How Does Stock Investing Affect the US Economy?

How It Affects You, Even If You Don't Invest

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Traders cheer as the Dow briefly moved into positive territory work on the floor of the New York Stock exchange October 10, 2008 in New York City. Photo: Photo by Spencer Platt/Getty Images

 

Stocks affect the economy in three critical ways. First, they allow individual investors to own part of a successful company. Without stocks, only large private equity investors could profit from America's free market economy.

Second, stocks provide the capital for companies to grow large enough to gain competitive advantage through economies of scale. Owners use personal credit cards, bank loans and eventually even float their own bonds.

But that only takes a company so far. To sell stocks, they take the company public through an Initial Public Offering. This raises a lot of cash and signals that a company is successful enough to afford the IPO process. The only drawback is that the founders no longer own the company. The stockholders do. But they can retain a controlling interest in the company if they own at least 51 percent of the shares.

Third, stocks give an assessment of how valuable investors think the company is. When stock prices rise, it means investors think earnings will improve. Falling stock prices mean investors have lost confidence in the company's ability to increase its profit margins

How the Stock Market Affects the Economy

The stock market is an excellent economic indicator of U.S. financial health. It reflects how well all listed companies are doing. If investors are confident, they will buy stocks, stock mutual funds or stock options.

Some experts believe markets predict what the savviest investors think the economy will be doing in about six months.

Stock prices usually rise in the expansion phase of the business cycle. The three main indices are the Dow Jones Averages, the S&P 500 and the NASDAQ. Here are the Dow's closing averages through the years.

The stock market also contributes to the nation's economy. That's because the U.S. financial markets are very sophisticated. They make it easier to take a company public than in other countries. It also makes information on companies easy to obtain. That raises the trust of investors from around the world. As a result, the U.S. stock market attracts the most investors. It’s a good place for U.S. companies to go when they are ready to grow.

Since the stock market is a vote of confidence, a crash can devastate economic growth. Lower stock prices mean less wealth for businesses, pension funds and individual investors. Companies can't get as much funding for expansion. When retirement fund values fall, it reduces consumer spending. For more, see What Are the Components of GDP? 

If stock prices stay depressed long enough, new businesses can't get funds to grow. Companies that had invested their cash in stocks won't have enough to pay employees, or fund pension plans. Older workers will find they don't have enough money to retire. 

stock market crash indicates a sudden and severe loss of confidence. An economic crisis normally causes it. For example, the Dow lost 700 points in the market crash of 2008.

Investors panicked when the Senate failed to approve the bank bailout bill. The loss of confidence led to the Great Recession. To find out how this works, see Could a Stock Market Crash Cause a Recession?

But investing in the stock market is the best way to beat inflation over time. Stock prices increase 10 percent a year on average. That's enough to compensate most investors for the additional risk. 

Stocks and Stock Investing FAQ

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