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Home > Asset Management Checklists > Stock Markets: Their Structure and Function

Asset Management Checklists

Stock Markets: Their Structure and Function


Checklist Description

This checklist describes stock markets, their structure and function, reasons for investing, and some things to look out for.

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Definition

A stock market is a private or public market for the trading of stocks and shares in companies and derivatives of company stocks at an agreed price. These include securities listed on a stock exchange as well as those traded privately. A stock market is sometimes also known as an equity market.

The estimated size of the world stock market is around US$51 trillion. Even larger, it is estimated that the world derivatives market is worth about US$480 trillion face, or nominal, value; that is well over ten times the size of the whole world economy. However, the derivatives market is stated in terms of notional values and therefore cannot be directly compared to stocks, which refer to an actual value.

Stock markets specialize in bringing buyers and sellers of stocks and securities together. Famous stock exchanges include the New York Stock Exchange, the London Stock Exchange, the Deutsche Börse, and the Paris/Amsterdam Euronext.

A stock market is an important way for a company to raise money. It allows businesses to be publicly traded, or to raise extra capital for expansion by selling shares in the company in a public market. Share owners then have a share of ownership of that company. A stock market provides liquidity to give investors the chance to sell securities rapidly and easily. This makes investing in stocks attractive compared with, for example, real estate, which is less liquid.

The price of shares and other assets plays an important part in the economic activity of a country. It can influence or reflect the social mood of a country. A stock market is often taken as a primary indicator of a country’s economic well-being as it enables the efficient allocation of capital. Stock prices reflect where capital is being invested, or should be. If share prices are rising, this is usually coupled with increased business investment, and vice versa. Share prices also have an influence on the wealth of households, and thus on how much they spend. Central banks watch the movement of the stock market closely and also the smooth operation of financial system functions. This was highlighted in September 2008, when stock markets plunged in response to failing financial institutions—particularly in the United States—and central banks stepped in to try to arrest the slide.

Stock exchanges act as a clearing house for each transaction made on them. This means that they guarantee payment to the seller of the security and collect and deliver the shares. In this way there is no risk to a buyer or seller of a default on the transaction.

With these activities functioning smoothly, economic growth is enhanced because lower costs and enterprise risks help to promote the production of goods and services, and employment. As such, financial systems contribute to increased prosperity.

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Advantages

  • Trading in stock and shares can be done rapidly and easily, making them an attractive liquid investment.

  • A rising stock market helps to boost prosperity in a country and promote a confident social mood.

  • Stock markets allow anyone to participate in the growth of any listed company.

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Disadvantages

  • Share prices can change very quickly in today’s electronic markets, driven by trading by very large institutions.

  • A falling stock market creates an unhappy mood in a country and can lead to difficult economic times and unemployment.

  • Prices of stocks and shares can fall as well as rise.

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Action Checklist

  • Check the history of a stock market. How long ago was it established? How stable is it? How does its average performance rate compared with other exchanges?

  • Check the risks involved in a particular stock market. Is it easy to buy and sell on your chosen stock market? What fees are involved? How well is it regulated? Some countries regulate less well than others, increasing your risk.

  • Check how easy it is to find current prices on your chosen stock market.

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Dos and Don’ts

Do

  • Understand the volatility and risk of a stock market before investing.

  • Understand the risks involved. Some emerging markets have higher growth potential, but much higher risks too.

  • Keep an eye on the progress of the stocks and shares you have purchased.

Don’t

  • Don’t rush into stock market investments.

  • Don’t buy when the price is high.

  • Don’t sell when the price is low.

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Further reading

Books:

  • Becket, Michael, and Yvette Essen. How the Stock Market Works: A Beginner’s Guide to Investment. 4th ed. London: Kogan Page, 2011.
  • Chapman, Colin. How the Stock Markets Work. 9th ed. London: Random House Business Books, 2006.
  • Gough, Leo. How the Stock Market Really Works. 5th ed. Financial Times Guides Series. Harlow, UK: FT Prentice Hall, 2011.

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