What is the Stock Market?

Unlike your local supermarket where you buy groceries, the stock market is where people go to buy small or large pieces of different companies. The first-ever stock market was established in 1611 in Amsterdam. Initially, only a few companies participated, but it quickly gained popularity.

Imagine you have a passion for sports, and one day you decide to start a new sports shoe company. You share this idea with a couple of your friends, and to start the business, you and your friends invest your own savings to get the company off the ground. Finally, you come up with the design and start producing thousands of pairs to sell to the public. Fortunately, your launch was successful, and people started to buy the shoes.

At some point, you run out of money, and it becomes difficult to keep up with the demand. You've had a successful launch, but your presence is not yet global. Some people start to notice your brand, but it’s still in the early stages. You and your partners decide it's time to raise some additional funds. You start to look for private investors and successfully raise money in exchange for a percentage of the company. With that money, your company starts to take off—some athletes start to wear your shoes, demand is exploding, and investors are eager to invest in your company. You start to feel that the company is on track to becoming a global brand.

Again, you are short on cash to take your company global, ramp up production, and open stores in new locations. You start to look for ways to raise additional hundreds of millions in exchange for a percentage of the company. You decide to offer part of your company to the public. To do so, you contact an investment bank that specializes in such processes. The investment bank starts the valuation process of the company. They consider many factors during a valuation, such as the current company value, future prospects, risks related to the company, and so on. After the valuation process, the company decides what percentage of the firm they want to offer publicly for sale.

After that, underwriters come up with a fair price for each stock. Keep in mind, the main goal for companies going public is to raise as much money as possible. If underwriters undervalue or overvalue the stock price, the company could lose out on a lot of money. After completing all these steps, the company starts the process of enrolling itself on a specific stock exchange. The first time a company offers its stock to the public is called an Initial Public Offering (IPO).

Let's go back to your company and its IPO. Bingo! You hit another success during the Initial Public Offering and were able to raise almost 800 million dollars. This is not a hypothetical company. I just told you the story of the Swiss-based sports shoe brand, On.

What Happens After the IPO?

After your initial offering, the pricing of your stock is mostly determined by the supply and demand trend. The more people want the stock and the less stock is for sale, the higher the price moves. It is normal practice that over time, after an IPO, original founders are significantly diluted. For example, if you look at Microsoft, Bill Gates currently owns only 2.5% of the company, even though he was the founder.

Let’s Look at it From an Investor’s Perspective

After a company goes public, everybody has the opportunity to purchase a stock. To be honest, retail investors are still at a disadvantage. In most cases, during IPOs, large institutions and mutual funds are first in line. After they purchase the desired amount, then retail investors are able to start trading.

To purchase a share, you need a brokerage account. After you open a brokerage account, you can choose a stock and put in an order for purchase. As a buyer, you can submit your asking price. For example, if Stock A is traded at $30, you can put in an order saying you’re willing to buy 100 shares of Stock A at $29. Once a seller accepts your offer, you become a part-owner of that company. Keep in mind, your asking price has to be realistic to the actual market price; otherwise, sellers won’t accept your offer. You can also simply purchase a stock at the market price and accept the bid currently sellers have.

Now that you have become a shareholder, you officially own a part of the company. As a shareholder, you have many different rights. You have voting power on major issues such as selecting a board of directors, proposals for fundamental changes, and many other things. The voting usually takes place at annual meetings. Even if you own one stock, you still have such power, but as you can guess, the more stock you own, the more voting power you have. You can also sell your stock anytime you want on an exchange, and most importantly, you have the right to receive dividends. Dividends are periodic cash payments that stockholders can receive if the company decides to distribute them. It is not obligatory to pay dividends, but many large companies that accumulate large sums of money every year usually decide to pay some portion of those earnings to their shareholders. Dividends are usually paid on a quarterly basis.

New companies that still need to reinvest all of their earnings back into the firm usually don’t offer dividends. It is nice to have dividend-paying stocks, but mostly shareholders make their money from capital gains. You probably have heard the advice to buy stocks and invest for the long term. In most cases, this is good advice, as long as the economy grows in the long term. The best advice for individual investors is usually to invest in mutual funds that follow different indexes. Indexes are the sum of the largest companies in a specific stock exchange. For example, U.S. investors look at the S&P 500 index to understand the overall trend of the stock market. The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. Not limiting yourself to one specific stock, you can invest in a mutual fund that follows the S&P 500 index. So, the fund purchases the 500 biggest companies' stocks for you and issues them under one single stock. It is much cheaper for retail investors to buy and a much safer investment. If we look at the historical average, the S&P 500 index usually grows about 10% each year.

But Can You Actually Beat the Stock Market and Outperform It?

I hate to break it to you, but the odds are against you if you’re trying to beat the stock market as a retail investor. But it’s definitely not impossible, and there have been cases where people have made significant amounts of money in the stock market. When talking about success in the stock market, it’s hard not to mention Warren Buffett. Warren Buffett is a great advocate of long-term value investing. Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively seek out stocks they think the stock market is underestimating.

There are many ways you can calculate the intrinsic value of a company, and you don’t have to be a genius to do that. Warren Buffett bought undervalued companies and tried to hold them long-term. He has made many wrong decisions, but the right ones outweighed them in the end. For the past 10 years, Warren Buffett's company, Berkshire Hathaway, has been underperforming compared to the overall market. I can say that intrinsic value investing has become pretty outdated. Due to the information era and the massive increase in venture capital money, it is very unlikely for a retail investor to find some undervalued hidden gems in the stock market. Once a company makes it to the public market, it already has many other private investors, and keep in mind going public is associated with millions of dollars in service fees. If you want to find a company that is still in the beginning stages and has huge upside potential, your chances are much higher as a private equity investor.

Maybe Warren Buffett’s approach has become outdated, but in this new era, there are still people who have significantly outperformed the stock market. Jim Simons, who was an MIT math professor, took a completely different approach to investing. Jim believed in statistics and tried to gain an advantage through algorithmic trading. But how does this complex process actually work? We all remember a simple linear regression model we learned in school. We have a Y variable that is predicted with other X variable or variables. For example, let’s say Y is the Tesla stock price, and X is the energy price. With this model, we might predict that every percentage increase in energy price could result in a decrease in Tesla’s stock price by a certain percentage.

This is quite simplistic, as not everything has a linear relationship. Through massive amounts of data and great computing power, Jim Simons and his team managed to find patterns in higher-dimensional, nonlinear models. Nonlinearity allows us to determine patterns and shapes that are hard to see physically. The more data you input into such models, the better they get. Over the past 30 years, Jim Simons' company has significantly outperformed the stock market, with an average annual return of 66%.

Conclusion

While beating the stock market is tough, investing wisely and understanding the fundamentals can help you grow your wealth. Whether through value investing or complex algorithms, the stock market remains a dynamic and exciting area for investors.