Stock Market 101: What Is the Stock Market and How Does It Work?

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When it comes to the main pillars of financial wellness – earning, saving, investing and protecting – investing in the stock market can be the most intimidating of the bunch. There’s a lot of confusing jargon to get your head around. The stock market can be volatile and has inevitable ups and downs. Plus, investing comes with a certain level of risk.

Because you might not be all that confident about how the stock market works, you might be putting off investing. Let’s make the thought of investing in the stock market less overwhelming. In our stock market 101 guide, we’ll help you better understand how it works so you can make the best choices for you.

We’ll cover the following stock market basics:

• What is the stock market?
• How does the stock market work?
• What are stocks?
• How do you read stocks?
• How do you invest in the stock market?

What Is The Stock Market?

Let’s start with a stock market definition, shall we? In a nutshell, the stock market is where investors can buy and sell securities, or stakes in individual companies as well as exchange-traded funds (ETFs). The market concept is also used for the trading of other items like bonds and treasuries, but the stock market has the most public visibility. Also known as a securities exchange, the stock market is subject to government regulation and has its own set of rules.

Analysts follow the performance of the overall market using what are called indexes. A securities market index indicates the performance of the stock market. How it works is that the index measures a weighted average value of a collection of securities.

Some of the major indexes are the Dow Jones Industrial Average (DJIA), the S&P 500 and the Nasdaq. When an index drops, it means the average value of all the stocks in the index is down from the previous business day. Conversely, when an index is on the rise, it means that the average value of all the stocks in the index is up from the prior day.

These securities are chosen as a sample that reflects how the market in general is behaving. But because these indexes include companies from myriad industries, they are seen as solid indicators of how the U.S. economy is doing overall.

How Does The Stock Market Work?

You can think of a stock market as a safe and regulated auction house where buyers and sellers can negotiate prices and trade investments. A stock market is a network of exchanges of sorts, and companies list shares on an exchange. Investors then purchase shares and buy and sell them among one another. Many of the investors are major funds controlling lots of money, but individuals can buy and sell through a broker like Acorns.

You might’ve watched scenes in movies or on TV shows where buyers and sellers are on the floor of the New York Stock Exchange fervently yelling “Buy, buy, buy!” or “Sell, sell, sell!” Whereas historically the stock market has been a physical marketplace, such as the New York Stock Exchange and the American Stock Exchange, these days securities are more commonly traded through a collection of trading platforms. Nearly all transactions these days are done digitally – not in person.

The Major Stock Exchanges

When you hear the word “stock exchanges,” these are the actual markets where company shares are traded. If someone is referring to the stock market in the U.S., they’re either talking about the NYSE (New York Stock Exchange) or the Nasdaq (National Association of Securities Dealers Automated Quotations). They might also be discussing one of the major indexes, like the Dow Jones Industrial Average or the S&P 500.

The NYSE and Nasdaq are the biggest markets in terms of market capitalization, which means the value of a publicly traded company, and is calculated by multiplying the total number of shares by its most current share price. The top five stock markets in the world are:

• NYSE
• Nasdaq
• Tokyo Stock Exchange
• Shanghai Stock Exchange
• Hong Kong Stock Exchange

How The Economy Affects The Stock Market

There are many factors that affect how the stock market is doing, and whether it’s moving up or down: the political climate, social factors, interest rates, trends and shifts in what investors prefer.

So how does the economy affect the stock market? If the general population feels as if the economy will soon be taking a turn for the worse, they tend to sell stock because bonds and treasuries offer a safer return. On the flip side, when people are feeling confident and optimistic about the economy, they tend to buy stock, taking more risk for greater reward.

From a high-level approach, when people feel good about the economy, they tend to buy more stock. When things are happening in the world make them feel unsure, they will be more conservative, and might gravitate toward lower-risk investments such as bonds and Treasury bills.

What Are Stocks?

At the most basic level, a stock is simply a share of ownership in a company or corporation. There are two types of stock: private and public.

Public Stocks

A public corporation is one that issues stock that the general public can buy and trade on stock market exchanges. Rather than stocks held by those in the company, these public stocks are owned by shareholders who are part of the general public.

When you hear a company going public, that means it’s listing on the stock market. It does what’s called an initial public offering (IPO). The company that’s going public, along with an underwriter that’s an investment bank, will make a specific number of shares available for a certain price. For instance, when Beyond Meat (stock symbol BYND) went public in early May 2019, it was priced at $25 a share with an implied market valuation of $1.46 billion.

