Learn How Wall Street Works
In the last lesson, we established the reason stocks came into existence. In this essay, we are going to examine how the stock market actually works - everything from what drives stock prices up and down to how stocks are purchased on an exchange. Perhaps more importantly, we will discuss one of the most important concepts of all, an allegory created by Benjamin Graham called Mr. Market.
Before we do, though, I want to take a moment to recap and expand on what you already know by talking about Wall Street.
I want to explain to you what Wall Street is, how it functions, what it does for civilization, why it is important, and ultimately, how that matters to you, not only as a citizen but as an investor.
By building this foundation, it will make it easier to understand the things we discuss later, answering questions that you won't even realize you are going to have. Before we begin, it's important for you to know that the term "Wall Street" has really come to mean two things in modern vernacular.
- The term Wall Street is used to describe a physical location. There is an actual place in lower Manhattan, home to the New York Stock Exchange and many important financial institutions, a not-insignificant number of which have been around for centuries, that is physically called Wall Street. It is an actual location where you can go and stand surrounded by offices that collectively control trillions of dollars in wealth.
- 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 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:
- To establish the primary market by connecting savers of capital with those who want to raise capital, most commonly either by borrowing it through 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 because it is what makes capitalism work; what moves money efficiently to its most productive uses, increasing standards of living over time.
- To facilitate a secondary market for existing owners of stocks and bonds to find others who are willing to buy their securities so they can raise cash, which has the effect of making primary 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.
- 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 advisor which is bound by a fiduciary duty to put the interests of clients above the interests of the firm, including registered investment advisors 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. As a Managing Director of Kennon-Green & Co., the asset management group through which I will manage my family's capital and the money of wealthy and affluent private clients who want to invest alongside us once it opens its doors later this year, this is where I will be spending what I expect to be the remainder of my career.
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 life-long consequences. That is what I want to focus on for the remainder of this investing lesson.
On another note, allow me to assign you some homework to help you in your quest to learn more about investing more efficiently and quickly. When I first penned this page back in 2001-2002, this part of the article contained a small glossary that defined certain keywords, investment terms, concepts, and definitions.
I've consolidated and expanded it with another of my older articles called Investing Terms You Should Know. In addition to defining the words, it provides links to more in-depth essays on each topic so you can learn more about those that interest you, specifically. It will help a lot in your road ahead and I recommend you take the time to open it in a new tab, bookmark it, and work your way through it when you have the time.
This page is part of Investing Lesson 2 - What Makes Stocks Become Over or Under Valued.