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How Does the Stock Market Work

How Does the Stock Market Work
Jen Smith
Updated October 10, 2021
6 Min Read

When I started investing I was absolutely clueless about stocks, bonds, exchanges, indices, and all the other terms that make the stock market sound equal parts fancy and horrifying. I wanted to know, how does the stock market work? But I was always too nervous about what I’d find to start looking.

But there comes a point where inaction is more painful than action. And once I finally got over my fear and researched investing, I realized the stock market isn’t as confusing as people seem to think it is. Sure, there are some complex ways to buy and sell stock but at its core, the stock market is just a supermarket for investments.

What is the stock market?

Just like you’d go to the supermarket to get your produce, meat, and bread, you go to the stock market to invest in stocks, bonds, and other commodities. Any company that’s available for the public to purchase is in the stock market.

And just like the grocery store organizes its produce, meat, and bread by sections, the stock market is also organized by sections called stock exchanges. The New York Stock Exchange is the world’s largest stock exchange. It’s been around since 1792 so it’s where you’ll see well-established companies that have been around for generations. 

The Nasdaq, on the other hand, was founded in 1971 and is known for attracting internet, biotechnology, and other innovative companies. Stocks listed on the Nasdaq are typically higher-growth but can be more volatile.

We track the market by using stock market indexes. An index measures the whole stock market, one of it’s exchanges, or another subset. Indexes help investors calculate market performance by comparing current price levels with past prices. The S&P 500, Dow Jones Industrial Average, and Nasdaq Composite are all stock market indexes.

How does the market work?

The stock market serves as a primary market and a secondary market for stock shares, meaning it sells brand new shares through IPO’s and allows investors to “trade in” shares where they’re resold to other investors. It’s the intermediary between companies and investors and ensures fair pricing and trading. 

A company can enter the stock market for a number of reasons but the biggest one is typically money. 

Many companies will start out with funding from private investors and once they’ve exhausted venture capital, or in order to pay those investors back, they choose to go public. Listing a company on a stock exchange gives it a whole new outlet for funding.

Companies get into the stock market through a process called an initial public offering, or IPO. They divide their company into a set number of shares and list some of those shares on an exchange. The shares are priced and divided in an effort to make as much profit as possible while also selling out all the shares.

Where the stock market differs from a supermarket is in the way you buy. The stock market is less like a store and more like an auction house. Sellers “ask” for a certain amount for a share and buyers “bid” a lower price. 

Historically the bids and buys would take place on the floor of the New York Stock Exchange but thanks to technology, everything takes place electronically and computer algorithms have made the process much more efficient.

What can affect the stock market?

Stock prices are driven by a number of factors, some are a result of data but many are circumstantial. The primary data factors are earnings and valuation. Earnings are the return on your investment that are either paid as dividends or reinvested to promote higher return on investment. Valuation is the present value of anticipated future earnings.

Most people are probably familiar with the non-data factors that affect the market like interest rates, inflation, unemployment and economic growth. Uncertainty in the economy or domestic and foreign politics often lowers the market. Alternatively, periods of low inflation can drive the market up.

At the end of the day, the biggest driver of the market in any direction is the result of human psychology. You can have all the facts about a company show that it’s a solid investment but a bad story about them in the news can sour an investor's attitude toward it. That’s why successful investors rarely put all their money into a single company or sector. 

How do stocks work?

Stock is the sum of all of the shares into which ownership of a public company is divided. A single share is considered fractional ownership of the company and individual shares are collectively known as "stock.” 

Today around 6,000 companies are publicly traded on the NYSE and Nasdaq, and you can own a piece of all of them. 

Owning stock doesn’t entitle you to any assets or give you a lot of say in the company’s direction. It does entitle you to a share of earnings, proceeds from liquidation of assets (should the company dissolve) and voting power proportionate to the amount of stock you own. 

To put it simply, if buying stock in a company helps it raise money to become more profitable, owning that stock entitles you to a share of that future profit. It’s important to note, if for some reason the company doesn’t use your money wisely, you share the losses as well.

How does investing in stocks work?

Investing in stocks is no longer a complicated or time-consuming process. Thanks to technology you can own stock in a single company, or every company in the market, in as little as five minutes. 

Most investors buy stocks by purchasing individual shares of the stock or by purchasing a collection of stocks via a mutual fund. A mutual fund is any bundle of stocks, bonds, or other commodities. By purchasing shares of a mutual fund you’re buying micro pieces of many different stocks in a single transaction. Mutual funds make investing in stocks much easier for the average retail investor.

Index funds and exchange traded funds, ETFs, are popular types of mutual funds that track indexes. You can purchase an S&P 500 index fund, total stock market fund, Nasdaq composite index fund, and so on. These funds are compiled so that the number of shares of each company in the index is reflected proportionately in the fund.

When it comes to profiting from your shares, returns are a result of two things: capital gains and dividends. A capital gain occurs when you sell a stock at a higher price than the price at which you purchased it. A dividend is the share of profit that a company distributes to its shareholders. 

Most investors are well aware of making a profit through capital gains, it’s much quicker and, frankly, more fun. But investors who don’t buy and hold miss out on dividends, an important component to growth. Since 1956, dividends have contributed nearly one-third of total equity return, and when average capital gains have fallen, dividends have risen. So even if you want to buy and sell single stocks, it’s smart to balance with long-term investments.

How can you buy stock?

There are several ways to buy individual stocks or mutual funds. First you’ll need to decide which route you want to go. If you want to buy individual stocks you can open an account with an online brokerage that offers single stocks. Some even offer the option to invest in fractional shares which means you don’t even have to buy an entire share, this is great for investing in high-priced shares like TSLA.

If you want to invest in mutual funds you may want to start with tax-advantaged retirement accounts like your employer’s 401(k) or similar plan. If you don’t like the options there you can open an IRA at a brokerage that sells mutual funds. You have several brokerage options as well. You can purchase funds through a financial advisor who’ll pick the funds and invest your money for you. When going this route be sure to find a fiduciary Certified Financial Planner who doesn’t work on commission. 

A more affordable option would be to invest through a robo-advisor which uses a computer algorithm to pick funds and invest for you. The most affordable would be opening an account at an online brokerage like Vanguard or Fidelity and designing your own portfolio of mutual funds to invest in.

Once you’ve decided how and where to invest, the key is to start now and invest regularly. The most successful investors are those who ignore intricate strategies and “get-rich-quick” schemes and simply invest regularly.

How to start investing

Investing in the stock market is easier than ever for the retail investor. Many employers offer some kind of 401(k), 403(b), 457, or similar to make it simple, and tax advantaged, for employees to start investing. If you don’t have an employer sponsored plan look into opening an independent retirement account, or IRA. This account offers you some of the same tax advantages while allowing you more freedom in your investing options.

Beyond tax-advantaged retirement accounts, or for those who want access to their money before 59 ½ you can open a traditional brokerage account at a number of places. New apps and robo-advisors are coming out all the time to make investing in the stock market easier and more accessible. There has never been a better time to learn how the stock market works and grow your money.

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