Private Stocks

When it comes to private stocks, the general public doesn’t have access to them. These shares are generally limited in number. The stock is usually held by a small number of people, and they’re not traded publicly on any exchange. Shares might only be given to employees and internal investors, such as managers. For example, the grocery store chain Publix is a privately owned company. Shares are only made available to its store associates and the board of directors.

Types Of Public Stocks

Once a company has gone public and people have bought initial shares, there are a few ways you can make money as an investor:

Common Stock

Common stock is the type of stock people think of when they are referring to stocks. It’s the most basic way to have ownership of a corporation. When you own a share of a common stock, you have a proportionate stake in the company that depends on how many shares you own.

You can make money in one of two ways. The first is through cash dividends, which may be offered by companies when the corporation is profitable, and income is greater than its expenses. When this happens, a company is able to pay dividends to their shareholders. The second way is through the market price of a share. When the price goes up, the shareholder can make money by selling shares.

When you own common stock, you usually have voting rights. You can vote on who is elected to a company’s board of directors, and how many votes you can cast depends on how many shares you own. You can vote either by proxy, or by attending an annual meeting.

Preferred Stock

With preferred stock, you receive a fixed dividend per share that a company needs to distribute before there’s a payout to shareholders of the common stock. If you’re a shareholder of a preferred stock, you’re guaranteed a dividend for as long as you hold it. A downside of holding preferred stock is that you rarely get voting rights.

Note that the dividend is paid at a fixed rate, and preferred stock is a type of fixed income. And a company rarely pays out extra income from the stock other than the dividend. If you want a more reliable stream of income, you might be attracted to preferred stock.

Classes of Stock

When you hear a reference to a Class A stock versus a Class B or Class C stock, it’s referring to how many voting rights a shareholder has. Shareholders of a Class A stock have more say than a shareholder of a Class B stock.

Here’s the thing: a company can create different classes of stock, and they can also determine how much voting power you have for each of the different classes. A company can also determine how much the stock is worth in comparison to its Class A stock, which is the common stock.

Why Stocks Go Up And Down

There are a host of underlying factors that can affect whether a stock moves up or down. But the most essential, rudimentary concept is the basic law of supply and demand. When there’s a high demand for a particular stock and few people holding that stock are selling, the price goes up. Conversely, if there’s a low demand with many sellers, it drives the price of a stock down.

Factors that drive demand boil down to data and a company’s performance and earnings, but it can also be partly due to speculation. For instance, how investors perceive and feel about the profitability of a company may determine if they are buying or selling.

How To Read Stocks

An important part of understanding how the stock market works is how to read stocks. But if you’ve ever tried to read a stock table, you’ll see a string of abbreviations and numbers. What do they all mean? Let’s break it down.

Each company has a trading symbol, which is usually abbreviated (for example the symbol for Apple Inc. is AAPL). The first number you’ll usually notice on any major financial news outlet with a stock tracker is the current price of a share.

If you’re looking at a stock table, it usually includes the year-to-date (YTD) change. This is usually expressed as a percentage and shows how the price of a particular stock has changed since the beginning of the year.

You might also find the high and low prices within the last 52 weeks, and the dividend amount. A stock table or stock quote also can include the price of the last trade of the day, and also the net change, which is the change between the closing price of the current day in comparison to the closing price of the prior trading day.

What’s more, you can research a company that’s traded on the stock market in a number of ways. You can go to a major financial publication to see how the stock price shifted over different periods of time, hunt down corporate filings on the Securities and Exchange Commission (SEC), or find more information about a company on Morningstar or Bloomberg.

Using a Candlestick Chart

When trying to figure out how a particular stock is doing, there’s a lot of ways you can use existing data to gauge this.

For instance, a standard line graph shows the ups and downs of a stock’s performance. Then there’s a candlestick chart. Also known as a Japanese candlestick chart, it delves into greater detail by showing you the actual buying and selling patterns over a period of time.

Here’s how it works: one candle represents one day in the market. Each candle, or box, contains four prices for a given day – the open and close; the high and low.

If you’re looking at the candlestick or box itself (aka the candle or body), the top and bottom ends represent how much the stock moved between where it opened and where it closed. You might see upward movement represented as a green box, whereas a red box equals downward movement.

As for outside the box (aka the wicks), the vertical line equates to the high and low prices of a given day for that particular stock; this is the stock’s trading range for the day. As a candlestick chart is jam-packed with information, it usually is used to represent shorter spans of time.

And while a candlestick chart shows you patterns and how a stock moves and is performing, it doesn’t tell you the why a stock moved the way it did.

How Do You Invest In The Stock Market?

