How the Stock Market Works
What is the Stock Market?
The stock market refers to a group of market exchanges where investors buy and sell securities such as company stocks and bonds. In other words, it's a set of exchanges where companies list their shares and other securities and make them available for public trading.
How Does it Work?
To gain a better understanding of how the stock market works, let’s briefly answer the following question - what is a stock?
Put simply, a stock is a security that has a monetary value and serves to represent ownership of a company or corporation. By purchasing a company’s stock, shareholders win voting rights and a proportionate claim on that company’s profit through capital gains and dividends. Stocks are also known as shares or equities.
Companies and corporations sell their shares on the stock market to secure funding to grow their business while helping investors increase or sustain their wealth. Otherwise stated, listing their shares on the stock market allows companies to raise the necessary funding without having to take on debt while offering their shareholders a way to become wealthier.
However, companies are also obliged to disclose certain information about how they run their business and allow their shareholders to be involved in business decisions.
Investing in the stock market entails a certain risk, but when done properly, it has proven to be one of the most effective methods to grow wealth. Instead of accumulating their cash at home, affluent individuals and investors have most of their money invested in financial securities.
How Does One Benefit From Investing in the Stock Market?
The answer to this question is quite simple. Investors purchase companies’ stocks, expecting these stocks will appreciate in value over time and help them make a profit on their investments. By investing in a company, investors provide companies with the funding they can use to launch new products and grow, making their business, and their stocks, more valuable.
Apart from capital gains, investors can also benefit through dividends. Dividends refer to a distribution of profits companies make to their shareholders on a quarterly basis. It is important to note that not all companies pay dividends, but mostly those that are financially sound and well-established in their respective industries.
Companies that pay dividends to shareholders regularly are known as dividend stocks. Some investors highly prefer to purchase dividend stocks because they offer a reliable and constant source of income.
While stocks can affect investors’ wealth both positively and negatively, it is clear that the stock market as a whole has historically gone up over time, bringing average yearly returns to investors of roughly 10%.
Apart from providing them with a way to grow their wealth, investors also purchase stocks in order to diversify their investments as experienced investors usually prefer to allocate their money across different markets such as real estate, stocks, bonds, and others.
How to Invest in the Stock Market?
The most common ways to access and invest in the stock market include using a brokerage account. One of the good things about investing in the stock market is that nearly anyone can do it. In other words, you don’t have to officially become “an investor” to buy company’s shares.
Perhaps the most popular way to invest in stocks today is through a brokerage account. Investors can easily open an account at one of the online brokerage firms, after which they have to deposit money to be able to start investing in stocks. Essentially, the broker serves as an intermediary between investors and the stock exchanges where stocks are listed.
Apart from buying individual company stocks, investors can also choose to invest in mutual funds, index funds, and exchange-traded funds (ETFs), which represent investment vehicles composed of hundreds of individual securities.
Employees can also invest in the stock market through the 401(k) retirement savings and investing plan, offered by their employers. These plans often offer investors exposure to mutual funds.
Each company listed on the stock market has its own ticker symbol, which represents a unique combination of letters and numbers that serves to distinguish companies' publicly available shares of a particular company on a particular stock exchange. For example, Microsoft’s shares are listed on the Nasdaq stock exchange under the ticker symbol “MSFT”.
What is a Stock Market Index?
In addition to following and purchasing individual stocks, numerous investors also closely monitor stock market indexes. A stock market index is an index that tracks the performance of a group of select stocks within a particular industry or market segment such as healthcare, energy, real estate, and technology, among others.
These indexes, also called indices, tracks the stock prices of companies within that particular segment and the price movement of an index represents the net result of each stock’s movement tracked by the index.
Some of the most popular stock indices include S&P 500, Dow Jones Industrial Average (DJIA), and the Nasdaq Composite. S&P 500 is a stock market index that tracks the performance of the 500 largest U.S.-based companies. Dow Jones consists of 30 leading blue-chip stocks listed on the U.S. stock exchanges, while the Nasdaq Composite tracks nearly all stocks listed on the popular Nasdaq stock exchange.
Investors often look at the performance of the S&P 500 index because many believe it is one of the best indicators of the stock market’s health. The reason for this is that S&P 500 follows the 500 largest stocks in the U.S. market, as opposed to the DJIA which tracks the stock performance of only the 30 leading U.S. companies.
In addition to the mentioned indexes that track the broader market, there are also stock market indices that track a specific market sector. Investors can buy and sell indices through future markets or ETFs, which track a particular index or sector and can be traded just like individual stocks.
Companies typically decide to go public because they are in need of significant amounts of capital to keep investing in their business and spur further growth. Securing such capital can be nearly impossible from regular business operations and that’s why companies decide to list their shares, or ‘go public’, via an initial public offering (IPO).
Through the IPO, a private company becomes a publicly-traded one as it makes its shares available for trading to the general public. By launching an IPO, a company lists its shares on a particular stock exchange, which essentially represents a centralized marketplace where investors can buy and sell company stocks.
When the company’s stock debuts on a particular stock exchange (e.g. Nasdaq), shares of that stock start fluctuating as investors continuously trade shares.
Share prices on a stock market can be established in multiple ways, with the most popular one being through an auction where investors make offers to trade the shares. The highest price an investor is willing to pay for a security is known as ‘Bid’ while the price at which sellers are willing to sell the security is called “Ask’.
It should be pointed out that when an investor buys or sells shares of a company listed on the stock market, they are not trading them with the company itself but rather with other investors.
In layman's terms, the stock market is where people buy and sell shares of public companies. Investors benefit from investing in public companies through capital gains and dividends. Investing in stocks is gaining more popularity every year as anyone can buy shares of publicly-listed companies today with an aim of making profits.