How the heck does the stock market work?

In previous posts of the Personal Finance Basics series we covered how we can use different accounts (e.g., 401k, IRA, Roth IRA, Backdoor Roth, HSA) to reduce our taxes and get on the road to financial independence.

We also covered Adjusted Gross Income (AGI) and Modified Adjusted Gross Income (MAGI) as well as how taxes work.

If you want a review of these topics, check out Checkpoint #1.

Using these accounts to reduce our taxes is only the first part of the puzzle, however.

We must also invest our money to accelerate its growth—saving $1,000 is awesome; saving $1,000 and having them grow by 6% every year is awesome-er.

The stock market is one method we can use to invest our money and accelerate its growth.

Let’s dive in and get a basic understanding of how the stock market works.

400 years ago

The year is 1602.

William Shakespeare is alive.

Jamestown, the first permanent English settlement in the Americas, is still five years away.

And in the Dutch Republic, fourteen years after gaining her independence from Spain, the Dutch East India Company is being formed.

The path to wealth at this point in history is the spice trade.

Spain and Portugal sent their ships to Asia and came back with tons of spices. Europeans had an unquenchable desire for pepper, a.k.a “black gold.”

The Dutch Republic was small (both in land and population), especially when compared to the might of Spain—if they were to survive, they’d need to band together.

Realizing this, the Dutch government decided to merge the rival spice-trading companies into one, the Dutch East India Company.

They granted the company a 21-year monopoly on the spice trade, along with all sorts of other powers, like allowing them to build forts, maintain armies, and sign treaties with Asian rulers on behalf of the government.

These powers essentially turned the Dutch East India Company into an extension of the Dutch Republic, a lean, mean, fighting machine ready to make profit and kill anybody who opposed them.

That’s the history background. What’s interesting for us is what happens next.

The Dutch East India Company

The Dutch East India Company needed money to build ships and hire captains and soldiers.

In order to gather this money, the government allowed any citizen to invest whatever amount they wanted into this new venture.

In doing this, they turned the Dutch East India Company into the world’s first public company (like Google or Netflix nowadays.)

In August 1602, the funding period closed—1,143 investors now owned a piece of the Dutch East India Company.

How much of the company each investor owned was determined by how much money they put in and the total amount raised.

For example, if the total amount raised was $1 million and Isaac Le Maire, a handsome Dutch gentleman, put in $50,000, Isaac would’ve owned 5% of the company.¹

These investors were hoping that the company would make plenty of successful voyages, bringing back lots of spices and making them rich.

They were also caught up in the nationalistic fever, eager to help the young republic survive because f**k the Spanish and the Portuguese.

Excited as they were, though, the investors were worried about the 21-year period. This is a long time when the life expectancy is 40 years.

It’s for this reason that trading companies before the Dutch East India Company only lasted 3 or 4 years, getting enough funding for a single voyage and distributing the profits when the ships returned.

“What’s the good of a ship full of Black Gold if I’m dead?” asked Isaac.

To help calm this fear and get the investors to stop worrying about their mortality and the meaning of life and all sorts of existential questions, the government added an interesting provision: shares can be transferred.

Now Isaac, our dashing Dutch merchant, no longer had to wait 21 years to make a profit. He could sell his shares in the Company to a willing buyer at any time by going to the bookkeeper and recording the transaction.

Hanging on

The year is 1608.

The Company has yet to make a successful voyage. As a result, they haven’t paid the investors a single dime.

Yet the price of a share in the Dutch East India Company has risen by 30% compared to 1602—a share that cost $100 now costs $130.

Why?

Demand outstripped supply.

Investors, lured by the promise of future profits, were still interested in buying into the Company. The only way to do so, however, was by buying a share from someone who’d gotten one back in 1602.

At this point, Isaac could sell his shares for a 30% profit or hang on to them in the hope that they would rise even further.

Isaac decides to hang on.

Dolla’, dolla’ bills y’all

It’s April 1610 and after a successful voyage, the Company shares profits for the first time.

A great quantity of mace, a spice made from the covering of the nutmeg seed, is brought back from Asia and distributed among the investors.

Isaac receives crates and crates filled with mace which he hopes to sell all over Europe for sweet, sweet profit.

The history of the Dutch East India Company continues. The 1600s were an exciting time.

There were plenty more wars (the Dutch head of state would become King of England in 1689), stories of rags to riches and riches to rags, panics and depressions (like our Great Depression and Great Recession), and all sorts of creative methods of corruption that are still used today.

But this brief history is enough to get a sense for the stock markets we have today.

Back to the present

Let’s flash forward to 1996.

Two PhD students at Stanford decide that the search engines of the day are broken—instead of determining a website’s importance by how many other websites link to it, these search engines essentially count how many times a term appears on the page.

A search for “IBM”, for example, might bring up a random page that says “IBM” a lot rather than the official website of International Business Machines Corporation.

These two students get some friends to join them and they build out their search engine, calling it Google.

