The Economics of the Stock Market

Stock Market Economy : Business firms can be classified in many ways. One common classification is to group business firms according to the way they are owned. The most common form of business firm is the sole proprietorship, representing nearly 75% of all business firms. A sole proprietorship is owned by one person. Another type of business firm is the partnership. This type is similar to a sole proprietorship except that two or more people are the owners. Partnerships allow the business to become larger because more than one person finances the business. But partnerships have a big disadvantage: each owner has unlimited liability for all of the debts of the business. This means that, if one owner gets the business into so much debt that it cannot pay and then leaves the area, the other owners are liable for the entire debt. An owner can lose a home, car, savings account indeed, all that he or she has accumulated based on the undesirable actions of another owner. The largest businesses are corporations. A corporation is a legal person separated from its owners. It can be sued separately and pays taxes separately. Its owners are called shareholders or stockholders. One advantage of the corporation is that the owners have limited liability. This means that owners can lose only the amount invested in the business. Because an owner only risks a fixed amount of money, the owner does not care who the other owners are. This feature allows easy transfer-ability of ownership shares. If I have invested $10,000 in Company X, this is the most I can lose. If another owner, Peter, sells his ownership share to Mary, I do not care. I do not need to know anything about Mary because no decision of Mary can cause me to lose more than $10,000. Easy transfer-ability of ownership shares allows corporations to raise large amounts of money. As a result, corporations tend to be large. Indeed, nearly all of the large businesses are corporations.

Corporations are categorized as public or private. A corporation is public if the shares are sold on an open market and are available to be bought by anyone who might wish to do so. Most of the very large companies are public corporations. A corporation is private if the shares are held by a specific group of people who will not sell them to outsiders. Many private corporations are owned within a family. Often corporations start as private corporations. When they need to grow, they “go public”. This means that they sell shares of ownership to anyone willing to buy them. Selling shares to the general public for the first time is called an Initial Public Offering (IPO).

Shares of stock of public corporations are traded. In most cases, they are traded on organized exchanges, such as the Indian Stock Exchange. Buyers come to these exchanges, usually through brokers, to buy shares of stock (that is, shares of ownership) in particular companies. Sellers also come to these exchanges, again usually through brokers, to sell the shares of stock that they own. Let us begin with the buyers. Why would a person wish to buy stock at all? And why would that person then buy the stock of a particular company?

As we saw earlier, there are seven factors that affect demand for any product. Of those seven, four will be particularly important in affecting the demand for stocks. One is income. Buying stock is a form of saving for people. As we shall see later, the higher one’s income, the more one is likely to save. So, as incomes rise (fall), people are likely to buy more (fewer) stocks. This is a reason that stock prices tend to rise when the economy is doing well (i.e., people’s incomes are rising) and tend to fall when the economy is doing poorly (people’s incomes are falling). The second important factor in affecting demand is the prices of the stocks themselves. The third important factor is the prices of substitutes to buying stocks. And the final important factor in affecting demand is expectations.

Investing Strategies

The demand for any of the forms of saving depends on these factors : expected return, risk, tax advantages, and liquidity. Generally, there are trade-offs between these. So, forms of saving that have low risk, tax advantages, or high liquidity usually have a low return. And conversely, risky forms of savings, forms of savings that have tax disadvantages, or forms of savings that are illiquid tend to have higher returns.

In stock markets, information about expected returns, risks, tax advantages, and liquidity is widely available. Because information is so widely available, it is not possible to systematically “beat the market”. Suppose that you know that a stock of a given company will give you a return of 10% while the stocks of other companies will give a return of only 5% . Of course, you will want to buy that stock. But many other people will also know this and they too will want to buy it. When they buy the stock, the price will rise. At a higher price, the return will fall, until it is no greater than that of the other stocks. There are only two ways you can “beat the market”: you can be lucky enough to buy a stock that turns out to be more successful that most people expected or you can have information about the company that is not available to others. And acting on “inside information” is severely restricted by law. Studies have been done comparing people who were “experts” in stock market investing with people throwing darts at the financial pages to decide what to do. The dart throwers tended to do just as well over the long term! Do not expect to be a millionaire at age 30 by playing the stock market.

In deciding what you should do, you need to know the attributes of each type of saving and you need to relate these attributes to your own personal situation. Do you need to be able to get access to the money soon? If so, you need something that is liquid and must correspondingly accept a lower return. Are you highly taxed? If so, you might need something with tax advantages and have to correspondingly accept a lower return. How do you feel about risk? The more risk you are willing to take, the greater your return could be. If you do not like risk, then you might want to diversify. Have a little of this and a little of that. It is unlikely that all types of saving will be hurt at the same time. It is usually a good idea to buy stock in a company because you like the business of that company and believe it can be successful over a long time. If you do this, the best advice is just to hold on to that stock and not worry when its price falls. Over the long term, you will probably so OK. But do not expect to get rich by “beating the market”.

Advertisements