Stock Markets And Index Funds 101
NASDAQ, FTSE… In today's episode, we’ll demystify stock exchanges, and explain how they impact investors or potential investors like you. We'll explore how stock exchanges serve as gateways to investment vehicles such as index funds, providing you with opportunities to grow your money and participate in the global economy.
You can listen (18 min) and subscribe here:
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1. What is a stock exchange?
Stock exchanges are places where people buy and sell stocks, bonds, and other financial items like mutual funds and ETFs. By doing it in one place, trading is monitored to ensure fairness and transparency.
A stock market is a broader term that includes all the exchanges and other places where people trade shares of companies. It covers well-known exchanges like the NYSE and NASDAQ, as well as other markets where trades can happen directly between people without an exchange.
“There are several stock market indices. A couple of the big ones are: S&P 500 and FTSE100. And they track how a group of companies stocks perform in the stock market and allow you to spread out your money in all of them. Instead of just buying shares of a single company that might fail tomorrow, you’ve got a more diversified portfolio of stocks.”
2. Why do stock markets exist?
Stock markets are important for three big reasons:
They Help Companies Grow: Companies list their shares on a stock exchange to raise money from investors. This process is called an Initial Public Offering (IPO). For example, when Apple went public in 1980, it raised $100 million, which helped the company expand and innovate.
They Provide Investment Opportunities: Stock markets give people the chance to invest their money and potentially grow their wealth. For instance, if you buy a share of a company for £2,000 and sell it 10 years later for £20,000, you've made a £18,000 profit. Additionally, some companies pay dividends, which are regular payments made to shareholders from the company’s profits. For example, Apple pays dividends to its shareholders, providing them with extra income on top of any gains from selling the shares.
Stock markets can indicate the health of the economy but not always: The economy represents how money is being made and spent by a country’s citizens, companies, and governments. Economic growth is typically measured by gross domestic product (GDP). The stock market and the economy often move in the same general direction, but they can behave very differently, especially over short periods. This is because the stock market is forward-looking, reflecting investor expectations about the future, while economic data often looks backward, showing what has already happened. The stock market is influenced more by how economic news compares to investor expectations than by the actual news itself.
3. So where did the markets even come from?
Stock markets have a long history, tracing back to ancient civilisations like the Roman Republic and the Dutch Republic - involving the exchange of shares in things like shipping and trade expeditions.
However, the modern stock market, as we know it today, started to form in the late 16th and early 17th centuries.
Since then, stock markets have continued to evolve and expand globally, with the development of electronic trading platforms and the emergence of new exchanges in countries around the world.
4. Now let’s talk about the major stock exchanges
Most developed countries have well-established stock exchanges. But you may not know that many emerging and developing countries also have stock exchanges, though they may be smaller and less liquid.
Liquidity refers to how easily you can buy or sell stocks on a stock exchange. Developed countries usually have big, busy exchanges where it's easy to trade. In smaller or developing countries, exchanges might be less busy, making it harder to buy or sell quickly. This difference in activity level is what we mean by "liquidity."
US: The New York Stock Exchange (NYSE) is among the world's biggest and oldest stock markets, where established companies, known as blue-chip stocks like Coca-Cola, IBM, and Microsoft, are traded. Blue-chip stocks are considered safe and low-risk investments, ideal for long-term growth and generating income.
The NASDAQ (National Association of Securities Dealers Automated Quotations) is a leading electronic stock exchange, specialising in technology and growth-oriented companies, known for its high-tech trading platform and innovation-driven listings. Examples: Amazon, Apple, and Tesla.
UK: LSE (London Stock Exchange): The LSE is the UK's primary stock exchange, hosting a diverse range of companies from various sectors, and is one of the largest exchanges globally by market capitalization. Examples: HSBC, BP, Unilever, GlaxoSmithKline, British American Tobacco.
The London Stock Exchange (LSE) caters to companies of different sizes and stages of growth.
