Investment Glossary – Stock Exchange
A stock exchange is one of those rare financial terms that is actually exactly what it sounds like – a place for buyers and sellers to exchange stocks or other securities. Originally, stock exchanges were physical locations where people would come to trade securities in person, largely before the advent of technology that made trading from distant locations possible. Over the last 40 years, most of the trading has moved off the floors of the physical locations many exchanges occupy. Today, most trades take place over the internet, with mobile trading continuing to grow in popularity among individual investors.
Most common stocks that people are familiar with today trade on one or more of the major stock exchanges throughout the world. Exchanges do not own the shares of the stock that trade on them, but rather act as a marketplace for trading to occur. They often have listing requirements in order to ensure that the companies that trade on them meet certain standards, though the requirements will differ from exchange to exchange. Stocks do not have to be listed on an exchange in order to be traded, as they can also trade “over-the-counter” in a direct transaction between two parties. The benefits of an exchange are that buyers and sellers typically have more transparency than in a direct transaction, along with greater liquidity when they are trying to buy and sell.
Those two ideas are the core components that make up the real function of stock exchanges. The transparency and liquidity give investors the ability to move their money to different companies quickly and efficiently, allowing capital to flow towards investments that are deserving of it, while punishing investments that are not. This is part of the reason that we see significant volatility in the stock market, as the liquidity allows prices to move rapidly as investors digest new information about individual companies or the economy as a whole. The liquidity also allows investors to move their capital to a new company if it goes through an initial public offering (IPO) to appear on an exchange for the first time, as well as for investors to pull their money out of an existing company if they are nervous about its prospects for the future.
So why are stock exchanges important to the individual investor? For the most part, on a day-to-day basis, it actually isn’t. The investor who puts money into their 401(k) plan or Roth IRA doesn’t have to worry about what exchange a stock trades on for the majority of situations. Some mutual fund and exchange-traded fund investments will use a certain exchange as a stock index to compare themselves to or try to replicate the index’s performance. The NASDAQ exchange is an example of the latter, with the NASDAQ Composite often appearing as a widely quoted index, though it is also an exchange. For most investors, knowing the exchange that a certain stock trades on doesn’t have any practical value. However, despite the inner workings of stock exchanges not being a critical piece for you to understand on a daily basis, it still does help as far as building knowledge to answer the question of “What do you own when you buy a stock?”