Stock markets exist to serve the economy. They do this by providing the opportunity for companies to raise capital, for investors to make money, and for the government to collect taxes from both.
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This answer may raise more questions than it answers. How exactly does the stock market offer these opportunities for companies, investors and the government? what about ordinary people who are not investors? How does the stock market affect you? how and when did the stock market arise?
Reading: Why does the stock market exist
In this post, we’ll dive a little deeper into why the stock market exists, and in doing so, answer all of these questions and more.
defining the stock market
Before we dive in, let’s take a second and define what we mean by “the stock market.” The stock market has a long history where investors can buy and sell shares. The stock market is often described as a singular entity: “the” stock market. In reality, the stock market is not a place or an exchange. Instead, any investment made in a stock market is part of the stock market. The United States has a significant presence in the stock market in part because it is home to the two largest stock exchanges: the New York Stock Exchange and the Nasdaq.
When a person refers to the stock market by saying something like “the stock market closed today,” this term is a shorthand for how stocks have performed recently and usually refers to one of the major indices, a Often the S&P 500 or the Dow Jones Industrial Average. These indices represent the performance of all stocks, although they don’t come close to including every stock in the market.
stock market history
Understanding why the stock market exists helps to know how it came about. There are arguably a few different years that I could point to as the beginning of the stock market, but it was more of an evolution.
It all started in Europe with lenders serving people the bigger banks wouldn’t serve. these lenders eventually began negotiating debt with each other. Soon, they began negotiating this debt with clients and then with investors. in the 1300s, the Venetians went a step further when they began trading securities from other governments.
In 1531, Belgium had the first stock exchange, but investors couldn’t buy or sell stocks because technically they didn’t exist yet. many versions of partnerships between companies and financiers allowed investors to make money, but there were no company shares (stocks) for sale. therefore, the first stock exchange only had bonds and notes.
in 1602, the first “real” stock exchange was born; the amsterdam stock exchange, founded by the dutch east india company.
The Dutch East India Company was one of a series of East India companies that transformed how people made investments. Previously, investors would help fund the ship owner’s voyages for part of the profits. This could be risky for the investor, though, since the investor would lose his money if the journey was unsuccessful. The East India companies created a new model. They would allow investors to purchase a stock that paid dividends based on all the company’s voyages instead of one individual journey. In 1602, the Dutch East India Company began issuing paper shares. Paper shares could be traded among shareholders, which meant stocks could be bought and sold with other investors (the definition of a stock market). The East India companies were huge and essentially had a government-backed monopoly. This led to massive profits for investors.
the first official stock exchange (where people could formally meet to buy and sell stocks) was the london stock exchange, which was not formed until 1773. in the united states, the philadelphia stock exchange was the First stock exchange founded in 1790. Two years later, the New York Stock Exchange began trading with two dozen stockbrokers gathered under a buttonwood tree on what is now Wall Street.
how does the stock market benefit companies?
Throughout history, whether it’s Venetian moneylenders, Belgians trading bonds, East Indian companies raising travel money, or stockbrokers meeting under a tree, one thing has remained Same. These investments have helped companies prosper. the same goes today. The existence of the stock market allows companies to grow in ways that would otherwise be impossible, including giving companies a way to raise massive amounts of capital.
If it weren’t for the stock market, every time a company wanted to raise money, it would have to get a loan from the bank. then you would have to repay that loan with interest. Due to the existence of the stock market, when a company wants to raise capital, it can create an initial public offering (IPO). An IPO allows a company to raise a large amount of money without paying a loan or worrying about interest. many of the world’s best known and most successful companies were only able to move beyond the seed stage by raising millions or even billions of dollars through an initial public offering or secondary offerings.
During an IPO, investors pay a company to own a small piece of that company (also known as a share). This transaction has the potential to benefit both the company and the investor. the company raises capital, and if the value of the shares increases, the investor can make a profit by selling the shares.
The additional benefit of this way of raising capital is that when the company does well, it has the option of sharing its profits with investors through dividends. In years when it’s not doing so well, you have the option not to pay dividends. this is a much better deal for the business than a loan from a bank, which would have to make payments regardless of how the business is doing.
