How Does the Stock Market Work?

The stock market can inspire different reactions depending on who you ask. Some see it as the key to building wealth. Others remember the 2008 financial crisis or the dot-com bust of the early 2000s and want to avoid it. 

See: 3 Things You Must Do When Your Savings Reach $50,000

Whether it involves your individual retirement account or 401(k), or even if you participate in a pension plan, the success of all of these funds depends in no small measure on the stock market. 

Here’s what you need to know about how the stock market works and the basics of stock investing.

What Is the Stock Market?

The stock market is the financial market for stocks. A stock, sometimes referred to as an equity, is a security — a financial asset that gives an investor fractional ownership in a given company.

The stock market is made up of the places where investors can buy or sell stocks. It’s a vital part of the economy because it gives companies a way to raise capital and the public a way to share in those companies’ profits.

In the U.S., the Securities and Exchange Commission regulates what it calls national securities exchanges, which are marketplaces where financial assets can trade. Fifteen securities exchanges currently are registered with the SEC. In the case of stocks, the exchanges are stock exchanges. While numerous stock exchanges exist, most American stocks trade on either the New York Stock Exchange or the Nasdaq Stock Market.

However, not all stocks trade that way. Shares in some companies trade over the counter, within a network of broker-dealers that charge a fee to facilitate trades, often from their own inventory. The OTC market is loosely regulated, which makes investing in OTC stocks riskier than investing in stocks that trade on an open stock exchange like the NYSE or Nasdaq.

How Does the Stock Market Work? An Explanation for Beginners

When a public company issues stock, whether for the first time or through a subsequent stock offering, it lists the shares for sale on whatever stock exchange the company is a member of. Apple, for example, is a member of Nasdaq, so its shares trade on the Nasdaq Stock Market. Procter & Gamble is a member of the New York Stock Exchange, so that’s where its shares are listed.

Although stock exchanges are physical places, investors can’t visit one or log in to its website to buy or sell shares. One reason is that a stock exchange operates more like an auction with a reserve (minimum price) than a store. In a store, the seller sets prices and sells items to buyers willing to pay those prices. In an auction with a reserve, each potential buyer bids what they’re willing to pay, but no one wins the auction unless they meet the reserve.

With a stock exchange, investors typically buy stocks from other investors rather than the company itself, and prices are continually negotiated. A trade is successful when a buyer bids as much or more than the seller is asking for the stock. In fact, the stock exchanges actually use those terms — “bid” for the amount the buyer offers to pay and “ask” for the share price the seller is looking to get. Software matches buyers and sellers with compatible bids and asks.

How To Invest in the Stock Market

Stock trades must go through an investment brokerage, so you’ll need to open an account with one before you can start investing. Beginning investors typically open a cash account where you deposit your own funds to trade with.

Advanced traders with significant assets can open a margin account, which, for a fee, allows them to make trades with funds borrowed from the brokerage, using their portfolio as collateral. Trading from a margin account is risky. If the purchased shares drop in value, the brokerage can demand that you make an immediate deposit to your account to cover the loss, or it can sell the securities in your portfolio.

Opening an account only takes a few minutes. You can do it online on a brokerage website by filling out a simple application for one of the following:

• Self-directed trading: You select your own investments and place your own orders using your brokerage’s trading platform.

• Robo-advisor: Answer questions about your investing goals and risk tolerance, and the brokerage robo-advisor will automatically create and manage a portfolio of funds based on your answers.

• Professional advisor: A professional advisor trades on your behalf or offers personalized guidance on trades you order yourself.

You can begin trading after you’ve funded your account.

How To Buy and Sell Stocks

Assuming you want to trade your own stocks, you can use research provided by your brokerage to decide what shares to trade. You then find that stock on the platform and click a button or link to trade it, much like making a purchase from an online store. In this case, however, you’ll select the type of order you want to use to make your trade. The most common ones are market orders, limit orders and stop orders.

Market Orders

In a market order, an investor buys or sells the stock immediately — usually at or near the ask or buy order price. However, there’s no guarantee because the posted bid and ask prices are based on the last executed order. This does not necessarily mean the next market order will execute at the same price.

Limit Orders

Whereas market orders are for an immediate trade regardless of price, limit orders are for trading at a specified price or a price better than your specified price. So, for example, if you place a limit order for XYZ stock at $25 per share, the purchase won’t be executed unless there are shares available for $25 or less. Likewise, if you want to sell shares at $25 using a limit order, the sale won’t be executed unless a buyer is willing to pay $25 or more for the shares.

Stop Orders

In a stop order, also called a stop-loss order, the investor specifies a price at which to buy or sell a stock. A beginning investor might use a stop-loss on a stock they’re selling, to specify the minimum price they’re willing to accept. If, for example, you own shares of XYZ stock, and shares are trading at $30 but are beginning to fall, you could use a stop-loss order to sell the shares if share prices hit $28. You can also use stop orders to buy stock when you’ve used a strategy called short selling that essentially bets on a stock falling in value. If shares are rising instead, you can use a stop order to sell the shares once they reach a certain price.

