WealthEffects Logo WealthEffects Portfolio  
 
Why a Stock Market?
by WealthEffect Staff

Return to Outline
 
 

The stock market isn't a casino — it just plays one on t.v.
 
  Companies need a stock market to raise money to grow  
  Initial public offerings (IPOs) are important to companies, not to investors  
 
1.

The stock market certainly seems like Las Vegas with quotes — down several hundred points one week, up several hundred the next. Individual stocks decline by 50% in three months, then rise by 100% in the following three. How can a stock market which does nothing for twenty years, then climbs more than ten-fold in the subsequent seventeen years — a market that can collapse by 22% in a single day — be anything but a roll of the dice?

The stock market might seem like a casino at times, but gambling is not its purpose and excitement is not the reason we need a stock market.

 
 
2.

The purpose of this intricate, intense and often irrational institution is to raise money for corporations. Companies need money to make money. Growth can be costly, given the expenses for production facilities, distribution networks and product inventories, among other things.

Without outside funding, many companies could not grow at the rate their opportunities offer them. Their products might be in great demand and their competitors in short supply, but if they can't produce, they can't provide.

Private companies — those not trading in the stock market — can finance their growth through reinvestment of profits, loans from banks and insurance companies, and investments by venture-capital firms.

 
 
3.

Eventually, private companies might grow to substantial size — and substantial needs — with a track record that inspires confidence in a bright future (or, at least, a future). At this point, they might "go public" by selling a portion of their equity in the stock market. This is called a new issue, or initial public offering (IPO).

Over time, public companies can return to the market to raise further funding when needed or appropriate — a new production plant might be necessary, or an acquisition might require financing, or the price of the stock might simply be high enough to justify selling shares to the public.

And the public will continue to buy these shares. You probably shouldn't be one of these buyers, however; you have no obligation to the free market to purchase a poor investment.

The reason that public offerings are usually unattractive is that they are rarely underloved and undervalued. More often, they represent industries that are highly popular with investors at the current time.

So envy those who make overnight killings in hot Internet IPOs, which shoot up in price on their first trading day. But remember, you probably can't get any shares of stock in those hot new issues until after they've traded up, anyway. They trade up because there is more demand than supply, and these valuable shares are allocated to the valued clients of the brokers involved. As a practical matter, new issues underperform over time. As an investor, you have better uses for your money.

Suggestion: Go to Myths of the Market