When you buy a stock, it seems like your money disappears into the ether and you are left with some stocks in a company. Similarly, when you sell a stock, you just click “sell” and all of a sudden you have money in your brokerage account.
Where does that money actually go? Where does that money come from?
Here’s the short answer: the money is exchanged between buyers and sellers with your broker acting as an intermediary. The money from the buyer goes to the seller and the stock goes from the seller to the buyer.
What is a stock
Without going into too much detail, a stock is basically a small piece of ownership in a company.
Sometimes you can get voting rights or dividends, but for the most part people are interested in the stock increasing in value over time.
If you want to get into all the details on stock market investing, check out this post.
Company IPO
An IPO stands for initial public offering. It’s when a private company puts shares up for sale to the public. It’s a way for companies to raise capital from public investors.
When you buy shares of a company that put shares up on the stock exchange in an IPO, that money goes directly to the company (via an investment bank) as investment capital. The company will use this investment capital to fund growth, research and development of new products, and expand operations or scale up production.
How does a company apply for IPO?
Companies need to meet certain requirements by the securities and exchange commission (SEC) before they can hold an IPO.
The price of a share during an IPO is determined by the underwriters, people hired by the company to do some analysis for them to drive the IPO process forward. They’re also going to hire some CPA’s, lawyers, and SEC experts to be part of the IPO team.
These underwriters determine the value and share price of the company using several analytical techniques.
Once all the requirements are met and the initial share prices determined, the company is ready to list their shares on a public stock exchange like the NYSE. The company will ring the opening bell Monday morning and the stocks will be ready to purchase on the stock exchange.
Stock Market
Once a company’s IPO shares have all been bought up by the public, the shares are now exchanged between buyers and sellers in the stock market (the secondary market). This is where most of the stock exchanges take place.
When you purchase a stock in the stock market, that money goes directly to someone who’s selling their stock (after passing through your broker). You’re literally buying the stock from another person who sold their stock, just like any other buying and selling transactions.
Let’s get into the details of how that happens.
What happens in the stock market?
To understand where the money goes in when a stock is bought or sold, we first need to understand the 3 main components involved in a trade: buyers, sellers, and brokers.
Buyer
If you’re reading this article, I’m guessing you’re probably a buyer. A buyer is someone who is looking to purchase shares of a company in hopes of earning a profit from the increase in share value or by cashing in on the dividends.
Basically, buyers are looking to exchange their cash for shares of a company.
Seller
The seller is the opposite of a buyer. They own shares of a company and are looking to sell them to cash in on their investment. They might also be looking to sell their shares because they think the stock price is going to drop in the future and want to get out before their investment loses value.
Alternatively, they could be shorting their stocks (selling stocks preemptively on margin) and eventually purchasing it later. Their hope is that they would sell it now while the price is high and purchase it at a later time when the prices are lower, earning them a profit.
In other words, sellers are trying to exchange shares of a company for cash.
So we have buyers who want to exchange cash for stocks and we have sellers who want to exchange stocks for cash. But how do buyers and sellers find each other? Furthermore, how do we make sure that the trade is “legit” and no one’s getting scammed? How do they agree on a price?
That’s where the stock broker comes in.
Stock Broker
Whenever you’re buying or selling stocks, that probably first goes through your stock brokerage firm (sometimes called a discount broker). The broker has membership at the New York Stock Exchange or the NASDAQ. They are licensed by the financial industry regulation authority (FINRA) to execute buy/sell orders on the stock exchange.
Technically you can do it yourself by becoming a stock broker, but it’s much easier to just work with a stockbroker like Fidelity. Otherwise you’re going to have to get a license yourself by passing the required licensing exams, your state, and your employer.
The stock broker executes buy and sell orders that are submitted by stock traders by connecting orders from buyers and sellers together. They ensure that the trades are legitimate, the company knows where it’s shares went, and the price at which the transaction takes place.
In the past you would execute these trades by calling a human stockbroker to do that for you, like what you would see on the floor of the New York stock exchange in the ’90s. These days, that’s done automatically through an automated trading system.
How stock prices are determined
Long story short, supply and demand. If more people want to buy a stock, the price will go up and vice versa.
At the micro level, the price at which a stock is bought or sold becomes the new market price. The last selling price acts as “proof” that the stock at this very second is worth this amount of dollars.
At a higher level, there are millions, even billions of trades happening per day. An automated algorithm is constantly monitoring these trades and adjusting the stock prices accordingly to balance supply and demand.
So let’s think about this conceptually:
What if there are only buyers, but no sellers? If that’s the case, the demand is going to be so high, that people are going to pay very high prices for stock ownership. When that happens, inevitably there’s going to be someone who’s going to find that price too irresistible to pass up and become a seller. As more sellers enter the market, the price eventually drops to a point where the number of buyers and sellers are roughly equal.
What if there are only sellers, but no buyers? In that case, people are going to lower their selling prices so low that eventually someone is going to take them up on that offer and become a buyer. As more buyers enter the market, the price eventually drops to a point where the number of buyers and sellers are roughly equal.
Of course, there’s always the possibility that if the stock truly has no underlying value, there’s going to be no one who’s going to buy it. If that’s the case, eventually the stock price is going to drop to pennies per share and the stock owners will have lost the value of their investments, with no buyers to get them out.
That’s what’s called an illiquid investment, or an asset that can’t easily be sold for cash without a huge loss in value (which is a whole other topic). You can think about it like trying to sell a cheap crayon drawing that no one wants. You can try selling it, but without buyers, you will never convert your drawing to cash and will just be stuck with it. At that point, you might as well just throw it in the trash.
Where does money come from when the stock price changes?
If we’re thinking about this in terms of transactions between buyers and sellers, you can think about the money as ending up in the seller’s hands at the last selling price. Any profit or losses in investments come from people’s changing perception of the value of a stock.
There’s no money making machine that inflates the price of a stock. There’s no one who’s stealing your money when the stock price drops. All that matters is what people perceive the price of the stock to be at the time of buying and the time of selling.
If you want to think about it in terms of profits and losses, one person’s profit is another person’s loss. If someone sold a stock to you at $10 and you sold it back to that person at $7 thinking it’s worth less than when you bought it, your loss of $3 would be that person’s profit of $3.
While it might seem like there are winners for every loser in the stock market, practically speaking, the price could continue to move upwards with no end because there are constantly more people coming into the stock market pushing stock prices up. It’s not a closed system.
Conclusion
So where does the money go when you buy a stock? Long story short, it goes to the seller, the person who sold that stock to you. That could be the company if it’s offered as part of an IPO, but most likely it’s another investor like yourself selling their stocks to you.
If you enjoyed reading check out some of these other articles:
- Retirement Investing for Beginners
- Financial Milestones by Age
- How to Build an Investment Portfolio
- Stock Market Investing for Beginners: the Complete Guide
Fun facts: used to lion dance in college, can speak 3 languages (sort of), can lift 400 lbs, once ate a chicken head.
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