Understanding the mechanism of how the stock market works

Stocks are financial assets that represent ownership in a company. Historically, investing in the stock market has provided the highest potential for returns compared to other asset classes. However, as the market is operated by the participants’ actions, it is highly volatile and associated with high levels of risk. 

Despite carrying the risk of losses, investing in stocks remains one of the most lucrative ways to achieve inflation-beating returns. Understanding how the stock market works and the basic factors associated with it is essential to making profits.

What is the Stock Market?

The stock market or share market is a virtual marketplace where companies sell their equity to investors to collect funds while investors purchase shares to grow their wealth.

Trades on this market are carried out by stock exchanges, which serve as an interface between the different investors.

Some of the assets traded in the stock market include shares, bonds, derivatives, ETFs, forex, etc. Investors including both individuals and institutions trade among themselves under an open pricing mechanism that is derived from demand and supply in the market.

Who are the Participants of the Stock Market?

The various participants involved in the stock market function can be described in two different categories:

1. Authorities

The regulatory authority and the various functionary bodies that it governs are listed below. These organisations monitor and operate the stock market, protecting the interests of all participants.

• SEBI

The Securities and Exchange Board of India (SEBI) is a regulatory body under the Government of India that is responsible for monitoring and governing all activities related to the stock market and other relevant securities. SEBI has several guidelines and requirements in place and all participants need to abide by them to participate in the stock market.

• Depositories

SEBI is the governing body for the stock market. It is responsible for individual bodies known as depositories which keep a record of all existing accounts and trades that take place in the stock market.

National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL) are 2 depositories that operate in India. All participants hold their investment accounts with either of these depositories. All activities of participants in the stock market are recorded by these bodies.

• Stock Exchanges

Stock exchanges are trading platforms where shares, derivatives, and bonds are traded. These exchanges are registered with SEBI as are all market participants. Stock exchanges in India facilitate transactions between investors and stockbrokers electronically.

In India, there are two stock exchanges:  National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). A participant can invest through any platform according to their preference.

2. Members

The members of the stock market who operate in the market under SEBI are:

• Companies

Companies are one of the primary participants in the stock market. They issue equity to investors to collect funds for their business. The performance of a company and its financial decisions directly affect its returns for investors.

• Brokers (Middlemen)

Stockbrokers are intermediaries who take care of the financial requirements of investors and work as a bridge between investors and the stock market. They offer their services in exchange for a commission on your transaction value or based on fixed charge. Brokers are available both offline and online.

• Investors/ Traders

Investors/traders include any stock market participant who invests/trade in stocks and other securities with the objective to earn profit. Investors are those who hold stocks for a long time for profits. In contrast, traders are short-term investors who target to earn quick profits from price fluctuations in a short time span .

Primary investors buy stocks from companies directly in the primary stock market. These investors then sell these stocks in the secondary market and these stocks are traded back and forth between investors as demand and supply in the market fall and rise. 

How Does the Stock Market Work?

Stock market is a virtual place that allows investors to grow their wealth by purchasing company shares that are offered by organisations trying to raise capital. SEBI regulates all stock market activities and ensures safe and ethical trading practices. The two depositories manage all investors, brokers and stock exchanges under the guidelines of SEBI to ensure the free flow of investments and trading.

Stock market has two parts namely, primary and secondary markets. A stock is first introduced in the primary market when a company launches its Initial Public Offering (IPO). Companies offer their equity to the public to collect additional funding for expansion or any other business plan. Primary investors bid for IPO subscriptions and buy shares in lots in the primary market. 

Such investors put in their money to earn profits by reselling their stocks in the secondary market. After launching an IPO, the stock is listed on the secondary market and shares purchased by primary investors are sold to other investors in this market the shares are then traded between investors based on demand and supply which are influenced by company performance and market capital.

All investors are required to have a DEMAT account to participate in the stock market. These DEMAT accounts digitally store an investor’s assets and funds with the depository and allow them to sell those assets when necessary.

Stock exchanges work as a platform for investors to access different shares and other assets like mutual funds, bonds, etc. Stock exchanges study the market and help companies and investors understand the market scenario daily. 

The performance of a sector and the whole market is represented by separate indices. Nifty and Sensex are the two broad market indices of the NSE and BSE, respectively. These indices calculate the market performance of top stocks from all sectors and produce a value that is representative of the overall market performance.

How to Invest in the Stock Market?

Investing in the stock market is easier with digital options; however, you must prepare yourself to understand market behaviour to get good returns.

