How does the stock market work

A. The stock market, also called the equity market, is a way for companies to raise money from those with cash to invest. Investors make money (hopefully) from buying shares in two ways - the income from dividends that the company pays to shareholders and from the capital gain on shares, realised when shares are sold at a higher price than that at which they were bought.

Q. So what's the FTSE 100

A. The market is simply the sum total of all the shares traded, and is represented by stock market indices: for example in the UK, the FTSE (Financial Times Stock Exchange) 100 (roughly the largest 100 companies) and the FTSE All-Share index (practically the entire market); in the USA, the Dow Jones Industrial Average and the Nasdaq index (mainly comprised of 'new economy' technology stocks).

Q. What about individual investors

A. Despite the recent trend towards dabbling in the market, it is still far from a collection of small investors. Only 16% of UK shares were held by private individuals in 2000, the rest were held by institutional investors, such as insurance companies, pension funds, investment trusts and other businesses, both domestic and foreign. These institutional investors often deal in large numbers of shares and can influence the price of a company's shares with a single trade.

Q. How do share prices rise and fall

A. Prices rise and fall for a number of reasons:

Factors specific to the firm - These are, of course, the perceived prospects of the company, particularly in delivering growth in profits and paying a satisfactory dividend to shareholders.

Analysts make recommendations about whether particular companies are likely to be a sound investment. Changes in these recommendations, for better or worse, can significantly influence the price of a stock. The company's own news releases are closely monitored. Most large companies report their figures each quarter, and any change in the expected fortunes of the company will be reflected in the share price. Recently there have been a spate of 'profit warnings' - companies informing their shareholders and the market that profits will be lower than expected - sometimes causing quite sharp price falls.

General market factors - Economic news often has an immediate effect on the stock market. Broadly speaking, economic growth is seen as good for equities since higher growth leads to higher corporate profits. Therefore, any positive news, such as lower unemployment or increased output, is likely to be seen as good for share prices. However, inflation is the enemy of the investor, and positive economic news will not be welcomed by the markets if it is seen to imply increased inflationary pressures.

An increase in interest rates is usually bad for equities as bank accounts and bonds pay higher rates - both are alternative uses of investors' funds. Also, higher rates are often linked with a slowdown in economic growth, probably hitting profit growth. Again, however, it is difficult to generalise, as a rate rise to quell inflation would be seen as a good move by the equity market.

News affecting a large or influential company will often affect similar companies. For example, the recent announcement of redundancies in Marconi's plants caused a fall in other companies in the IT sector.

Q. So is the market generally predictable

A. Up to a point, bearing in mind the factors discussed above. However, markets are not always rational and sometimes the herd mentality takes over. We have just witnessed one of the greatest ever stock market 'bubbles' with the rise and fall of the dot.com companies. Many of these are now members of what's called the '90 per cent club': shares that have lost over nine tenths of their value.

Generally speaking, however, share prices tend to rise over the long run - significantly outperforming other forms of investment. This is because shares represent a claim on corporate assets and profits, which tend to grow in line with the growth of the economy as a whole.

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By Simon Smith