Sep 22, 2023
What Is the Stock Market and How Does It Work? Everything You Need to Know
|What is the stock market?|
The stock market is a common umbrella term for the variety of stock exchanges, or marketplaces, in which shares of publicly traded companies are bought and sold by investors. Broadly, the stock market acts as a venue for companies to raise capital and individual investors to buy shares of those companies’ stock.
Specific stock exchanges, like the New York Stock Exchange (NYSE) or the Nasdaq, act as marketplaces within the overall stock market. But investors will often use “the stock market,” “stock exchanges,” and “Wall Street” interchangeably to discuss the entire scope of securities trading.
In this article, we cover:
- What stocks are
- How the stock market works
- How to invest in the stock market
- Why people invest in the stock market
- Stock market FAQs
What is a stock?
A stock, also referred to as a share or equity, represents ownership of a fraction of a public company. Owning stocks makes an investor a shareholder and grants them a proportional claim to that company’s profits. That investor can then make money by selling a stock after its price increases or through earning dividends if a company offers them.
There are two primary types of stocks: preferred and common stocks. Preferred stocks are less common, come with no voting rights, and are prioritized for a payout over common stocks. On the other hand, common stocks are considerably more typical, grant shareholders voting rights, and are normally paid last if a company has to liquidate assets.
How does the stock market work?
A company will “go public” to begin selling shares on the stock market when they’re hoping to raise capital or expand their business. Companies will typically offer a limited number of shares during their initial public offering (IPO), and investors will then buy and sell those shares on the stock market.
Supply and demand will drive stock prices up and down because there are limited company shares on the market at any given time, and traders will determine the stock’s value. Buyers offer a “bid,” or the maximum they will pay, and sellers will offer an “ask,” which is the lowest amount they’re willing to sell for. A trade occurs when the buyer is willing to buy at the price offered. Investors can look at a stock chart to map how a stock’s price has changed over a period of time in order to gauge its overall performance.
Most common U.S. stock exchanges
Stock exchanges are a fundamental component of how the stock market works; they are where shareholders and buyers can make their trades. These stock exchanges bring companies and investors together. Many people are familiar with the top three U.S. stock exchanges:
- New York Stock Exchange (NYSE)
- National Association of Securities Dealers Automated Quotations (NASDAQ)
- Chicago Stock Exchange
There are also many large exchanges outside of the U.S., such as the Japan Stock Exchange (JPX), China’s Shanghai Stock Exchange (SSE), and the Toronto Stock Exchange (TSX) in Canada. Most brokerage firms give investors the ability to buy and sell stocks on international exchanges.
How to invest in the stock market
Individuals can’t buy stocks directly. If you’d like to invest in the stock market, you’ll need to open an account at a brokerage, which will make trades on your behalf.
- Select a brokerage. Your brokerage is your middleman who connects buyers and sellers and executes your trades. The brokerage you use defines what markets you can participate in and when/how frequently trades are executed.
- Select an investment account. There are several types of investment accounts to choose from, including standard brokerage accounts, retirement accounts like IRAs, kids’ investment accounts, and education accounts. Different types of accounts come with different advantages, tax rules, timelines, and limitations. Many investors will have several different investment accounts to accommodate their different needs.
- Fund your account. Depending on your goals for investing in the stock market, you may fund your account in several different ways. People who are investing for long-term goals like retirement often transfer money to their investment account on a regular basis. You can usually transfer money to your brokerage from a linked bank account, wire transfer money, deposit a check, or transfer investments from another broker.
- Choose what you want to invest in. Investors in the stock market have access to various potential investments, depending on the brokerage they choose. Investment types include specific stocks, exchange-traded funds (ETFs), mutual funds, and index funds.
Why people invest in the stock market
Most investors hope to put their money to work in the stock market to build wealth, hedge against inflation, or save for retirement. Over the long term, a well-diversified portfolio might help investors grow their money more compared to keeping it in a standard bank account. While investing in stocks has a higher risk than some other investments, the average stock market return has historically been about 10% per year, as measured by the S&P 500 stock market index.
Stock market FAQs
1. Who regulates the stock market?
The stock market is regulated by the U.S. Securities and Exchange Commission (SEC). The SEC is an independent federal agency dedicated to protecting investors, maintaining fair and efficient markets, and facilitating capital formation.
2. What is a stock market index?
A stock market index isn’t an actual marketplace like a stock exchange. Instead, it’s a measuring tool used by investors to understand the overall behavior of the market by tracking specific stocks. Three of the most well-known indexes in the U.S. are:
- The S&P 500 Index: a market-capitalization-weighted index of 500 leading publicly traded companies on the NYSE or Nasdaq stock exchange.
- The Nasdaq Composite Index: a market-capitalization-weighted index of around 2,500 stocks listed on the Nasdaq stock exchange.
- The Dow Jones Industrial Average Index: an index that tracks 30 large, blue-chip companies trading on the NYSE and Nasdaq.
Investors often reference these indexes to judge how the stock market is doing overall. Indexes are also used to create index funds that aim to match the performance of a specific index, like the S&P 500.
3. When does the stock market open and close?
The NYSE and Nasdaq are typically open Monday through Friday, 9:30 a.m. to 4:00 p.m. Eastern Time. Both stock exchanges are generally closed evenings, weekends, and holidays. Sometimes, external forces such as severe storms, global disasters, or potentially catastrophic stock price drops can cause the markets to close early.
4. How do you lose or earn money in the stock market?
Investors earn money on the stock market in two primary ways:
- When they sell a stock for a higher price than they purchased it
- By receiving dividend payments if a company offers them
A common way investors lose money in the stock market is when they sell shares at a lower price than they initially paid. They can also lose money if a company they’re invested in declares bankruptcy without enough money to pay out their shareholders.
5. What is volatility?
Volatility is a measure of risk that refers to how much the price of an investment tends to change over time. The stock market is considered volatile because stocks experience price changes every day. Some stocks experience more extreme change more quickly (higher volatility) than others, and different stock market sectors tend to have varying levels of volatility overall. A diversified portfolio can help investors reduce volatility because it spreads risk across a number of different types of investments.
5. What is diversity in investing?
A well-diversified portfolio aims to reduce overall risk by spreading investments across different types of assets, such as stocks, bonds, and funds. By splitting your portfolio across investments that behave differently, you reduce your vulnerability to the risk tied to any single asset. When investing in the stock market, you can diversify your holdings by investing in a variety of sectors, industries, and types of companies so that a poor outcome from one company doesn’t significantly impact your overall profits.
Start investing in the stock market
Once you understand what the stock market is and how to invest in it, you’ll want to put together an investment strategy that matches your specific goals, income, timeline, and comfort with risk. You might want to read up on stock market terminology and interesting statistics to deepen your understanding and build your confidence.
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