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Why Does The Stock Market Exist?

Stock markets exist to serve the economy. They do this by providing the opportunity for companies to raise capital, investors to make money, and the government to collect taxes from both.

This answer may raise more questions than it answers. How exactly does the stock market provide these opportunities for companies, investors, and the government? What about everyday people who aren’t investors, how does the stock market impact them? How and when did the stock market come about?

In this post, we’re going to dig a little deeper into why the stock market exists, and in doing so, we’ll 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 is where investors can buy and sell stocks. The stock market is often described as a singular entity - “the” stock market. In reality, the stock market is not one place or one exchange. Instead, any investment made on a stock exchange is part of the stock market. The United States has a significant presence in the stock market partly because it’s home to the two largest stock exchanges in the world - The New York Stock Exchange and The Nasdaq.

When a person refers to the stock market saying something like “the stock market closed down today” this term is a shorthand for how stocks have recently performed and is usually referring to one of the major indices, often the S&P 500 or the Dow Jones Industrial Average. These indices act as a representation of how all stocks are doing, though they do not come close to including all the stocks in the market.

History of the Stock Market

To understand why the stock market exists, it helps to know how it came into existence. There are arguably a few different years you could point to as the beginning of the stock market, but it was more of an evolution.

It all started in Europe with money lenders who served people that larger banks would not. These money lenders eventually began to trade debt with each other. Soon, they began trading this debt with customers and then with investors. In the 1300s, the Venetians took things up a notch when they began trading the securities of other governments.

Arguably, in 1531, Belgium had the first stock exchange, but investors couldn’t buy or sell stocks, since stocks didn’t technically exist, yet. There were many versions of partnerships between businesses and financiers that allowed investors to make money, but there were no shares of companies (stocks) for sale. Therefore, the first stock exchange had only bonds and promissory notes.

In 1602, the first “real” stock exchange came into existence; the Amsterdam Stock Exchange, which was 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 in exchange for part of the profits. This could be risky for the investor, though, since if the voyage was not successful, the investor lost his money. The East India companies created a new model. They would allow investors to purchase stock that paid dividends based on all the voyages of the company, as opposed to one individual voyage. 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 wasn’t 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 meeting under a buttonwood tree on what is now Wall Street.

How Does the Stock Market Benefit Companies? Throughout history, whether it’s been Venetian money lenders, Belgians trading bonds, East India companies raising money for voyages, or stockbrokers meeting under a tree, one thing has remained the same – these investments have helped businesses flourish. The same holds today. The existence of the stock market allows companies to grow in ways that would be impossible otherwise, including giving businesses a way to raise massive amounts of capital.

If it weren’t for the stock market, every time a business wanted to raise money, it would have to get a loan from the bank. It would then have to repay that loan with interest. Because of the existence of the stock market, when a business wants to raise capital, it can instead create an initial public offering (IPO). An IPO allows a company to raise a large amount of capital, without having to pay back a loan or worry about interest. Many of the most well-known and successful businesses in the world were only able to advance beyond the startup phase by raising millions or even billions of dollars through an IPO or secondary offerings.

During an IPO, investors pay a company in order to own a tiny 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 share value increases, the investor can make a profit by selling the shares.

The added benefit to 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 doesn’t do as well, it has the option to simply not pay dividends. This is a much better deal for the business than a loan from a bank, which it would have to make payments on regardless of how the company is faring.

How Does the Stock Market Benefit Investors?

The existence of the stock market benefits businesses, 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 a lot of opportunities for a lot of 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 for an investor.

Over 90 years, from 1928 to 2016, the S&P 500 index (which, as we discussed earlier, is often used as a way to gauge the overall performance of the stock market) has had an average annual return of 9.8%. It’s important to remember that this number is an average. It does not mean that every year the stock market has returned 9.8%, only that over the course of 90 years, the average return for a year is 9.8%. Some years have seen higher annual returns, and some have seen lower.

What does an average return of 9.8% mean for investors?

Let’s do a few 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. While you’ve more than doubled your money, you’ve barely begun to take advantage of the powers of compounding interest. To see how that can impact 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 over $150,000 in profit earned off of a $10,000 investment.

Keep in mind; these calculations are overly simplified. They don’t take into account inflation or years with varying returns. And as anyone in finance will tell you, past performance is not a guarantee of future results. But even with these oversimplified calculations, the message is still clear; many investors have significantly benefited from the stock market.

How Does the Stock Market Benefit the Government?

In simplest terms, more money means more taxes. As companies and investors earn money, the government does too. As companies 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 the government is to serve the people. Arguably, how effectively it does this can vary, but that is the ultimate mission. The more the government collects, the more opportunities it has to benefit its citizens and increase a country’s standard of living (more on that later).

It’s impossible to point to a specific amount of government money and say that it’s thanks to the stock market. The stock market is so interwoven with the economy. It has so many implications that it’s impossible to separate money into two distinct categories of connected to the stock market or not connected to the stock market. The critical takeaway is that the stock market creates an enormous amount of money, which provides the government with a massive amount of money.

What About Everyone Else?

