How does the stock market work?
to start huge businesses, which no single merchant could raise alone. It therefore became inevitable for them to come together, pool their savings and start these businesses as partners or co-owners. The contribution of each partner to the enterprise was to be represented by a unit of ownership. This was the precursor to what we call shares. And through this, ‘joint stock’ companies were born.
Initially, trading in shares began as informal “hawking” in the streets of London. As the volume of shares increased with more companies floating shares (giving people opportunities to buy their shares), the need for an organized marketplace for the exchange of these shares escalated. As a result, these traders decided to be meeting at a coffeehouse, which they used as the marketplace. Eventually, they took over the coffeehouse and changed its name to ‘stock exchange’. This was in the year 1773, and the first stock exchange, the London Stock Exchange, was founded. Financial intermediaries (brokers, fund managers, investment advisers investment banks etc) and other instruments like bonds were then to follow suit as an inevitable consequence.
The Nairobi stock exchange
The Stock Market is therefore a market, which deals in the exchange of shares of publicly quoted companies, and government, corporate and municipal bonds among other instruments for money. The Kenyan stock market; the Nairobi Stock Exchange, which was formed in 1954 as a voluntary organization of stockbrokers, is now one of the most active markets in Africa. It is located on 1st Floor, Nation Centre on Kimathi Street, in Nairobi. As a capital market institution, the Stock Exchange plays an important role in the process of economic development:
- It helps mobilize domestic savings thereby bringing about reallocation of financial resources from dormant to active agents.
- Long-term investments are made liquid, as the transfer of securities (shares and bonds) among the participating public is facilitated.
- The Exchange has also enabled companies to engage local participation in their shares ownership, thereby giving Kenyans a chance to own shares of reputable firms.
- Companies can also raise extra finance essential for expansion and development. To raise funds, a company (issuer) issues extra shares; an issuer publishes a prospectus, which gives all pertinent details about the operations and future prospects of a company, while at the same time stating the price per share of the Issue.
- A stock market also enhances the inflow of international capital.
- Stock markets also facilitate government’s privatization programmes.
Share and bonds
Shares are financial instrument where one acquires ownership stakes of a company rather than an IOU. Returns are neither fixed nor guaranteed one acquires voting rights and benefits from exceptional performance.
Bonds on the other hand are financial instruments that serve as an IOU; an investor loans an issuer, and returns are fixed and guaranteed, no voting rights and no benefits from exceptional performance by a company. One can acquire shares or bonds in the primary market (when the company is issuing them) or in the secondary market (which is more common) –by buying from an investor who has bought them. Much of what is predominant at the Nairobi stock exchange is the latter. When one buys a share he/she owns a fraction of the company; while when ones buy a bond he/she becomes a creditor of the company. While the shareholder is allocated a fraction of the profits in terms of dividends, bond holders will be paid a percentage interest on their bond value in agreed interval until the bond reaches maturity when the principal will also be paid back by the company. Share and bonds are collectively referred to as securities
How to buy and sell Shares/bonds (securities)
The first step when buying securities (shares/bonds) is to decide what company to buy in. When selecting a company to invest in, one should make sure the company is in a strong industry, and/or that it is strong or growing. Choosing the company to invest in is no easy job, and there are many different methods people have come up with to select one. These include:
- Fundamental analysis; which is a method, in which you study the company's current management and position in the market.
- Technical analysis; this is a method which is totally based on charts, in which you identify trends the company has, and invest accordingly.
After one decides what company to invest in, you need to select a stockbroker/investment bank to use. The two are the only ones that can make an order to buy or sell securities. Potential customers
contact stockbrokers/investment banks either by mail, telephone, personal visits or regional agents and give their buying or selling orders. When one gives a stockbroker/investment bank an order, they
relay the order to the floor traders. The floor traders do all the actual buying and selling, since they hold a seat on the stock exchange. After one finds a stockbroker/investment bank and buys the securities, the stockbroker/investment bank does the rest of the work to seal the
Types of Orders
- The most basic order is the market order, where one just asks thestockbroker/investment bank to buy or sell securities at the best price it can get its hands on.
