The stock market is a fundamental cornerstone of the global economy and carries a certain mystique that makes it intimidating to some novice investors. Many of us are adults who have worked for years without looking into investments in the stock market; it seems like there’s so much to learn and understand about investing if we’re going to be successful at it.
While that’s not wrong, the truth is that just about anyone has access to the stock market. Its fundamental principles are easy to grasp, even if they take time to master — just like every other part of life.
How do stocks work? What does the stock market do? Here’s a primer for those who are just getting started.
How the Stock Market Works
What is Stock?
When a person holds “stock” in a certain company, that means they own a part of that company. Granted, it’s a very, very small percentage of the company’s overall ownership, but it’s legitimate. Stocks are sold to the public in the form of “shares.” The more shares of stock you own in a given company, the higher your percentage of ownership.
Owning stock means you have a vested interest — called “equity” — in the company’s success or failure. As the company grows and becomes more successful, the price of a share goes up and the value of your holdings increases. If a company runs into some hard times, the share price may decrease and your stock value decreases.
Most investors buy stocks and hold onto them for a long time. They buy shares in companies that they believe have great long-term prospects for success and just leave their investments intact to watch them grow in value over multiple years. Other traders are more aggressive, buying stocks when they’re low in price and selling them as soon as possible after they reach a certain price threshold.
Why Do Companies Sell Stock?
Businesses need money to operate. Corporations have multiple branches that need funding: New product development, hiring employees and contractors, leasing offices, marketing, office supplies, and so forth. All of those functions require infusions of capital.
Small and developing companies need to raise money to get through the early phases of their existence. They need to make investments in their products, manufacturing, buildings, marketing, sales and distribution networks, and so on. Startups require fast access to cash to fund immediate growth and future expansion.
Selling shares is one way that companies can raise that money. Startup businesses, in particular, rely on stock shares — as well as venture capitalists, angel investors, and their own cash reserves — so that they can obtain capital without having to borrow money from financial institutions.
What is a Stock Exchange?
Shares of stock are sold at stock exchanges. Historically, these have been literal marketplaces where traders bought and sold stock shares in an open-room marketplace, sort of like an auction. In modern times, the stock exchange is mainly a virtual concept — traders use online brokerage accounts for their stock transactions. Physical stock exchanges, like the New York Stock Exchange (NYSE), still exist, but the large majority of stock shares are now traded electronically.
There are several stock exchanges across the world. The NYSE is the most famous and still the biggest. Nasdaq is the next largest and the first to conduct all trades electronically. Tokyo, Shanghai, Hong Kong, Amsterdam, Riyadh, and London are all home to other high-volume stock exchanges.
Before the age of the Internet, private investors retained the services of professional stockbrokers who would take their orders to buy or sell over the phone. Information didn’t travel quite as fast as it does now, so the transactions weren’t always turned around quickly. With modern online brokerages, stock buyers place their orders to the exchange themselves. During normal business hours, the transaction takes place in close to real-time.
All transactions on the stock exchange happen between individual stock owners. 99.9% of the time, companies don’t sell stock directly to common investors. Instead, investors buy and sell stock from shareholders like themselves. It’s a little like selling items on consignment. That’s why the stock exchange is considered to be a secondary market.
Companies sell on the primary market when they go public and offer stock for the first time (an initial public offering or IPO) and in a few other, very rare situations. The average investor seldom has access to the primary market — you’ll be dealing with the secondary one in almost all your trading activities.
How Are Share Prices Decided?
There are several ways in which individual stock shares are priced. The method that most people will recognize is the principle of supply and demand. When a company is thriving, more investors want to buy into it; when that’s the case, the share price goes up. If a company is going through a difficult stretch, more investors want to sell their shares, which drives the stock price down.
Professional traders tend to drive the market for stocks. The stock market is heavily dependent on their evaluations and speculations, and they consider several factors when deciding whether a company is worth their continued investments or whether they should bail out.
Business and market news play a large part in that valuation. Earnings reports, new product releases, leadership changes, and other company events are typically used to judge a company’s health and future. Political and broader economic news — jobs reports, sector-wide news, legislation, federal regulations, and so on — can also impact the share price of a certain company or industry.
Market psychology can also factor in. Like many aspects of commerce, the stock market occasionally succumbs to a herd mentality. Individual investors see a whole lot of other investors jumping all over a hot stock, and they want to get in, too. That can drive the share price up. But if they haven’t gotten in on a stock early enough, they may not realize a great deal of profit from their investment. Timing is a huge factor in how the stock market works.
Conducting a Transaction
How do stocks work? The stock market can be a complex beast, but these days, making a stock purchase is extremely easy.
