another matter. ↩
It’s not real money until you’ve cashed out, but then numbers on a spreadsheet are arguably what we mean by money. ↩
Typically only outstanding shares, or shares available for trading by the public, are considered. ↩
Money just handed out to investors every so often. ↩