“And so God made the world and stocks and bonds.” —Geoff Dodd, my hilarious and competent Series 7 instructor.
What is Wall Street? What’s the difference between a stock and a bond? Why do we even have a stock market?
You are not alone if you have made it to adulthood and you don’t know these things. I’m going to help you out via an eight-minute read, hopefully in a way that sticks.
A lot of smart people, even with advanced degrees in law or medicine, get fuzzy brained on this stuff.
It’s never formally taught to anyone outside of business, and even people with masters degrees in business need further studying to pass a licensing exam to work in the financial markets.
In fact, much of the media that reports on this stuff doesn’t really understand it. I know because I’ve been a financial journalist and then, as an analyst, have helped journalists at financial publications get up to speed.
You probably know that there is a such thing as a stock market and that you’re supposed to be involved in it to win at life, but maybe then it kind of falls apart for you. And yet, everything about Wall Street is so ubiquitous that nobody is allowed to admit that they don’t know anything about it.
If that last paragraph resonates, then this post is for you. Seriously, no worries.
Here’s a Q&A based on real conversations with friends over the years.
What is Wall Street?
Wall Street is literally a street in the lower Manhattan section of New York city. The New York Stock Exchange is based there.
Wall Street is figuratively a term used to describe the ecosystem of high finance. That includes the broader financial community, hedge funds and mutual funds, brokerages, investment banks, and everything having to do with the capital markets.
In late 2011, when the Occupy Wall Street movement took up space at a lower Manhattan park about two blocks off of the literal Wall Street, a lot of people who work on figurative Wall Street kind of, well, laughed. Because everyone knows the real money is managed out of midtown. And besides, it wasn’t stocks that caused the global financial crisis of 2007-2009. It was bonds. Duh.
What are the capital markets?
A bright and creative English major asked me this once. Great question!
So, capital is a fancy word for money. In general, you wouldn’t use it to describe the cash in your pocket but rather amounts so large that it would be silly to call it “money” anymore, and so we call it “capital.” Capital is synonymous with large sums of wealth or assets.
Capital is fuel for growth. A great idea that would enrich people’s lives at scale would go nowhere without capital.
When someone says, “I need startup capital,” they are referring to the money they need to get their business running — to buy equipment or hire people. When an individual says he hopes to “capitalize” on something, in a literal sense, he means he wants to make money off of it or use it to his advantage in some way. When an investment bank says it wants to capitalize something, it means to fund it, or provide capital for it.
The term capital markets primarily refers to the stock and bond markets.
What are the stock and bond markets?
The best way to answer this question is to first answer the question that you are not asking. Knowing the purpose of a thing can help you to better understand it. Ask me what’s the purpose.
Ok. What is the point of the stock and bond markets?
Yay!
Every business is a glorified lemonade stand. So let’s start there.
Off to a good start.
(Photo credit: Rebecca Schley, Flickr, Creative Commons license)
You open your first lemonade stand. It’s popular, people love it. You want to expand. All businesses need money to grow. You calculate that you’ll need $70,000 to open a physical store on Main Street.
To generate this $70,000, you could use your own money. But maybe you don’t have $70,000 laying around (because if you did you might be smarter than going into the lemonade business?) Anyway, to raise the money, you could go to a local retail bank* or credit union.
Ok, so you go to the bank and the friendly loan officer gives you a bank loan and you use it to open your lemonade stand.
Now let’s say your lemonade stand is awesome and you decide to expand nationwide. What do you do next**?
If you need a tens of millions of dollars, you might raise what’s called venture capital. Venture capital, or VC money, comes from wealthy people called venture capitalists who run their own companies, aka VC firms, that take big risks on startups in hopes of making more money later.
But what if you wanted to raise hundreds of millions of dollars?
Well, then you would turn to the capital markets: Wall Street.
Organizing funding so that companies can grow is exactly what Wall Street is for***.
If you need hundreds of millions of dollars to make your dream a reality, no retail bank is going to lend it to you. To raise large sums, you need an investment bank, the ten largest of which are JPMorgan Chase, Goldman Sachs, Bank of America Merrill Lynch, Morgan Stanley, Citigroup, Deutsche Bank, Credit Suisse, Barclays, UBS and Wells Fargo.
In sum, there are two primary ways to raise a lot of money:
And so God made the world and stocks and bonds
Here are some synonyms to guide your thinking:
Stocks = equity securities = ownership
Bonds = fixed income securities = debt
If you sell stocks, then you are selling equity. Another way to say this is that you are raising equity, that is, selling shares of ownership of your company. Others buy a little piece of your company, or a share of your company, and you get the shareholders’ money. In return, you no longer own 100% of your business. When a corporation sells stock to the public for the first time, that is known as an initial public offering, or IPO.
What is cool about raising money by selling stock in your company is that you never have to pay that money back. What sucks is that your profit forevermore belongs to the shareholders in proportion to their ownership percentage. The only way to get back ownership is to buy back your own stock. Once you sell equity, it is sold, no matter how big your company gets.
In sum: Stocks are equity and equity means ownership. The holder of the stock is an owner of the company.
If you sell bonds, then you are selling debt. In other words, you are borrowing money that you eventually have to pay back with interest. On the other hand, the ownership structure is maintained. After bond holders are paid back with interest, they have no claim on the company. Your company could grow to the moon and all that profit is yours so long as you own 100%.
In sum: Bonds are borrowing and borrowing means debt. The holder of the bond is a lender to the company.
That’s the point of view of the company that needs capital.
On the flip side of all that is the investor — the person who lends or gives money to the company that needs it. If you’re reading this blog, you are probably an investor in some form. Investors are anyone with an individual retirement account, anyone counting on a pension, anyone who puts money into a 401(k), and all the people on up the money management chain who guide an individual’s money into a proper portfolio of investments.