As we’ve now seen, the stock market benefits companies, investors, and the government, but what about everyone else? The stock market and the economy go hand in hand, and what’s right for the stock market is usually good for the economy. The ways in which the stock market impacts the economy and, therefore, every person in the country is incredibly complex and wide-ranging. The stock market has a ripple effect that impacts every job, industry, and person. Two areas where we can see this most clearly are the standard of living and employment.

Standard of Living and the Stock Market

The existence of the stock market leads to an increased standard of living. Companies have access to more capital, which allows them to create more and better goods and services, increase their size, and hire more people. The more jobs there are, the higher the number of people who can make a living and spend the money they earn on other industries, therefore creating even more jobs. These improved products and services have an enormous impact on our standard of living.

The standard of living is also increased thanks to more money coming into the government. A government with more spending power can improve the standard of living in that country by putting in place social safety nets, providing essential services, putting in place rules and regulations to protect citizens, etc. To better understand this concept, let’s look at the role of the government in the United States.

The U.S. government is certainly not perfect, but we often fail to realize how much government spending impacts our day to day lives. Did you drive your car today? If so, you were on roads created by the government. Did you get any mail today? If so, you can thank your mail carrier, who’s a government employee. The list goes on and on - public education, college loans, certification of organic foods. All of these things, and many more, are funded by the U.S. government.

There’s also the direct benefits people receive from the U.S government, including 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 almost three in four adults. These programs increase many people’s standard of living by allowing them to retire, buy food, receive medical care, etc.

The stock market also increases the standard of living by providing a means for people to save for retirement. Pension plans and tax-advantaged retirement savings plans, such as 401(k)s, 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 harder, and many people would have to work longer or not retire at all.

The Stock Market and Jobs

Another significant way the stock market affects even those who aren’t investors is through the creation of jobs. This happens in several different ways.

As we previously discussed, the stock market allows a company to grow beyond the startup phase through an influx of capital gained by an IPO. More capital enables the company to expand, which means more jobs. This increase doesn’t just mean more jobs for those employed at the company; it also means more jobs for 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, which can lead to increased spending leading to more jobs. The thing with employment is that it’s cyclical. The more people who are employed, the more people that can spend money, which leads to more jobs in other industries and so on and so forth.

Opportunities the Stock Market Provides

We’ve seen all the benefits the stock market provides to companies, investors, the government, and everyone else. Still, a discussion of the stock market wouldn’t be complete without also discussing some of the opportunities it provides. We’ll wrap up this post by touching on three of the most noteworthy opportunities: foreign investment, economic data, and higher standards for companies.

Foreign Investing and the Stock Market One of the most significant opportunities the stock market provides is a way for people to invest in foreign markets. For U.S. investors, this offers the chance to diversify by investing outside of the United States. While this is a useful diversification strategy, it is more often the reverse that happens - foreign investors purchasing U.S. stocks. These foreign investments account for a substantial amount of U.S. stock investing.

Foreign investors’ interest in U.S. stocks isn’t all that surprising. Compared to stocks in many other parts of the world, the United States has a comparatively mature market with lower risk. As of late 2019, foreign investors held $7.7 trillion in U.S. equities. Clearly, the stock market provides U.S. companies with an opportunity to access a massive amount of foreign capital.

The Stock Market as an Economic Indicator

Another opportunity the stock market provides is a way to gauge the health of the economy. There is a clear connection between the stock market and the economy. When the economy is doing well, the stock market tends to do well. When the economy is doing poorly, the stock market tends to do poorly.

Before continuing, let’s pause for a moment and think about something that may sound obvious, but is all too easy to forget; the stock market is an indicator of the economy, but the economy and the stock market are not the same things.

The economy is the level of 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 look at an example. If a news article comes out that sheds a company in a bad light, the stock price of that company will usually drop. Did anything about the company change from one day to the next? No. But people’s perception of the value of the company changed, and this caused the stock 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 meant to represent the country as a whole. Calling a representative sample of three thousand people is far more reasonable than calling every person in the country. However, as long as the survey is created thoughtfully, the data can still be used to represent the whole country. Similarly, the Dow Jones Industrial Average and the Nasdaq do not cover all data relating to the economy. Still, they contain a sample that economists can use to draw conclusions about the broader economy.

Why is having an economic indicator so important? There are a lot of reasons, but an especially important one is that a better understanding of the economy can help shape economic policies. Economists can gather data about the past performance of the stock market to help them create more effective economic policies for the future.

The Stock Market and Reporting Requirements

It may not be the first thing that comes to mind, but the stock market does provide an extra layer of standards through its reporting requirements. Companies listed on a stock exchange, especially more prestigious exchanges, must abide by specific rules and regulations, including disclosing a large amount of financial information. This benefits employees and those who work in jobs supporting the business (such as suppliers), since the public nature of the company means that 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 never have financial issues. This is obviously not the case. But the reporting requirements create an opportunity for another layer of oversight.

Wrapping Up

We’ve covered a lot in this post, from the Dutch East India Company’s role in the creation of the first stock exchange to the $7.7 trillion of foreign investments in the U.S. economy. Entire books could, and have, been written on this one topic alone.

The stock market is complicated, but understanding its finer, more nuanced aspects often requires first taking a step back and asking the more broad 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 not only the stock market but the economy and the field of finance.

leo

Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.