It all starts when an investor opens a brokerage account, which is largely done online. Traditional brokerages like Fidelity, Charles Schwab, TD Ameritrade, and Merrill have online presences, alongside newer companies like Robinhood and E*TRADE. You can open an account with as little as a dollar, but you’ll need to start with enough money to purchase a share.
You’ll want to spend a little bit of time researching the stock you want to buy. You can do this for yourself or by using a service like Gorilla Trades, which does tons of research before suggesting their stock picks. In general, you’re looking for a stock that stands a great chance of turning a profit in the form of share price increases over a given period of time.
When you’re ready to buy, you’ll have two options. The first is called market order. This method is best when you want to buy the stock as soon as possible at whatever price it’s at. The advantage to market order purchases is that they happen quickly. The risk is that the price will go down after you’ve purchased it. Unless you’ve spent a huge sum of money the first time out, the decrease probably won’t hurt you that much.
The second option is the limit order. This means that you only buy the share once it reaches the price you set. If a stock’s currently trading at $52, but you don’t want to purchase it until it gets down to $50, you’d place a limit order that automatically executes the trade when it hits $50 (or lower). The advantage of this strategy is that you don’t spend more than you want. The disadvantage is that you could be waiting a while for that stock to get to that price — and it may not ever get there.
When a brokerage sells stocks in a certain company, it fills market orders first. Limit orders are then fulfilled on a first-come, first-served basis. All stocks fluctuate in price every single day, which is why market orders are usually sufficient. Huge, precipitous gains or declines in a single trading session don’t happen that often, so most times, a market order won’t hurt you too much. The share value will hopefully grow over the longer term.
Using Indices
An index (or “indices,” if you prefer) is a benchmark that offers rough measures of how well the overall stock market performs over a given period of time. The media uses them to report on present market conditions and trends.
Although indices probably hold less meaning for beginner investors, it’s good to know about them. Down the road, you can use them to gauge how your stock portfolio is performing by comparing your stocks’ value growth to that of the rest of the market — if you’re gaining at a higher percentage than these indices, you’re doing well.
There are hundreds of different indices that measure how different groups of stocks are performing: Companies of certain sizes (“market caps”), companies in certain business sectors, regional companies, foreign companies, and so forth.
Three indices every stock trader should be familiar with include:
- Dow Jones Industrial Average: This calculation measures the stock performance of 30 of the biggest American companies on the market. It’s generally used as a barometer of how the overall economy is doing but is not the only such barometer.
- S&P 500: This index measures the stock performance of 500 of the top U.S. companies, covering about 80% of the total U.S. stock market value.
- Nasdaq Composite: The Nasdaq is both an index and a stock exchange. It’s come into prominence over the last few decades because it focuses on tech stocks, with a few more traditional securities, as well.
Bull vs. Bear Markets
Timing is a vital component of stock marketing investing. Market conditions are a big influence on investors’ decisions. The terms “bull” and “bear” are used to describe prevailing, overall trends in the markets — and they’re also used to describe certain types of investors.
A “bull” market is on its way up. It reflects an economy that’s in good shape, in which share prices are going up dependably and consumer confidence is high. Bull markets reflect uptrends.
A “bear” market is one that’s going through some period of decline or economic recession. When the market has dropped by 20% or more from fairly recent highs, it’s considered to be heading into a bear market. Share prices fall, the economy slows down, and unemployment usually goes up.
Bull and bear markets dictate investor mindsets and strategies. Sometimes, investors overreact to both good and bad stock market conditions, making fatal decisions on incomplete or inaccurate data. But keeping an eye on how the market is trending is a trait of wise investors, so it’s smart to start tracking market movements as soon as you become an investor.
Buying and Selling
Transactions fuel the stock market, just as ordering and selling products fuel your local supermarket. But there are a thousand different strategies for knowing when the right time to invest in or unload stocks might be.
The most basic rule of thumb is to “buy low, sell high” — but that’s really only a starting point for your strategy. Sometimes, you’ll want to buy into a blue-chip stock: A large, globally known company that’s been around for years with a history of dependable, consistent growth. These stocks are usually safe, even in turbulent market conditions where their value declines a bit.
Sometimes, you’ll think about investing in a startup company that stands to make a big gain as it increases its foothold in the marketplace. When that stock rises a certain price point, you might want to sell it to maximize your profits — or you may choose to hold onto it if you think it still has room to grow.
The key to understanding how the stock market works is research. No two companies share the same prospects. An investor needs to review as much information as they can get their hands on — annual reports, news, historical trends, fundamental and technical analyses, and more — to know when to pull the trigger on a transaction.
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