Where do we go to acquire the assets that will make up our portfolio? For the most part, we’ll access the stock and bond markets.
You’ve probably heard of stock exchanges like the NYSE or NASDAQ. These are places where companies can choose to list ownership shares for the general public to trade. Initially, they most often access this market of investors in the primary market via an IPO. Investment banks generally lead this process acting as brokers to bring together institutional investors and the company to agree on a price to begin trading at. Once the shares are listed, they are then considered in the secondary market of any investor with access to the exchange. The day-to-day trading of the stock allows a price to be consistently found between those that are willing to buy the stock and those that are willing to sell the stock.
Bond markets work in much the same way, but they are generally less liquid (they have lower trading volume). This means that many bond transactions are still completed the old-fashioned way with salespeople at big banks creating a market for bonds that need buyers or sellers.
The efficient market hypothesis states that this price takes into account all information publicly (and in the strong version privately) available about the company. That means that at any point, the price you pay for a given number of shares is the fair market price. In practice, there are deviations from this hypothesis, but generally, we observe that large, frequently traded companies, adhere to this theory.
On the other hand, because individual investors are not always perfectly rational in their assessments, this dynamic can lead to bubbles. Bubbles can be found in any type of market. They generally don’t last too long before investors wake up and question whether the price they are paying to own a security maps to the underlying value of the investment.