How does the stock market benefit investors?
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The existence of the stock market benefits companies, but it also helps investors by allowing them to make a profit. This does not mean that all investors will make a profit or that all investments will be profitable, but historically there have been many opportunities for many people to make a lot of money.
To get an idea of how much the stock market has benefited investors, let’s look at some historical returns and what those returns would mean to an investor.
for 90 years, from 1928 to 2016, the s&p 500 index (which, as mentioned earlier, is often used to measure the overall performance of the stock market) has averaged a 9.8% annual return . it is important to remember that this number is average. It does not mean that the stock market has returned 9.8% every year, just that over the course of 90 years, the average annual return is 9.8%. some years have seen higher annual returns and others lower.
What does an average return of 9.8% mean for investors?
let’s do some calculations. Let’s say you invest 10,000 and have an annual return of 9.8% for ten years. you would end up with 25,470. Although you have more than doubled your money, you have only just begun to harness the powers of compound interest. To see how that can affect an investment, let’s increase our time horizon. Let’s say you invest 10,000 and have an annual return of 9.8% for 30 years. you would end up with 165,223. that’s more than 150,000 in profit earned on a 10,000 investment.
please note; that these calculations are oversimplified. they do not take into account inflation or years with variable returns. And as anyone in finance will tell you, past performance is no guarantee of future results. But even with these simplified calculations, the message is still clear; Many investors have benefited significantly from the stock market.
how does the stock market benefit the government?
In simpler terms, more money means more taxes. As companies and investors make money, so does the government. As businesses have more money to spend, they can hire more people, which means more income taxes for the government. more people employed means more spending, which means more taxes collected.
The idea of paying more taxes may not sound appealing, but the ultimate goal of government is to serve the people. arguably how effectively it does this can vary, but that’s the ultimate mission. the more the government collects, the more opportunities it has to benefit its citizens and raise a country’s standard of living (more on this later).
It’s impossible to point to a specific amount of government money and say it’s thanks to the stock market. the stock market is so intertwined with the economy. it has so many implications that it is impossible to separate money into two distinct categories connected to the stock market or not connected to the stock market. The bottom line is that the stock market creates a huge amount of money, which provides the government with a huge amount of money.
what about the others?
As we’ve seen, the stock market benefits businesses, investors, and the government, but what about everyone else? The stock market and the economy go hand in hand, and what’s good for the stock market is often good for the economy. how the stock market impacts the economy and therefore every person in the country is incredibly complex and far-reaching. The stock market has a ripple effect that impacts every job, industry, and person. Two areas where we can see this most clearly are living standards and employment.
standard of living and stock market
The existence of the stock market leads to a higher standard of living. companies have access to more capital, creating more and better goods and services, increasing their size and hiring more people. the more jobs there are, the more people can make a living and spend their money in other industries, thus creating even more jobs. These improved products and services have a huge impact on our standard of living.
The standard of living also increases because the government receives more money. a government with more purchasing power can improve the standard of living in that country by establishing social safety nets, providing essential services, establishing rules and regulations to protect citizens, etc. To better understand this concept, let’s look at the role of the US government.
America’s government is certainly not perfect, but we often don’t realize how much government spending affects our daily lives. did you drive your car today? if so, you were on government created roads. did you get any mail today? if so, you can thank your mail carrier, a government employee. the list goes on and on: public education, college loans, organic food certification. All of these things, and much more, are funded by the United States. government.
The direct benefits people receive from the US government include the six major entitlement programs; social security, medicare, medicaid, food stamps, welfare and unemployment. According to a Pew Research Center survey, “71% of adults are part of a household that has benefited from at least one of these six programs.” that’s nearly three out of four adults. these programs increase the standard of living of many people by allowing them to retire, buy food, receive medical attention, etc.
