Understanding the Stock Market. What It Is and How It Works

The terms ‘stock market’ or ‘stocks’ are common terms you hear on the news or amongst investors. While many people have a vague idea of what stocks could mean, only some people understand how stocks and the stock market works. In very simple terms, a stock market is a place where investors connect to buy and/or sell stocks and other related securities. Stocks are simply shares of ownership in a public company.

In this article, we will be considering what the stock market is, how it works, and how you can invest in it.

What is the stock market?

A stock market is a place where individual and institutional investors meet to buy and sell shares or trade shares publicly. The US stock market is collectively made up of the major stock exchanges like the New York Stock Exchange or Nasdaq. There are also stock market indexes that track the performance of each stock listed on the stock exchanges. These indexes function as secondary markets by tracking different stocks listed under them. They also include a section of the primary stock market and the performances of these exchanges serve as representatives of the entire stock market. Investors come together to buy and sell on these stock exchanges.

Whenever it is said that the stock market is bullish or bearish; or closed up or down for the day. It mostly means that collectively the stock market indexes are either performing well or underperforming. Basically, the indexes have either lost or gained value by some points.

In past times, stock exchanges were limited to brick-and-mortar through a system known as “open outcry” whereby traders used verbal and hand signals when communicating. These signals were used to buy and sell large blocks of stocks in the “trading pit” (also known as an exchange floor). The open outcry system has since been replaced by the electronic system at most exchanges. In recent times exchanges exist mostly electronically through the internet and online brokers. That way investors and stock traders can access the market easily and remotely.

How does the stock market work?

The stock market works like every other market place where buyers and sellers meet to exchange or trade commodities for commodities or commodities for cash. There is also the ‘auction house’ aspect to stock markets where buyers and sellers can negotiate prices before making trades.

As earlier stated, the stock market functions through secondary markets called ‘exchanges.’ The most popular stock exchange is the New York Stock Exchange. Usually, for companies to be able to have investors buy or sell their stocks, they must be publicly listed on an exchange. Companies get publicly listed on stock exchanges through a corporate process called ‘initial public offering’ (IPO). In a company’s IPO, investors will be allowed to purchase shares of the company which in turn will allow the company to raise funds to further develop the business.

It is the duty of the stock exchange to track the supply and demand of the listed stocks. By doing so, they will help in determining the price of each security, or the levels at which investors and traders are willing to buy or sell. The calculation is generally done using computer algorithms.

This is how it works, buyers offer a “bid” which means the highest amount a buyer is willing to pay. It is a price that is usually lower than the “ask,” that is, the amount sellers are requesting in exchange. If a trade must occur, then buyers and sellers must agree on a price—either the buyer increases his price or the seller decreases his price.

While investors’ and traders’ activities can determine stock prices, there are other external determining factors such as news, economic reports, or political events.

How to invest in the stock market

There are many ways to invest in the stock market or stocks. You could either do so by purchasing individual stocks through a brokerage account, through an individual retirement account (IRA), or through a 401(k) offered by your workplace. You can also consider mutual funds which comprise of stocks of different companies.

You can set up an account with an online broker, through which you will be able to buy and sell stocks. This is with the exclusion of the 401(k) because it is the responsibility of employers to set up 401(k) accounts for their employees. The purpose of a broker is to act as the middleman between investors and stock exchanges.

There are quite a variety of stock-related investments that trade on the stock exchange, however, the most common are stocks. All investments come with risks, including the stock market. As a way to mitigate risks, investors build diversified portfolios comprising of stocks and other investments.

Another way would be to invest in a type of mutual fund called an ‘index fund’ or exchange-traded fund. These funds will help you build a diversified portfolio that doesn’t comprise of individual stocks alone. The purpose of these funds is to passively reflect the performance of an index by holding all the stocks or investments in a given index. Through index funds, you can invest in both the S&P 500 and the Dow Jones, and other index funds you wish.

Investing in stocks and stock mutual funds are best for long-term investments like retirement or wealth growth. They are not ideal for short-term investments, which are usually below a 5-year timeline.

Top online brokers to consider

Top index funds to consider