How To Make Money Trading Stock

You might be wondering how to make the stock market work for you. Individual stocks carry risk as they can fluctuate in value based on both internal and external factors. However, stock investing tends to generate returns in the long term. The S&P 500 — a stock index that tracks the returns of about 500 of America’s largest companies and represents the broader stock market — has produced an average annual return of about 10% over the last 10 years.

Stocks produce returns in two ways.

Rising Share Prices

Stocks can generate profits through capital appreciation — a rising stock price. For example, if you buy 100 shares of stock XYZ at $10 per share, your cost is $1,000. The stock may rise to a value of $12 per share one year later, however. At that point, your original investment of $1,000 is now worth $1,200.

Remember that stocks are meant to be a long-term investment. Buying and holding shares of high-quality stock is often the best way to profit from rising share prices.

Dividends

Many stocks offer cash payouts or dividends. These dividends are a portion of a company’s profit paid out to shareholders. Most companies pay dividends in fixed periods, often every quarter. However, no rules exist regarding when publicly traded firms issue dividends. Hence, they can also pay special or extra dividends at any time. 

Dividends represent income for investors, and you can withdraw them from your brokerage account. However, reinvesting dividends in more shares can grow your money faster through the same principle as compound interest. Some companies offer dividend reinvestment programs, or DRIPs, that automate this process.

Managing Risk

Despite the S&P 500 rising overall, buying a stock places your investment capital at risk. Your initial investment can fall in value and, in theory, become worthless should the company declare bankruptcy. For this reason, you may want to receive advice from a financial advisor when considering the purchase of a given stock.

Investors can mitigate this risk in other ways.

Invest In Funds

One way to mitigate risk is to buy mutual funds or exchange-traded funds instead of individual stock shares. Funds invest in numerous types of stocks based on sector, index, countries or regions of origin and countless other factors. Should one of the stocks in the fund go under, investing in such a basket of stocks reduces that impact.

Some funds are actively traded — fund managers buy and sell shares to meet the fund’s objective. Other funds, called index funds, replicate the return of a stock index like the S&P 500 or Dow Jones Industrial Average.

Diversify Your Portfolio

Investing in more than one fund or in different categories of stocks, such as large-cap, small-cap and foreign stocks, is one way to diversify your portfolio. It’s also a good idea to place some of your capital in other asset classes such as bonds and cash or a cash equivalent. What percentage of your portfolio you should devote to various asset classes depends on how much risk you’re comfortable with and how long you have until retirement. The more stock you have, the riskier your investment but the higher your potential gains.

Use Dollar-Cost Averaging

While it might be tempting to try to buy stock when prices are at their lowest and sell when prices are at their highest, it’s often a losing strategy. A safer, and usually more lucrative, one is to set a budget and invest on a regular schedule, such as monthly or quarterly, regardless of what the market is doing. This results in dollar-cost averaging, where you buy more shares when prices are low and fewer when prices are high, with no risky (and usually unsuccessful) attempts to time the market — or worse, panic-sell shares at a loss.

Should I Invest In Stocks?

Stocks can carry risks. Moreover, if you know little about stock investing, self-education and seeking professional advice is critical. As an investor, you should also gauge your tolerance for risk. 

Even so, the aforementioned return of about 10% on the S&P 500 dramatically exceeds the average interest rate offered by 60-month certificates of deposit, which is 1.40% as of Dec. 18. This alone justifies some interest in investing in stocks. By seeking both funds or stocks best suited to meet your investment needs and goals, you can make stock investing work for you while mitigating possible downside risks.

FAQ

If you find the whole idea of stock markets and investing to be confusing, you're not alone. Here's some more information that might help you understand how it all works.

• How does the stock market work, in layman's terms?

  • Publicly held companies issue shares of stocks for a variety of reasons. Each share issued represents a small share of ownership in the company. A stock market is a marketplace where investors, working through a brokerage, can buy shares being sold by other investors or sell shares to investors who want to buy them. Although more experienced investors can specify the conditions under which they'll buy or sell — when shares reach a certain price, for example — beginners typically place market orders to immediately buy or sell shares at the best available price.

• How do you make money on stocks?

  • You make money on stocks by selling shares for a higher price than you paid for them. Stock prices are in constant flux, so you might have to hold on to your shares for a long time before you can sell them at a profit.

• How do you make money when stocks are down?

  • You can use a number of different strategies to profit in a down market. For example, you can buy shares in financially sound companies at a low price and hold on to them in the hope share prices will eventually rise. More experienced investors might short-sell declining shares — that is, borrow shares from their brokerage, sell them on the stock exchange, buy them back at a lower price and keep the the money that remains after repaying the brokerage for the borrowed shares.

This article originally appeared on GOBankingRates.com: How Does the Stock Market Work?