Learn How Wall Street Works

The New York Stock Exchange
••• Cultura Travel/WALTER ZERLA/The Image Bank/Getty Images

In the last lesson, we established the reason stocks came into existence. In this essay, we are going to take a look at how the stock market actually works. When you finish reading this article, you will have a better understanding of what Wall Street is, how it functions, what it does for civilization, why it is important, and how that matters to you. 

What Is Wall Street?

"Wall Street" has really come to mean two things in modern vernacular. 

1.   The term Wall Street is used to describe a physical location.  The street is in lower Manhattan, home to the New York Stock Exchange and many important financial institutions, many of which have been around for centuries. You can go to Wall Street and stand surrounded by offices that collectively control trillions of dollars in wealth.

2.   The term Wall Street is a metonymy for capital market finance. Wall Street is frequently used as a figure of speech to describe a person, institution, or activity tied to high finance and banking. If you look at an asset management company such as American Century Investments in Kansas City, it oversees more than $1 trillion, mostly through mutual funds and institutional relationships. It is located in the heart of the Midwest, surrounded by plains a few miles out from its impossible-to-miss headquarters at the Country Club Plaza. It is nowhere near Wall Street physically but it's very much a part of what people think of when they discuss the activity of portfolio managers, retirement plan administrators, and such.

Understanding the Role of Wall Street in Civilization

Wall Street, both the physical place and the metonymy, exists for three primary purposes:

1.   To establish a market for institutions to raise capital through a centralized trading area that connects savers of capital with those who want to raise capital. Wall Street trading can come in many forms including the issuance of bonds or by selling ownership in a business through the issuance of stock. This is the core reason Wall Street is so important: It is what makes capitalism work; what moves money efficiently to its most productive uses.

2.   To facilitate a secondary market for existing owners of stocks and bonds in order to find parties willing to buy their securities so they can raise cash. This makes markets more successful as investors have more confidence in the ability to use their portfolio as a source of liquidity, generally demanding lower risk premiums as a result.

3.   To assist those who wish to outsource the job of investing their capital so the client can focus on his or her primary career or activity. Sometimes this is done through a broker-dealer. Increasingly, this is done through a firm that is a registered investment adviser bound by a fiduciary duty to put the interests of clients above the interests of the firm. This includes registered investment advisers that are primarily asset management companies. That way, if you are a high earning, successful individual such as a software developer or a doctor, you can pay someone else to handle your portfolio as you focus on generating more money, not reading 10-K filings or mutual fund prospectuses

When most people think of the stock market, they are usually thinking about the secondary market—the buying and selling of existing shares of outstanding stock by individual investors through their retirement and brokerage accounts; the daily fluctuations in the major stock market indices such as the Dow Jones Industrial Average and S&P 500. That fluctuation is what interests a lot of people; what causes otherwise intelligent folks to become emotional or make financial mistakes that can have lifelong consequences.

Trading Mechanisms

Trading on all types of markets, including the stock and bond markets that make up Wall Street, involves a multitude of factors and mechanisms that affect prices. Central to all trading exchanges, you will find market makers. These market makers, also known as broker-dealers, are integrated into the trading system to facilitate the flow of money and trades.

Generally, most investors believe that the prices of traded securities are based on influencing factors such as management changes, news events, corporate actions, and so on. What many investors often don’t realize is that market makers and the supply and demand for a traded security on any given day also plays a big part in a security’s trading price.

Market makers come in several forms, including individuals located on the exchange floors and electronic communication networks. Every transaction on an exchange requires a counterparty willing to take the opposite side of the trade. Market makers work as a go-between and earn a small fee for their service in the process.

If an investor wants to buy a stock, the transaction is ultimately facilitated through a market maker who matches the trade order with an investor willing to sell. When there is higher demand for a stock it pushes the price up. When investors are selling a stock in high volumes, it pushes the price down.

Understanding Wall Street

Wall Street and its many trading exchanges are repositories for investments across a variety of different security types. Exchanges allow institutions to issue securities for capital. The trading of these securities by investors is known as the secondary market. Overall, the support of government regulations and American institutions is what makes Wall Street a highly functional and reliable trading arena for investors to invest capital and grow their wealth over time.