Understanding Equities: An Overview of Stocks and Stock Markets

Note: For the purpose of this article, the terms “equity”, “stock”, and “share” are interchangeable. It pains me to repeat the same few words ad nauseum!

Equity markets reside at the core of modern capitalism. As a relatively efficient, broadly accessible, and low-cost system, today’s stock markets facilitate the exchange of company ownership, allow businesses to raise capital from a wide array potential suitors, and (when utilized prudently) provide investors an opportunity to grow their wealth. For the analytically oriented and/or those interested in learning about complex systems, these platforms and the shares that trade on them offer seemingly endless fodder for intellectualism. Below, we will forgo minutiae in favor of what I hope are straightforward (if not overly simplistic) accounts of how these markets function and why they can be beneficial to corporations and individuals, alike.

Stock Markets and Exchanges

Equity markets are platforms where buyers and sellers of stocks can transact with one another. In the US, these trades are regularly facilitated by stock exchanges, such as the New York Stock Exchange (NYSE) or the NASDAQ. As a complement to these marquee intermediaries, over-the-counter (OTC) markets serve the function of matching buyers and sellers in smaller, low priced, and less liquid shares. There are two main types of markets:

Primary Market: A primary market is where newly issued shares of stock are sold to institutional investors or the general public for the first time. An initial public offering (IPO), wherein a company sells (floats) shares of equity is an example of a primary market activity. The monetary proceeds from these transactions go directly to the entity that issued the newly minted securities.

Secondary Market: Any transaction in previously issued shares is said to occur on the secondary market. As such, when stock changes hands on a secondary market, no funds are remitted to the corporate issuer of said shares. The above-mentioned stock exchanges primarily serve to enable, and profit from, a vibrant and liquid secondary market.

Two Types of Stock

A share of stock represents an ownership stake (equity) in a company. Among other reasons, businesses may issue stock as a means of raising capital to undertake growth initiatives, to finance day-to-day operations, or to solidify their balance sheet. There are two primary types of stock that are offered by US domiciled corporations: common and preferred.

Common Stock: Shares of common stock typically confer voting rights and the potential to receive dividend payments. In the event of a corporate bankruptcy, common stock shareholders are “at the bottom of the capital stack”, meaning they are last in line to recoup value from the sale of any company assets that are remaining after debts and other obligations are paid to more senior investors. Common stock is the most prevalent (common) form of stock.

Preferred Stock: Preferred shares have bond-like and stock-like qualities. Shares of this kind traditionally offer less upside (capital appreciation) potential, but more stability and income, when compared to their common stock counterparts. Holders of preferred shares typically receive a fixed dividend and have a higher claim on corporate assets relative to common stock owners. As such, they have priority over common shareholders in bankruptcy proceedings and when receiving dividend payments. However, owners of preferred stock are less likely to be granted voting rights and therefore may have less say in guiding company policy.

Potential Benefits of Equity Ownership

As of mid-2023, Gallup, the Washington, DC based analytics firm, estimated that ~61% of adults in the US own shares of stock. Despite a significant portion of these investors having been defaulted into equity ownership through the default investment option in their workplace retirement plan, a majority of owners have made the conscious decision to participate in the capital markets via equity ownership. The foremost expected benefits of stock ownership can be summarized as follows:

Capital Appreciation: The primary reason behind most individuals’ choice to invest in stocks is the potential for capital appreciation, which occurs when the share price increases above the investor’s acquisition price. Owners of appreciated shares may sell their holding to another participant on the secondary market to lock in (recognize) a profit.

Dividends: Companies may distribute a portion of their earnings, most commonly on a quarterly basis, to shareholders in the form of dividends. Dividend proceeds can be received as cash payments or automatically reinvested in additional shares of the payer’s stock.

Inflation Hedge: Over long time periods and when viewed in the aggregate, equities have historically produced returns in excess of inflation. Hence, stocks as an asset class are often referred to as “real return assets”. For this reason, shares of stock may provide a better option for preserving and increasing purchasing power when compared to fixed income securities (bonds) over extended investment horizons.

Ownership and Voting Rights: While individual shareholders are unlikely to accumulate a large enough portion of any given company’s stock to have significant sway when voting on corporate resolutions, institutional investors can impact corporate policy when casting their votes.

Three Types of Diversification

While these benefits may accrue to stock market investors, particularly those that exercise patience and maintain a long-term perspective, there are best practices that have been proven to enhance the experience of the average investor. One of the key strategies to mitigate both short-term volatility and the risk of a permanent impairment of capital is diversification. Diversification involves spreading investments across different sectors, industries, and geographic regions to reduce exposure to any single stock or market-wide downturn. The goal of a diversified equity allocation is to create a portfolio of securities that provides a positive expected return while reducing the volatility that is inherent in asset markets. In theory, holding an array of non-perfectly correlated stocks with similar expected returns should improve risk-adjusted performance across market cycles. As such, investors should seek to diversify their holdings broadly across stocks of various size (market capitalization), across companies that operate in different sectors of the economy, and by owning shares that are listed both in their domestic market as well as those listed on foreign exchanges.

Market Capitalization Diversification: Companies are often categorized by their market capitalization, or the total value of all outstanding shares (market capitalization = share price x the number of shares outstanding). Investing in a mix of large-cap, mid-cap, and small-cap stocks can mitigate volatility and smooth market risks.

Sector Diversification: Companies operating in different sectors of the economy have displayed unique return profiles across past economic cycles. For example, a sustained period of high oil and natural gas prices may benefit companies that sell those commodities in the energy sector but may serve as a drag on utilities that face an increasing cost structure. Building a multi-sector stock portfolio can help protect against a downturn in any one area of the corporate landscape.

Geographic Diversification: Investing in both domestic and international markets can provide exposure to differentiated return streams. Although there is arguably a higher degree of interconnectedness between economies than ever before, equity market performance across the globe is not fully synchronized. By holding a representative sample of listed companies across the global market, investors may be better positioned to balance their returns.

Drivers of Stock Price Volatility

Understanding what causes stock prices to fluctuate can be accretive any investment process. Stock prices change based on the interaction of supply and demand in the market. Below are three of the most common catalysts for equity market volatility, but there are innumerable reasons as to why individual and institutional investors may be buying, holding, or selling shares:

Company-specific Financial Performance: Share prices can be influenced by whether companies beat or miss investor expectations for revenue, profit, and free cash flow growth (among many other metrics). Theoretically, the present value of a stock should represent the market’s estimate of the discounted value of all future cash flows. As company fundamentals change over time, so should the value of their shares.

Economic Variables: Macroeconomic variables such as the prevailing and expected level of interest rates, the rate of change and level of inflation, and the pace at which economic growth is expanding or contracting can influence stock prices. For example, a prolonged period of low interest rates may reduce corporate financing costs (improving margins, all else equal) while simultaneously increasing revenue’s (via an increase in debt-funded consumer spending).

Market Sentiment: The collective psychology of market participants can impact buy and sell decisions, and therefore the price of individual stocks and market indexes. As investor sentiment oscillates between optimism and pessimism with respect to future events, so may equity prices. Particularly at the extremes of the sentiment spectrum, “herding” behavior may occur. This tendency for individual investors to follow the actions of the majority, wherein participants succumb to groupthink, can cause dislocations in stock market prices as trades become crowded with a disproportionate number of buyers or sellers.

Conclusion

By and large, the barriers to entry have been broken down and the ability to participate in stock market investing has been democratized. As such, having an educated public that maintains a thorough comprehension of equity market basics is likely now more important than ever. I hope the above parsing of terms will aid in your understanding of stocks and the markets they trade on.

Aaron