Now that you know the basics of the stock market, how do you actually dive in?

Choose Your Preferred Method

There are quite a few ways you can invest in the stock market. It depends on a number of things: Your time frame, target date, comfort level and tolerance for risk.

For instance, if you have more time to invest – we’re talking 30-plus years – and have a high comfort level with risk, your approach will be on the aggressive side. On the flip side, if you’re older and have less time to invest in the stock market, and aren’t as comfortable with risk, your approach will veer toward conservative.

Here are some types of investment accounts and vehicles to go about investing:

• 401(k). This is an employer-sponsored plan that is a defined contribution. A defined contribution means that either the employer, the employee, or both make regular contributions to the plan. You can only open a 401(k) account if your employer offers such a plan.
• Whereas you have to go through an employer to open a 401(k) account, an IRA is a type of retirement account that you can open on your own. Note that IRAs aren’t an investment, but rather a type of account for your investments. The two main kinds are Roth IRAs and Traditional IRAs. The main difference is when you’ll be taxed. With a Roth IRA, you’re contributing after-tax dollars. The money in your account grows tax-free, and you won’t owe any taxes on your distributions. With a Traditional IRA, you’re putting in pretax dollars, which lowers your taxable income in the year you make your contributions. However, you’ll owe taxes when it’s time to take money out of your account.
• Buying individual stocks. You’ll need to understand industry trends, and stay afloat of news about companies you’re buying stocks in. You also need to buy these through a broker, online or otherwise.
• Mutual funds. A mutual fund is an investment program that pools funds from many investors to buy assets. The goal is to invest to achieve income or growth. Mutual funds are professionally managed and the majority invest in a diversified portfolio made up of many types of assets such as stocks, bonds, and other securities.
• Index funds and ETFs. If a stock and a mutual fund had a baby, you’d get an exchange traded fund (ETF). Like mutual funds, ETFs hold a basket of assets, such as stocks, bonds, commodities and currencies, only they trade just like stocks. As for how their prices are determined, they’re determined by the forces of the market, and they’re traded throughout the business day on a stock exchange. These can be good for a beginning investor who isn’t sure what to buy. Services like Acorns will let you buy ETFs and index funds.

Set Your Budget

As they say, “it takes money to make money.” How do you know if you’re ready to invest? For one, you should have enough to cover your monthly expenses and bills, have some savings in case an emergency expense pops up, and have your debt repayments under control.

Next, figure out how much you can reasonably afford to budget for your stock investments. Ideally, a sound investment strategy means being able to invest continually for a long period of time. Even if it means starting small, or boosting your contribution amount to an employer-sponsored 401(k) a percentage.

These days there are a handful of online platforms and apps where you can get started with investing in the stock market with just five dollars. The important thing is to get the ball rolling now. That way when you have more money for investing, you’ll have carved out the inroads and developed the habits.

Diversification Is Key

When investing, you’ll want to keep diversification in mind. The point of diversification is that it protects your investments against risk. There will be times when the stock market overall is performing great, and other times when it will take a tumble.

However, there’s usually a bit of confusion as to what diversification is exactly. True diversification isn’t just about having a bunch of different types of investments in different accounts. You’ll want to have a good mix of asset classes, such as stocks, bonds, and cash equivalents. Stocks are typically higher risk but have the potential for higher gains, and bonds are lower risk but also have lower gains.

Diversification means having different types of investments that respond differently to events happening in the world. This mix of investments also act differently depending on conditions in the market. And within each asset class, you might have a different set of investments.

Follow Your Interests

If you’re choosing to go the active investing route, consider companies and industries in which you have a natural interest. If you already have the finger on the pulse of these particular realms, it’ll be easier to know what’s going on with your investments. Are you ready to get started?

As an active investor, you’ll need to stay on top of what’s going on in the world, market trends, and economic and political shifts that could affect the performance of your investments. To stay in the know, you can use research reports from stock advisory firms or stock brokerages, and subscribe to newsletters. While there’s no way to predict the future, the more research you do and knowledge you have, the better place you’ll be in to make informed decisions.

Are you more of a passive investor? If so, you’ll most likely be focusing on investing in securities such as mutual funds and ETFs that can provide gains in the long run. With this approach, you’ll want to try to match a broad market index. This means in terms of diversification, the returns, and low fees and costs.

Now that you understand what the stock market is and how it works, you hopefully won’t feel as overwhelmed or intimidated by getting started. Remember, everyone’s financial situation is different and it’s best to speak with a licensed financial expert or advisor before making any major financial decisions.

 

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