For many decades, London Stock Exchange provided a trading floor where members could buy and sell shares. Today, share trading is almost entirely done electronically and London Stock Exchange offers this service with state-of-the-art systems that can process over a million trades per day.
5. Indices
You’re tuning in to this podcast because you want to know how investors like us access stock markets like the LSE or NYSE to trade shares of individual companies and indices.
Each stock exchange typically has one or more indices that track the performance of a specific group of stocks. They help measure performance and offer insights into market trends.
We, as investors, use indices to compare our portfolio's performance against the broader market, evaluate investment strategies, and assess market sentiment.
Don’t panic, that might sound complicated but we’ll go through some examples to make it easier.
Let’s go through some examples:
FTSE Russell is a leading provider of stock market indices in the UK and globally. It is best known for the FTSE UK Index Series, which includes an index you’ve probably heard of: Take the widely followed FTSE 100 Index, The FTSE 100 tracking the performance of the 100 largest companies listed on the London Stock Exchange by market capitalization - which is the total value of a company's outstanding shares in the stock market.
These companies are BP, Unilever, and HSBC.
On the London Stock Exchange (LSE), investors have the choice to buy shares of individual companies like BP or invest in indexes containing these stocks, such as the FTSE index, which comprises companies like Unilever, HSBC Holdings, and GlaxoSmithKline.
Moreover, the LSE offers access to stocks from global companies, including popular US stocks, which are increasingly favoured by British investors. Additionally, a diverse range of funds spanning major indexes like the Dow Jones, Nasdaq, and S&P 500 are available, providing investors with a wide array of investment options.
To invest in and gain exposure to companies listed on the LSE, you just need an account with an online provider or stockbroker.
Let’s move onto another big one that you might have heard of.
The S&P Dow Jones Indices is a major provider of stock market indices in the US and globally. It is best known for the S&P 500 Index, which tracks the performance of 500 large-cap US companies and is widely regarded as a benchmark for the US stock market.
And just like the FTSE indices, many of which include the FTSE 100, S&P Dow Jones Indices also offers a comprehensive range of other indices covering various market sectors, sizes, and regions.
So in summary, there are several stock market indices. A couple of the big ones are: S&P 500 and FTSE100. And they track how a group of companies stocks perform in the stock market and allow you to spread out your money in all of them. Instead of just buying shares of a single company that might fail tomorrow, you’ve got a more diversified portfolio of stocks.
6. Can I invest in those indices?
While you cannot directly invest in an index like the S&P 500 or FTSE100, you can invest in index funds, which are investment funds designed to replicate the performance of a specific index.
Index funds are created to replicate the performance of a specific index, like the S&P 500 or the FTSE 100. These funds can be managed by portfolio managers who select and adjust the securities to match the index.
Although there is someone managing these index funds, they are passively managed, meaning they aim to match the performance of the index rather than actively selecting individual stocks in an attempt to outperform the market.
This passive approach results in lower management fees compared to actively managed funds, making index funds an attractive and cost-effective investment option for many investors.
Additionally, many index funds use algorithms to automatically buy and sell securities, ensuring the fund stays aligned with the index.
For example, an S&P 500 index fund would invest in the same stocks that comprise the S&P 500 index in proportion to their weighting in the index.
By investing in an index fund, you gain exposure to the performance of the underlying index, allowing you to participate in the potential growth of the market represented by that index.
7. Stock markets are designed to be efficient
When we say that stock markets are designed to be efficient, it means that they facilitate the buying and selling of shares in a fair and timely manner. This efficiency is achieved through a system where buyers and sellers place orders indicating the quantity of shares they want to buy or sell and at what price they are willing to transact.
Now, while there isn't a limited number of shares available in the sense that new shares can be issued by companies or bought back, each individual company has a finite number of shares outstanding at any given time. So, when you buy shares of a company, you're buying from someone who is willing to sell their shares, and vice versa.
The stock exchange matches these buy and sell orders, ensuring that transactions occur smoothly and at fair market prices. If there's high demand for a particular stock, it can become harder to buy shares at the desired price because there are more buyers than sellers, and vice versa.
