A stock market is a physical or virtual place where buyers and sellers trade in securities. It operates through stock exchanges, providing a platform for trading instruments like equity shares, bonds, and derivatives. One of the key functions of the stock market is to offer a transparent and trustworthy marketplace for businesses to raise capital by publicly trading their shares, while also enabling investors to create wealth.
As an investor, understanding the functions of a stock market is just as significant as knowing basic stock market terms. In this article, we have highlighted the varied functions of a stock market to give you a better understanding of how stock markets maintain liquidity and fair prices and serve as economic indicators.
List of popular stock exchanges
The Indian stock market is dominated by two main stock exchanges — the BSE and the NSE. Here’s a quick overview of both:
BSE
The Bombay Stock Exchange functions as a facilitator for trading in equity shares, debt instruments, mutual funds, and derivatives. Established in 1875, the Bombay Stock Exchange, or BSE, is Asia’s oldest stock exchange and the world’s 9th largest exchange. The Bombay Stock Exchange functions as a key player in India’s capital
markets with a market capitalisation of Rs. 41,220,552.19 crore (as of 31st May 2024). BSE’s Sensex Index tracks the top 30 largest and most actively traded stocks on the exchange and remains India’s most tracked benchmark index.
NSE
The National Stock Exchange or NSE was established in 1992 and opened for trading in 1994. It was the first Indian stock exchange to introduce an electronic screen-based trading system to ensure transparency and convenience in trading. Functions of National Stock Exchange include creating a marketplace for trades in equity, debt, and other asset classes. Nifty 50 is the benchmark index for NSE and tracks the weighted average performance of the top 50 stocks from 13 sectors. This makes the Nifty 50 an important indicator of the equity markets in India.
What are the functions of a stock market?
Stock markets fulfil a range of functions in the economy. Some of the chief functions of a stock market are listed below:
Capital formation
Stock markets help companies raise capital to meet requirements, such as expansion of operations, R&D efforts, and investment in new projects. Companies raise capital by issuing stocks, while investors purchase these stocks to earn returns. Both the listing and purchase happen on a stock exchange, making capital formation one of the chief functions of a stock market.
Liquidity
A stock market creates a unified trading platform to bring all buyers and sellers of a security together at a single place. With multiple buyers and sellers, liquidity is ensured.
In other words, a stock market provides investors with a trading platform where they can buy and sell stocks easily. Easy and high liquidity is beneficial for investors since they can quickly convert their investments into cash to meet urgent requirements or exit positions.
Price discovery
Price discovery is arguably one of the most significant functions of a stock market. The price of a security in the stock market depends on the forces of demand and supply. In other words, an asset’s fair market price is determined by the interaction of buyers and sellers. The trading of stocks on the exchange establishes their market prices, reflecting the investors’ perception of a company’s current and future performance.
Wealth creation
When it comes to the most crucial functions of the stock market for investors, wealth creation tops the list. Stock markets allow investors to invest their money in market-linked instruments and gain inflation-beating returns. Long-term investment in the stock market can help investors grow their wealth due to capital appreciation.
Dividend income
Apart from long-term wealth creation, the share market also facilitates earnings in the form of dividend income. Investing in dividend stocks entitles you to obtain a share of the profits of the company as its shareholder. Dividend income from your investments provides a steady, passive cash flow that can be used to meet short-term requirements.
Transferring risk
Stock market investments involve a certain degree of risk. Investors are always conscious of the fact that they can lose the value of their investments due to market
downturns or the declining performance of the asset. Participating in the stock market allows investors to transfer and share these risks with other investors.
Risk diversification
The versatility of stock markets helps mitigate investment risks. Investors can better handle risks by spreading their investments across a range of financial instruments, including stocks, bonds, derivatives, and mutual funds. Diversification helps minimise the risk associated with investment concentration in just one asset class or sector. Holding stocks of different companies from varied sectors reduces the impact of poor performance of one company/sector on your overall returns.
Corporate governance and control
Owning shares of a particular company entitles investors to ownership rights in the said company. In other words, as a shareholder, you have voting rights in major company decisions such as board member selection, strategic direction of the company, etc. Additionally, the companies you invest in are accountable for their decisions to you, the investor. This function of the stock market helps foster greater accountability and better corporate governance.
Benchmark for performance
Various stock market indices like the S&P BSE Sensex, NSE Nifty, BSE Midcap, BSE 100, and others serve as benchmarks. Broad market indices like the Nifty 50 serve as a benchmark for the overall market performance, while sector-specific indices like the Nifty IT highlight the performance of particular market sectors. Comparing your portfolio’s performance with the overall market or sector allows you to gauge its effectiveness and make necessary changes.
Economic indicator
One of the chief functions of the stock market is to serve as an economic indicator for the country. The stock market’s performance serves as a barometer for the economy’s overall health. A rise in the stock market can point to economic growth and better investor confidence, while a decline in the stock market can signal economic downturns.
Market efficiency
Market efficiency relates to the degree to which market prices of a security reflect all the available and relevant information vis-a-vis the asset value. Efficient stock markets incorporate all available information into prices. This offers traders the utmost transparency and reduces instances of outperforming the market with share market timing strategies.
Conclusion
Stock markets serve a multifaceted role, serving investors, businesses, and the overall economy. The functions of a stock market are many and varied, ranging from capital formation to wealth creation. Right from price discovery of assets and risk diversification to providing benchmarks and economic indicators, stock markets serve a pivotal role in the present financial landscape. Since the benefits of a stock market are closely intertwined with its functions, it is essential to understand these functions carefully.
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