The stock market also increases living standards by providing a means for people to save for retirement. pension plans and tax-advantaged retirement savings plans, such as 401(k), are invested in the stock market. These plans use the stock market to help investors save for retirement. Without these retirement savings plans, saving for retirement would be much more difficult and many people would have to work longer or not retire.
the stock market and employment
Another important way the stock market affects even non-investors is by creating jobs. this happens in several different ways.
As mentioned, the stock market allows a company to grow beyond the seed stage through an influx of capital raised by an IPO. more wealth allows the company to expand, which means more jobs. This increase not only means more jobs for the company’s employees; it also means more jobs for the companies and industries that support that company; this could include everything from marketing to suppliers. since the government also has more money, it can spend more money. this spending includes hiring more government employees, which also means more jobs.
Investors also have more money to spend, leading to more spending that creates more jobs. The thing about employment is that it’s cyclical. the more people can spend money, the more jobs will be created in other industries.
opportunities offered by the stock market
We’ve seen all the benefits of the stock market for companies, investors, the government and everyone else. Still, a discussion of the stock market would not be complete without also discussing some of the opportunities it provides. We’ll end this post by mentioning three of the most prominent opportunities: foreign investment, economic data, and higher standards for business.
foreign investment and the stock market one of the most important opportunities that the stock market provides is a way for people to invest in foreign markets. This offers us the opportunity to diversify by investing outside of the United States. Investors While this is a useful diversification strategy, the opposite is more often the case: foreign investors buy the US. stocks. these foreign investments represent a substantial amount of US dollars. investment in shares.
interest of foreign investors in the us. stocks is not so surprising. Compared to stocks in many other parts of the world, the US has a comparatively mature market with lower risk. at the end of 2019, foreign investors held US$7.7 trillion. shares the stock market allows us companies to access a massive amount of foreign capital.
the stock market as an economic indicator
Another opportunity that the stock market offers is a way to measure the health of the economy. There is a clear connection between the stock market and the economy. the stock market tends to do well when the economy is doing well. the stock market tends to perform poorly when the economy is poor.
Before we continue, let’s pause and think about something that may sound obvious but is very easy to forget; the stock market is an indicator of the economy, but the economy and the stock market are not the same thing.
The economy is the country’s production and consumption of goods and services. the stock market is investors’ perception of future earnings from those goods and services. Let’s see an example. If a news article comes out that casts a company in a bad light, the stock price will generally go down. Did something change in the company from one day to the next? No. but people’s perception of the company’s value changed, causing the share price to drop. the same applies to industries and the stock market as a whole.
With that out of the way, let’s continue.
The stock market is like a survey conducted with a sample that represents the country. calling a representative sample of three thousand people is much more reasonable than calling everyone in the country. however, as long as the survey is carefully created, the data can still be used to represent the entire country. Likewise, the Dow Jones Industrial Average and the Nasdaq do not cover all data related to the economy. still, they contain a sample that economists can use to draw conclusions about the economy as a whole.
Why is it so important to have an economic indicator? There are many reasons, but an important one is that a better understanding of economics can help shape economic policies. Economists can collect data on past stock market performance to help them create more effective economic policies for the future.
the stock market and information requirements
It may not be the first thing that comes to mind, but the stock market provides an additional layer of standards through its reporting requirements. Companies listed on a stock exchange, especially the most prestigious exchanges, must comply with specific rules and regulations, including the disclosure of a large amount of financial information. This benefits employees and those who work in jobs that support the business (such as vendors), as the public nature of the company means it is more likely to do things like have fair working conditions and make payments on time. This is not to say that publicly traded companies are more ethical or that they never run into financial trouble. This is not the case. but the reporting requirements create an opportunity for another level of oversight.
the end result
We’ve covered a lot in this post, from the Dutch East India company’s role in creating the first stock exchange to $7.7 trillion of foreign investment in the US. uu. economy. entire books could have been written on this topic alone.
The stock market is complicated, but understanding its finer, more nuanced aspects often requires first stepping back and asking larger questions, like why the stock market exists in the first place. Only once you understand these essential concepts can you begin to understand the finer points of the stock market and economics, and the field of finance.