8. examples
This is not an invitation to invest in this stock but let’s look at Microsoft! Let’s say you like the stock and want to be able to track the performance.
Microsoft is a publicly traded company, which means the company shares are bought and sold by investors on an exchange, with prices determined by supply and demand.
Microsoft's stock is traded on multiple exchanges around the world, including the NASDAQ Stock Market in the United States - yes you can be listed on more than one exchange. This means that investors have many different opportunities to buy and sell shares during different trading hours.
To buy Microsoft stock from the UK, you would typically find the right investment platform (a place to buy shares) for you and add money.
You would search for Microsoft using its ticker symbol "MSFT" on the trading platform, place your order to buy the desired number of shares, and complete the purchase.
Buying shares in just one company is riskier than investing in a mix of investments, which is called a "diversified portfolio." Experts suggest holding a mix of assets and funds. Funds are collections of shares from different companies, like Microsoft, and the idea is that if one company's share price drops, gains from other companies might balance it out.
Microsoft is a major part of the NASDAQ, so it's included in many funds and investment trusts, as well as tracker-style exchange traded funds (ETFs).
Microsoft is included in various stock market indices. For example, Microsoft is one of the top components of the S&P 500 Index.
Remember that you can't invest directly in a stock index like the S&P 500, but you can invest in the underlying stocks through index funds or ETFs.
9. So what’s the difference between an index fund and an ETF?
Both index funds and ETFs provide investors with exposure to the S&P 500 Index, including companies like Microsoft, but they differ in structure, minimum investment requirements, costs, tax efficiency, trading flexibility, and liquidity.
Index funds are mutual funds priced once per day and often have minimum investment requirements, while ETFs trade on stock exchanges throughout the day with no minimum investment.
ETFs generally have lower expense ratios and are more tax-efficient due to their structure, offering intraday trading flexibility and liquidity, whereas index funds may have liquidity limitations and trade at the end of the day.
I typed in “best index fund with Microsoft”: and Google came up with the Fidelity 500 Index Fund, Schwab S&P 500 Index Fund and Vanguard 500 Index Fund Admiral Shares but also some ETFs like iShares Core S&P 500 ETF.
By investing in one of these index funds, you gain exposure not only to Microsoft but also to other large-cap U.S. companies represented in the S&P 500 Index, such as Apple, Nvidia, Amazon, Meta, Alphabet, Berkshire Hattaway, Tesla!
If you want to increase your investment in a particular stock like Microsoft, you can look for index funds or ETFs that have a higher allocation to that stock. For instance, if you're interested in having more exposure to Microsoft, you might consider investing in funds or ETFs like iShares Global Tech ETF, which have a significant portion of their portfolio invested in Microsoft. This way, by investing in such funds, you indirectly increase your exposure to Microsoft along with other companies in the fund's portfolio.
To research these funds, you can try Morningstar, FT, and even Yahoo Finance and Financial Press.
10. regulation
In the UK, the Financial Conduct Authority (FCA) regulates financial markets (including the London Stock Exchange LSE). It ensures that financial markets are honest, fair, and effective, and it protects consumers by enforcing rules against market abuse and financial fraud.
The Financial Services Compensation Scheme (FSCS) in the UK doesn't directly regulate stock exchanges, but it protects consumers by compensating them if authorised investment firms fail. This protection includes investments in stocks, providing a safety net and enhancing investor confidence in the financial system.
In the US, the Securities and Exchange Commission (SEC) is the primary regulatory body overseeing securities markets in the US, including the New York Stock Exchange (NYSE) and NASDAQ.
For example, regulators like the FCA and SEC enforce rules against insider trading, which is when someone uses confidential information to make unfair trades. They also ensure companies disclose accurate financial information to investors, like their profits and debts, so investors can make informed decisions. This helps reduce the risk of investment losses caused by fraud or manipulation, making the investing environment safer for everyone.
So although investing is risky, so you may come away with less money than you invested, the regulators minimise any risk that could occur from other parties making it safer for you to invest.
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