The stock market health is a good indicator of how the overall economy is doing, which is why it is often used interchangeably with the economy—but these two are not one and the same. To clear up the confusion, I’ll answer the question: how does the stock market affect the economy?
And how do your personal investments in the stock market affect individual businesses? Spoiler alert—they do affect businesses! When you invest in the stock market, you can actually impact the economy and make the world a better place.
If you want to learn how investing affects the economy, keep reading.
Stock Market vs. The Economy
The stock market is not the economy, but it is part of the economy.
It is a financial institution that allows businesses to sell portions of their companies to the public. Most of the big businesses you and I interact with on a daily basis are publicly traded in the stock market.
The U.S. economy, on the other hand, is the entire makeup of goods and resources in the country. The manner in which U.S. citizens, businesses, and the government produce and consume goods make up the economy.
The difference between the stock market and economic performance is that one is based largely on the feelings of individual investors, while the other is based on concrete data such as gross domestic product (GDP), employment rate, and consumer spending.
How The Stock Market and Economy Work Together
Because the stock market tracks all publicly-traded companies it can be used as a measure to track economic growth.
If the stock market is going up, it typically means businesses are doing well and producing more, and therefore GDP is going up.
How GDP is Affected
The stock market affects individual consumer spending as well, which also impacts GDP. GDP is one of the largest contributing factors to a healthy economy. In these ways, you can see how the stock market affects the economy.
However, the stock market can rise based on investor optimism or fall based on investor fear, which makes it far more volatile than the economy. In this case, the market is not always a true indicator of overall economic health.
How Does the Stock Market Affect Businesses?
Not all businesses are traded publicly in the stock market, but those that are are greatly affected by the price of their stock.
When a business initially sells part of its company on the stock market, it issues shares and receives the money from the purchase of those shares directly. Later, it can decide to sell more shares of the company to receive more money.
But in all other cases, when you or I buy a share of a company, the money goes to the seller of that share—not the company.
Although the company doesn’t always receive the money directly when you invest in it, your purchase still largely affects them.
Investing Helps Businesses
Investing in a company drives its stock price higher. So, why is a high stock price good for business?
First of all, the stock price helps a company determine its value.
Stock prices are based on supply and demand, so if the demand for a company’s share is high, the price will be high. Based on the demand for its stock, the company can evaluate how much it is worth. Knowing its value can help a company make better decisions for the business as a whole and for employees.
For example, based on that value, the company can offer payouts in the form of company stock to its employees. As long as that stock is valuable, shares of company stock can be a great incentive for employees and give companies an advantage over competitors.
The value of a company’s stock also comes into play when merging with or acquiring other companies. It can indicate the value of a company for sale, or sweeten the deal for employees being acquired.
Finally, the value of a company’s stock can help it secure funding from banks and investors to grow and scale. As you can see, your investment in a company’s stock is vital to its overall health.
How Does The Stock Market Affect The Economy?
As I mentioned above, the stock market is part of the larger economy and does play an important role in economic health.
It reflects the profitability and potential of so many large businesses that make up a large portion of the country’s GDP.
If the market is rising, it is a good indication that businesses are doing well and GDP is growing. If the market is falling, it can mean businesses are losing money, becoming less profitable, and maybe laying off employees, which can lead to shrinking GDP.
How Consumer Spending is Affected
The rise and fall of the stock market also affect consumer spending. For instance, if a person is employed and experiencing growth at work, they are likely to increase spend, whereas if a person is laid off, his or her spending will drastically decrease.
In another case, if a person’s investments are performing well, they are more likely to feel secure and spend money, but if investments are performing poorly, they are more likely to feel uncertain and rein in spending.
The stock market can cause an increase in or reduction in spending not only for individuals but also for businesses, which in turn affects the economy as a whole.
What Affects Stock Market Performance?
The stock market is affected by the thoughts and feelings of individual investors, which are influenced by a variety of factors, but boil down to excitement and fear.
Excitement and Fear
Excitement drives people into the market, and fear drives people out of the market. Excitement and fear can be caused by economic policy, business news, and world events.
When other investors see stock market prices begin to fall, fear mounts, and they begin to sell as well. This causes a ripple effect that can drive the stock market further and further down.
On the other hand, world events such as important elections and exciting innovations can make investors feel hopeful and put money into the market, thus driving it higher and higher.
How Does Investing Help The Economy?
When you invest in the stock market, you are contributing to the success of the businesses you are investing in and the economy at large.
Similar to a storefront, or business of any kind, a strong stock market depends on the number of purchases made.
If you and I are buying stock in a company, we are contributing to both the company and the stock market by causing demand for that company’s stock to rise, and therefore the price of that company’s stock to rise. Multiply that by millions of people investing in hundreds of companies, driving demand and prices higher, and you can see how the stock market goes up.
When the stock market is falling, it signals that there is a lot of fear in the market. This is a prime opportunity for Rule #1 investors not only because you have the chance to purchase a company’s stock at a lower price, but also because you have the chance to support that company.
The willingness to buy when there is a lot of fear can help establish the value of a business. By helping establish the value of a business you are making it possible for companies to stay afloat, employee stock options to stay valuable, and enabling that business able to go out and acquire other businesses that need rescuing.
How Does Investing Make The World A Better Place?
When you purchase the stock of a company, you are voting for that company with your money and contributing to its success.
As a Rule #1 Investor, I believe it’s so important to vote your values. The investment you make in companies helps ensure they will be bigger and better down the road.
If you invest in companies you believe in and whose mission you support, you are helping them to grow and continue to act on that mission.
We really do have the power to move the needle by investing in wonderful businesses. If a business is making the world a better place, you are making the world a better place by investing in it.
This is one of the coolest parts about investing: you can support real companies with real missions, with real employees. In fact, 85% of the money in the stock market is coming from individuals like you and me. We can have a real impact when we use our money to fuel a company’s growth.
How Does The Stock Market Influence The Finances of Individuals?
In addition to making the world a better place, investing can also help secure a better future for you and your family. If you’re wondering why you should invest in the U.S. stock market, this is reason enough!
Here is how the stock market can affect the average person like you or me:
You’re able to own a part of growing businesses. I’ll say it again, investing in wonderful businesses that align with your values can help make the world a better place. You can play a part in the success of businesses you believe in and receive the positive financial impact of their growth.
You’re able to beat inflation. Putting your money in a savings account is safe, but with interest rates under 2% at best, you won’t beat inflation in the long run. The stock market, on the other hand, gives you an average return of 7% year over year if you invest for the long run.
You can have a much better retirement. By investing in businesses that will grow and thrive in future years, you can experience a great return on your money. If you can follow Rule #1 principles, you have the opportunity to generate passive income that will support you and your family in 10, 20, 30 years down the line.
If you’re ready to learn more about how to invest, get started with my Do's and Don’ts of Investing Cheat Sheet. You will not only be prepared to jump into the market when it’s down and support the economy, but also be on your way to a better financial future.