What Is the Role of the Stock Market?

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The stock market is identified with wealth creation. Private investors, corporation, and government officials all transact business within the stock market to grow returns above the rate of inflation. Meanwhile, analysts and commentators function to research and disseminate information stock market information to prospective investors. Although financial asset performance is associated with national pride, stock market fluctuations expose the overall economy to distinct risks.

Identification

  • The stock market matches corporations looking to raise capital against savers that are in search of investment opportunities. Corporations offer shares of stock to investors at the initial public offering (IPO). In exchange for their investment, shareholders are granted ownership rights over the underlying company. After the IPO, stocks trade hands in the secondary market, or directly between investors.

    Stock markets provide liquidity, by providing an organized arena for interested parties to trade securities. Liquidity describes the ease of which investments are converted into cash. Without stock markets, you would be forced to solicit prospects to buy and sell investments. Stock exchanges significantly reduce the time and expense of the marketing process. The New York Stock Exchange (NYSE) and NASDAQ are the largest stock markets in the United States.

Features

  • Stock markets function to create wealth for society. Corporations are structured to create shareholder value, and do so by investing capital financing into projects that grow profits. Shareholders benefit by gaining entry into businesses that they lack the funding and expertise to own, outright. For example, you may need to raise millions of dollars to purchase the equipment to establish an integrated oil company. The stock market, however, enables you to access the profits of an oil company, such as ExxonMobil, for the relatively small price of one share.

Considerations

  • The stock market serves as an economic indicator to foreshadow and confirm economic trends. Stock market declines of 20 percent, or more, are referred to as bear markets. Government officials and voters may highlight bear market losses to signal that the nation's economy has entered into recession.

    In the United States, the Federal Reserve Board responds to severe stock market declines and recession by lowering interest rates. Lower interest rates reduce borrowing costs, and encourage individuals to make investments and spend money on consumer goods. Alternatively, rapidly appreciating stock prices are associated with economic booms. The Federal Reserve may elect to raise interest rates to slow down the economy and contain inflation.

Misconceptions

  • The stock market is not always the perfect gauge of business valuations and economic conditions. Stock market values may actually distort reality. The dot-com boom of the late nineties, alongside the early 2000s credit bubble, serve as examples of irrational exuberance. Both time frames are identified with overvalued assets, which inevitably crashed, or lost significant value heading into recession.

Risks

  • Stock market valuations introduce political and economic risks to society--at diverging points. Rapidly appreciating stock markets may ignite social unrest by widening the income gap between wealthy investors and the working poor. Conversely, stock market declines deepen the impact of recession. In bear markets, savers are less likely to make investments, purchase goods and create jobs.

References

  • Photo Credit wall street with flag image by Tomasz Cebo from Fotolia.com
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