By 2002, the verb “google” is added to the dictionary and the term is mentioned in an episode of Buffy the Vampire Slayer. Success, baby.

Smelling the money, the founders of Google decide to “go public,” that is, they decide to sell shares of Google to any interested buyer in the same way that the Dutch Republic did with the Dutch East India Company.

Due to computers and banks and four-hundred-years’ worth of extra laws and regulations, the process was a bit more convoluted but essentially the same.

In August 2004, Google made 19,605,052 shares available at $85 a pop. Each of these shares represented a tiny sliver of the company.

The only people who owned shares of Google before this date were the founders, early Google employees, and some well-connected investors. These early shareholders had gotten to buy shares at a much lower price and stood to make a big profit.

Why were people clamoring to buy Google stock?

The same reason that Isaac and his fellow Dutchmen bought shares of the Dutch East India Company—the desire for profit.

These investors were willing to bet that Google would become a big deal—this would cause demand for Google stock to increase, pushing up the price of each share and making them lots of money.

In the case of Google, they turned out to be right—Google stock has grown by over 4,000% percent since 2004.²

Has anything changed?

Investing in the stock market today can be daunting.

Everything is digital.

You buy shares of a company with money you don’t see and receive a share you can’t touch.

The only proof of your ownership is a number on a screen.

This lack of anything physical, of any paper or certificate, can make the whole process seem like a sort of black magic.

But if we peel back the four-hundred-years’ worth of laws, regulations, and advancements in technology, the underlying process that occurs when you buy a share of Amazon, Google, Netflix, or Chipotle is the same process that Isaac went through to buy a share of the Dutch East India Company.

Despite the lack of tangible proof, by purchasing a share you come to own a tiny sliver of a company.

If the company makes lots of profit, demand for shares will increase and the price of the shares will go up. You too will (hopefully) make a handsome profit.

The company might even decide to share profits like the Dutch East India Company did—the only difference being that this profit-sharing will be paid in dollars rather than crates of mace or pepper.

Swim at your own risk

Not every company manages to be as successful as the Dutch East India Company or Google, however.

Look at Toys “R” Us or Sears. These companies were once big players. Now they barely exist.

If you have shares in Sears nowadays, you’re out of luck. Sears makes no profits and pays no dividend—no one wants to buy your share from you.

This lack of demand drives the share price ever lower. You’re stuck with a dud.

No rabbit in this hat

As you can see, there’s no magic.

The stock market is only a crowd of people looking to make money by buying shares in public companies.

Some of these investors think that company XYZ is the future. Others think XYZ is dumb and that EFG will come to dominate the world.

The price of shares of XYZ and EFG will constantly fluctuate depending on how investors feel about each company’s prospects at any given time.

Whoever is ultimately right will reap the rewards—the value of their sliver of the company will increase and they might even receive a share of the company’s profits.³

Whoever is ultimately wrong will be stuck with the loss—the value of their sliver of the company will decrease and they’ll be left licking their wounds.

Given these dangers, we must proceed with caution when it comes to investing in the stock market.

Summary

There you have it. You now know how the stock market came to be, how it works today, and why people invest in it.

As a quick summary:

• Back in 1602, the Dutch East India Company became the first public company when they allowed people to invest in the company.
• Dutch investors sold and bought shares of the Company amongst themselves. Everyone aimed to make a profit.
• Investors sold shares if they needed the money or if they were pessimistic about the Company’s voyages. They bought shares if they expected the profit-sharing, i.e. dividends, to be good.
• Companies “go public” in order to raise funds to expand the business or because the founders and early investors want to cash out.
• When a company goes public, they offer shares at a certain price per share.
• Each share is a tiny percentage of the company. In other words, owning even a single share makes you an owner of the company.
• The price of each share constantly goes up and down based on how the company is doing.
  • Demand for Google stock is high as Google makes lots of money. This drives the price of Google shares up.
  • Demand for Sears stock is low as Sears makes no money. This drives the price of Sears shares down.
• You can buy or sell your shares in a company whenever you want.
  • Given our global markets, you might be buying or selling the share from a fellow investor in Malaysia, Argentina, or Serbia! And it all happens in the blink of an eye through the magic of the Internet.

Remember, the stock market is a crowd of people buying and selling shares of companies in an attempt to make money.

This is where the phrase ”buy low, sell high” comes from.

Investors attempt to buy a company’s shares when their price is low and sell them when their price is high to maximize their profit.

We’ll see in the upcoming posts why this isn’t as simple as it might seem.

I hope this was helpful. Send me an email if you have any questions.

And if you’re looking to learn more, you can check out the whole Personal Finance Basics Series.

If you want to learn more about the Dutch East India Company and the stock market it created, I recommend The World’s First Stock Exchange. It’s a really interesting book written in Dutch by a Dutchman (Lodewijk Petram) and translated to English.

Video for this post

If you prefer watching to reading, here’s an easy-to-follow video I made with all this info:

Slides for this post

If you’re interested, check out the slides I made for the video.