Wall Street’s basic function is to allow money to flow to where it is most needed. This flow makes modern life possible.
In the case of bonds, entities borrow from future earnings to make that future better in some way. In the case of stocks, entities democratize their future earnings by allowing people to take a risk and invest, and hopefully gain wealth without expending effort.
Ok, so the point is to get money from the people who want to invest and give it to the people who need it. I still don’t get the New York Stock Exchange. What are the stock and bond markets?
Ok so let’s say Jill buys shares in Tom’s lemonade stand company. Jill buys $2,000 worth of stock in Tom’s company. Tom got his money, good for him. Jill now gets a share of Tom’s profits, no matter how small. Is Jill stuck with that investment for life? No. Jill can turn around and sell her shares to someone else. But she needs a market to do that.
After a corporation (or government entity) has raised money by selling stocks or bonds, the stock holders and bond holders can sell their holdings to other people. This is called trading**** and it happens in what’s known as the secondary market.
When you think of the stock market, you are thinking about the secondary market, which is the trading, or buying and selling, of shares of corporations. The initial purpose of raising money for the company has been met, and now the shares trade. The value at which shares trade depends on how buyers and sellers view that company’s future prospects. By value, I mean stock price.
As opposed to bonds, stocks are the easiest to understand and the easiest for media to report on. That’s because the stock exchanges are highly regulated and public. Some of the largest are the New York Stock Exchange (NYSE), the NASDAQ, the London Stock Exchange Group (LSE), and the Japan Exchange Group (JPX). The stock markets have a definite opening time each morning, a closing time, and an after-markets trading time.
Stocks are cool because you can know a given stock price at any time. Tesla shares closed at $222.93 today, which Google told me, here.
The stock market is bold, beautiful and open. There’s glamour to it. The media loves it. Many people understand it.
The bond market is more, uh, dark. And confusing. And it’s way way way bigger than the equity market. Remember the subprime lending crisis that caused the Great Recession of 2007-2009? Yeah, that happened in the bond market.
The mainstream press rarely writes about the bond market. It’s a snoozer of a topic, the prices aren’t public, and bonds are way confusing.
If you want to check the price of a bond, you have to call your broker. And he’d find out the price by calling someone else. I think. And check his Bloomberg screen. Or something.
If you specialize in debt structures or bonds in this lifetime, you can make a killing.
Is there anything else I should know?
There’s a lot more to all this, but you now know enough to make people avoid you at parties.
Know that the word security refers to any type of financial instrument, including stocks, bonds, some types of insurance, and options. And that there are lots of different types of securities to invest in — basically products created by the financial world.
Also, know that I used the term bonds loosely here and that other debt instruments include notes and bills.
Finally, I used corporations as an example here. Know that beyond corporations, governments are huge participants in the debt markets. As of this writing, the US government has $19,443,266,164,413.41 in debt outstanding. In English, that’s nineteen trillion, four-hundred-and-forty-three billion, two-hundred-and-sixty-six-million, one-hundred-and-sixty-four thousand, four hundred and thirteen dollars and forty one cents. All of that debt is held by individuals, institutions and other governments in the form of bonds, notes and bills.
Commodities are super fun and also have markets. Commodities include hogs, corn, currencies, wheat, oil, rice and so on. I’ve toured the Chicago Board of Trade in Chicago where everything is traded from corn to hogs to cattle, done in trading pits of men yelling at each other. Incredible to watch.
Footnotes:
*You could also do a Kickstarter or open a GoFundMe account to collect from people. I believe that it’s a bit disingenuous to ask other people to fund your dream without giving those people a return, but there’s a market for it and it seems to work for some. Here’s my unofficial simplified hierarchy of raising capital, by amount needed:
- family and friends
- kickstarter / crowd funding
- community / retail / commercial bank loan
- venture capital series A round
- venture capital series B round
- venture capital series C-F round
- private equity raise
- Initial Public Offering (IPO) / Debt offering
- Secondary offering / Debt offering / Convert / Line of Credit, etc.
**Well, you should probably go read, “Pour your heart into it: How Starbucks built a company one cup at a time,” by Howard Schultz, but I’m digressing.
***In May 2015, I wrote to investor clients a partially tongue-in-cheek e-mail about concerns about Tesla’s cash burn. My e-mail was later quoted by Bloomberg News. Notice how much Wall Street looks at cash, capital, and access to capital. Excerpt from my e-mail:
I saw some hand-wringing this morning in other’s published research about Tesla’s cash burn. I think this is missing the point – the current cash burn rate is not a solid-set-in-stone line. Tesla has the option of drawing down further on its warehouse line and opening new lines to recoup the cash off of its leased vehicles. Also, deliveries in Q4 will be roughly 2x what they were in Q1, whereas expenses will only grow ~15% in that amount of time. And, in Q1, Tesla’s SG&A (recurring cash burn) actually ticked down sequentially, so they are to be commended for that – good cost control in Q1.
Finally, it turns out that Wall Street has some great solutions for companies in need of capital. In fact, funding rapid growth and sea change through companies such as Tesla is exactly what Wall Street is for. Worst case, a straight-up equity raise (and Tesla likely has even more favorable options) at the current level would raise more than $1b with about 3% dilution. As far as bear arguments go, the cash burn one misses the mark.
****I have yet to meet a stock trader I didn’t like. Traders are the blue collar Wall Street folks — usually pretty colorful and inappropriate. They’re forced to live in the moment as they enact trades and try to get the best price for clients. It’s almost like playing a sport.