Step 1: The first step to invest in the stock market is to open a DEMAT account and register with a depository. Dematerialised Account (DEMAT) is a virtual account that stores all your financial assets with the depositories in a dematerialised form. It is compulsory to have a Demat account to invest in stocks.

Step 2: Research is very important for investing in market assets. You should do your research about companies, stock market practices and create an investment goal before you start investing in shares.

Step 3: You need to create a budget for your investment plan and keep aside a percentage of your savings to invest in stocks.

Step 4: You need to select stocks that you want to invest in and watch their performance before you invest.

Step 5: Invest in your desired stocks when the price point is right for you.

Step 6: Monitor the graphs and performance of all stocks you invest in.

Understanding Share Price

In the stock market, the prices of all assets are driven by demand and supply. Shares are traded freely on stock exchanges which execute buy orders by matching them with sell orders and vice versa.

Hence, when there is excess demand for a stock and a shortage of supply, the investors increase their bid prices to buy the stocks. Every time the share is sold at a higher price, the market price also increases inflating the share’s value.

Similarly, when a share has many sell orders and fewer buy orders, investors offer a lower ask price to sell their holdings. Due to this reason, the stock price falls overall. 

The current price of a stock is called its market price and the last average price at which a stock is traded for is called its close price. When the market opens the first price for a stock at which it is sold is called its opening price.

Share prices are also influenced by financial news and information about a company and its business actions. In addition, the market valuation of a share also affects its price mechanism.

What are the Benefits of Investing in the Stock Market?

Because of their benefits, stocks remain one of the most popular investment options among investors. A few of the most impressive benefits are provided below:

• High Returns

Investors prefer buying shares because of the high returns. Compared to other asset class, shares offer very high returns on investments. If you plan your investment and focus on price points in addition to risk management, you can get much higher returns from stocks than other asset classes.

• Diversified Portfolio

Stock market includes company shares from all sectors. By investing in different types of stocks, you can diversify your portfolio and earn balanced returns. Diversification mitigates risks considerably, as losses from one or more shares are offset by gains from other stocks in your portfolio.

• Right to Ownership

Shares in your portfolio offer you a percentage of ownership in the invested companies. Because of this feature, you are entitled to voting rights as well as incentives such as bonus stocks and dividends. It makes stocks different from other types of assets.

• Liquidity

Unlike long term investments like real estate, stock market investments carry high liquidity. This allows you to liquidate your assets and get cash in case of an emergency or any other requirements you may have.

• Additional Income

Stock investments offer additional income like dividends and bonuses other than the percentage return on your invested amount.

• Helps in inflation proofing your Wealth

Stocks offer high returns which helps in offsetting the inflation effects. If you invest your money in assets with low returns, it is difficult to stay above inflation rates. However, in the case of stocks, you can keep your wealth way ahead of inflation over a longer time frame.

What are the Things to Consider When Investing in the Stock Market?

Investing in shares and other stock market assets offers good returns and provides you with a hedge against inflation; however, there are a few things to keep in mind before investing in shares.

• Create Financial Goals

Before you start investing in shares, plan your future goals and invest your money accordingly. For example, if you have a long-term goal like building a retirement corpus, you should choose companies with long-term growth potential.

• Have an Invest Strategy

Always make an investment strategy before you begin your investment journey. It will provide you with a clear picture of your investment plans. Do not try your luck with multiple strategies. Instead, learn which strategy best suits your needs and stick to it. 

• Conduct Due Diligence

Always check the stock’s fundamentals and other necessary criteria before investing. Always remember that research is very crucial to safeguarding your wealth.

• Avoid Investing in One Sector

Never invest in just one sector if you want to avoid taking additional risks. Always diversify your investment across multiple sectors and keep your portfolio balanced.

• Know Your Risk Appetite

Understand your capacity to take risks for each investment and try not to push beyond your limits. Ensure that your investment strategy follows your risk appetite.

• Risk management

Shares come with several risk factors that affect investors’ portfolios. It is crucial to understand all such risks and keep your portfolio safe from them. Company risk, default risk, liquidity risk and market risks are a few risks involved in share market investments.

• Avoid Investing in Penny Stocks

Avoid investing in stocks with very low market capitalisation and low demands. These stocks have the highest risk of loss and are the most volatile.

Final Word

Stock market is a great platform for investors to earn passive income and multiply their wealth. It is one of the largest open markets for asset trading and involves large-scale financial transactions daily. Therefore, government bodies like SEBI are put in place to safeguard the interests of its participants.

Frequently Asked Questions