[MUSIC] In the early 1600s, the Vereenigde Oost-Indische Compagnie, also known as the Dutch East India Company, became the first example of what we now call a multi-national corporation. It was engaged in a lucrative spice trade between Europe and the Indian subcontinent and was granted exceptional powers by the Dutch government to wage war, issue currency, establish colonies, and even execute prisoners. In the realm of finance, the company is remembered for something extraordinary. It was the first joint stock company. This meant that the managing directors, their families, and other investors could receive an acti or action or what we might refer to as a piece of the action, in the form of shares in the company's future profits, which, of course, may or may not be realized. This is where the idea of having an equity stake or owning stocks in a firm originates. So the Dutch East India Company can be credited with creating the first stock ownership system. This differs fundamentally from owning bonds, which, as we've discussed in the previous video, entails a contractual obligation where the firm must pay, as well as another important distinction, in that stocks afford the unique privilege to vote on the firm's governance. That is, shareholders have the exclusive right to appoint members of the board of directors, who are responsible for appointing senior management, like the CEO, and therefore, have significant influence over the governance of the company. While one share one vote is generally considered the golden rule to give everybody a voice to express their views and concerns, this is not always the case. Many companies, including Facebook and Google, allow superior voting rights for founding members and insiders. Stocks are traded in regulated exchanges and over the counter, which refers to any place other than an exchange, such as online trading. The world's five top stock exchanges, in terms of their market values, are in the NYSE and NASDAQ in New York, the LSE in London, the JEG in Tokyo, the SSE in Shanghai. Collectively, they are estimated to be worth in excess of $40 trillion. Despite these impressive totals, many people question why stock exchanges are important and how they affect our lives. One answer is that since a stock exchange is an organized marketplace to raise money, it breeds a competitive space for the best ideas to surface, ideas that promise to generate future cash flow, which we discussed in course one, decisions. This leads to capital formation and efficient allocation, which are fancy terms that simply mean it leads to economic growth that increases our standard of living. Well functioning stock exchanges also encourage institutions and the public to have an equity stake in companies, which, again, gives them influence on the governance of these firms. Another more textbook answer is that stock exchanges help us to discover price. If prices are to be determined fairly, this requires abiding by established rules and regulations for reporting financial information, ensuring transparency, and trust in executing the buying and selling of shares, and maintaining a level playing field, where insiders don't benefit from privileged information. In course one, we saw an example of price discovery, when we determined the value of t-shirts using a Dutch auction that drew on the laws of supply and demand. While still atypical, Dutch auctions have been used in the initial public offering, or IPO, of several new companies coming to market, including the partial sale of stocks for Google. In the absence of these proper conditions, vested interest groups can exert power and influence for the financial benefit of the few. Later, we'll look at these conditions in more detail after considering a couple of basic valuation models that are commonly used to determine stock prices. A stock split is when a company issues new shares to existing shareholders in a way that is proportional to their current holdings. So this means that there are more shares of the company, but the value of that company does not necessarily change. The result is the value that we hear on the news every single day that is used to gauge the performance of the economy at large. For example, the DOW is at 17,900 today. This is meaningless on its own, unless, of course, we compare it to changes over time. Let's say the DOW moves 179 points in a day, which might sound ominous, but still, it's just 1% of the total index value. Since the index is a price weighted average, small changes in the higher priced stock, such as 3M and Goldman Sachs, will have a much bigger impact on the index value than, say, lower priced stocks like Cisco or Coca-Cola. Despite these limitations as seen in the graph, the DOW correlates pretty well with large industries, like the Standard & Poor's 500 index, which has 500 stocks in its index. The DOW is easy to understand, and it's often used as a benchmark for equity performance compared to other investments. For example, take a look at the Dow's performance over a very long period as shown in the graph. This kind of graph, which clearly shows an upward trajectory, is used repeatedly to argue that since the DOW is a good proxy for the stock market, one can prosper handsomely if you hold equities for long periods of time. Personal financial analysts also talk about dollar cost averaging, which speaks to the important question of timing, entries, and exits to and from the market. This implies that generally speaking, as long as you keep buying equities, over the long run, you will buy at both high and low prices, which will average out the cost. So this logic of the long run and averaging is compelling. But the red circles on the graph are also worth noting. These indicate that equity investments can underperform over periods of ten years or more. Given the large demographic of aging baby boomers, if they are entering the market today when it has peaked, the prospect of holding equities may not help them at all after this considerable volatility within various sectors of the market caused by factors that appear to be more psychological than economic. And we have the appearance of markets that resemble the odds you might find in a casino. To summarize, the process of price determination is absolutely critical. But let's face it, the smartest people on Earth have been trying forever to figure out just how this happens. So that they can time their entries and exits just right and make a lot of money. What we do know is that there are no money making machines out there. But we can tackle this important question in course three, and we will. We've broadened our discussion to price risk and explore insights grounded in theoretical frameworks and in political studies to test just how efficient markets are for reflecting old and new information in the stock price and what other investments we might want to consider. Of course, we need to have an appetite to invest in volatile stock markets.