- Another type of order, which takes more research and predicting on one’s part, is a limit order. In a limit order, one tells the stock broker/Investment bank to trade only when the stock is at a certain price or better.
- A stop order is an order, which can save an investor from extreme loss. In a stop order, an investor tells the broker to sell his/her securities if the price drops below a certain specified level.
Categories of investors
- Many investors invest in anticipation of capital appreciation as they expect prices to rise in the long run thereby enabling them to make capital gains.
- There are also those who buy shares for investment income, and they therefore rely on dividends. An investor who invest for this purpose should invest in firms with a concrete dividend declaration policy or history
- Investors with substantial financial resources may buy shares with a view to control a company by owning over 50% of the issued capital.
- Since shares and stocks are easily marketable and transferable, some people buy them for use as a means of exchange.
- There are also those who buy shares as a collateral security for raising loans - on the strength of the share certificate/account at the current market prices, a bank can at short notice work out the amount of money that can be loaned to a customer, and should a borrower default in repayment, the securities pledged can easily be marketed and the loan recovered.
- A number of people also buy shares for speculative purposes hoping to get short-run profits. They buy when the share prices are low and sell when they are high. Chances of one burning their fingers here are very high. Only investors who are well versed on market movements can afford to do this effectively.
- There are investors who would like to invest with a bias towards safety of their investments. These investors go for corporate and government bonds and shares of very solid firms.
- Finally there are the risk-averse or small net worth individuals who want to invest in shares and bonds but fear the risk. This investor are advised to invest through collective investment schemes (CIS) like Unit trust and Mutual funds; a CIS is a professionally managed investment fund which pools ones money with that of many other investors with similar investment objectives. The aggregate sum is then used by the fund to build a diversified investment portfolio, which comprises shares, bonds and other investments. Unlike stocks, whose prices are subject to change at each trade, the fund’s NAV is calculated at the close of each day’s trading and fund’s unit price is quoted in major newspapers on the following Business Day. One can sell off there stakes at a CIS at any time in short notice.
What to look out for when choosing selecting securities
- One needs to have in mind the reason for which they are investing in securities
- One must also consider the state of management in the company. The Board of Directors and other key management personnel in the company ought to be people of repute. They must be reliable people who can be trusted to run the company honestly and successfully.
- To be considered also is the nature of the product dealt in and its market share. Is the product vulnerable to weather conditions and is it subject to international trade restrictions? Is the organization a monopoly or an oligopoly? Is the future of the company clear or blurred?
- The marketability/liquidity of the shares/bonds is another important consideration. One has to find out whether the shares from a particular company can readily be sold or bought. There are some slow-moving shares and there are some fast-selling ones too. There is hardly a point for an investor to hold shares which cannot sell should it become necessary to dispose them off.
- Again it is always advisable not to put all one's eggs in one basket. In this regard, when it comes to buying securities, the buyer needs to finds out if the company concerned has diversified its operations. All other things equal, a company with multiproducts is preferable to one without, since not all products can fail at the same time. One line of business might fall while another succeeds and thus the company's overall position can almost certainly be expected to be a profit.
- Other considerations will be the company's trading partners both local and abroad, competitors and possible changes in people's life styles.
- A good company to invest in is one, which shows signs of progress and readiness to meet rowing future demand. Hence, the company's development and expansion programmes should be looked into. If a company has the capacity for future growth, then it is a good company to invest in.
In conclusion, it is important to re-emphasize the essentiality of consulting a licensed stockbroker/investment banker, investment advisor, and/or fund manager when one is in doubt about where to invest as these institutions have the requisite professional expertise and experience, which should be taken advantage of.
The Capital Market Authority
Finally it is important to note that among other things the Authority is charged with the role of protecting investor interests. Any investor with any complaint is advised to contact us at the Capital Market Authority.