What Is the Stock Market and How Does It Work?

The stock market is where investors connect to buy and sell investments — most commonly, stocks, which are shares of ownership in a public company. Investors buy and sell stock and other investments through the stock market.

Summary:

  • What is the stock market?
  • How does the stock market work?
  • Why invest in the stock market?
  • How to invest in the stock market?
  • Stock Market Basics

 

What is the stock market?

The term “stock market” often refers to one of the major stock market indexes, such as the Dow Jones Industrial Average or the S&P 500. Because it’s hard to track every single stock, these indexes include a section of the stock market and their performance is viewed as representative of the entire market.

You might see a news headline that says the stock market has moved lower, or that the stock market closed up or down for the day. Most often, this means stock market indexes have moved up or down, meaning the stocks within the index have either gained or lost value as a whole. Investors who buy and sell stocks hope to turn a profit through this movement in stock prices.


How does the stock market work?

The concept behind how the stock market works is pretty simple. Operating much like an auction house, the stock market enables buyers and sellers to negotiate prices and make trades.

The stock market works through a network of stock exchanges — you may have heard of the New York Stock Exchange or the Nasdaq. Companies list shares of their stock on an exchange through a process called an initial public offering or IPO. Investors purchase those shares, which allows the company to raise money to grow its business. Investors can then buy and sell these stocks among themselves, and the exchange tracks the supply and demand of each listed stock.

That supply and demand help determine the price for each security or the levels at which stock market participants — investors and traders — are willing to buy or sell. Computer algorithms generally do most of those calculations.

Buyers offer a “bid,” or the highest amount they’re willing to pay, which is usually lower than the amount sellers “ask” for in exchange. This difference is called the bid-ask spread. For a trade to occur, a buyer needs to increase his price or a seller needs to decrease hers.

» Learn more about how to invest in stocks

Historically, stock trades likely took place in a physical marketplace. These days, the stock market works electronically, through the internet and online stockbrokers. Each trade happens on a stock-by-stock basis, but overall stock prices often move in tandem because of news, political events, economic reports, and other factors.

Continue reading or start playing around with a stock market simulator and learn the stock market psychology in real-time.

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Why Invest in the Stock Market

Investing in the stock market doesn't provide immediate gratification or frustration that a short-term trade does, but it has a few distinct advantages over short-term trading.

  • In day trading, if you develop a large account you very quickly get "capped out." There simply isn't enough liquidity in most markets for you to keep increasing the size of your position indefinitely. With longer-term trading though you can acquire a position over days or weeks. The larger your account gets, eventually you need to consider investing because you simply can't find enough shares/opportunities on very short time frames to utilize all your capital effectively.
  • Investing is passive income. With short-term trading you need to constantly be monitoring positions, closing out trades and opening new ones. Your investments work for you all year, with minimal effort once the trade is underway.
  • Investing acts as a savings plan. Investing is fun, and forces you to curb spending. Instead of spending money on frivolous things, money is directed toward your investment accounts instead. 


How do you invest in the stock market?

You can purchase individual stocks on any stock market through a brokerage account. The account can be opened at an online broker, through which you can buy and sell investments. The broker acts as the middleman between you and the stock exchanges.

» No brokerage account? Open one here

With any investment, there are risks. But stocks carry more risk — and more potential for reward — than some other securities. While the market’s history of gains suggests that a diversified stock portfolio will increase in value over time, stocks also experience sudden dips.

To build a diversified portfolio without purchasing many individual stocks, you can invest in a type of mutual fund called an index fund or an exchange-traded fund. These funds aim to passively mirror the performance of an index by holding all of the stocks or investments in that index. For example, you can invest in both the DJIA and the S&P 500 — as well as other market indexes — through index funds and ETFs.

You can invest in many stocks at once through index funds and exchange-traded funds.

Stocks and stock mutual funds are ideal for a long time horizon — like retirement — but unsuitable for a short-term investment (generally defined as money you need for an expense within five years). With a short-term investment and a hard deadline, there’s a greater chance you’ll need that money back before the market has had time to recover losses.

In any endeavor, it's best to look at norms instead of outliers. When investing here are two norms to keep in mind:

  • Stocks that performed the worst over the last three years will typically tend out outperform over the next three. Stocks that performed the best over the last three years, will typically tend to underperform over the next three. 

In other words, stocks don't stay strong or weak forever. If you're investing in solid companies, that have been around a long time, then they typically won't stay high or low for very long. There are always downtrends and uptrends, given a long enough time frame. Ideally, you want to buy stocks at lower levels compared to higher levels.

High Dividend-paying stocks are typically well-established companies that can afford to distribute a portion of the profits to shareholders. The dividend acts as money in hand and helps offset fluctuations in the stock price. Investing in solid dividend stocks is a fine way to establish wealth; investing in risky ventures isn't required. Statistics show that dividend-paying stocks--the tortoise as opposed to the hare-- win the race over the long-run.

Looking for more in-depth information? Here are our stock investment guide


Stock Market Basics

If you’re not well-versed in the basics of the stock market, the stock trading information spewing from CNBC or the section of the market of your favorite newspaper can border on gibberish.

Phrases like “earnings movers” and “intraday highs” don’t mean much to the average investor, and in many cases, they shouldn’t. If you’re in it for the long term — with, say, a portfolio of mutual funds geared toward retirement — you don’t need to worry about what these words mean, or about the flashes of red or green that cross the bottom of your TV screen. You can get by just fine without understanding the stock market much at all.

If, on the other hand, you want to learn how to trade stocks, you do need to understand the stock market and at least some basic information about how stock trading works.

Understanding the stock market

When people refer to the stock market being up or down, they’re generally referring to one of the major market indexes.

A market index tracks the performance of a group of stocks, which either represents the market as a whole or a specific sector of the market, like technology or retail companies. You’re likely to hear most about the S&P 500, the Nasdaq composite and the Dow Jones Industrial Average; they are often used as proxies for the performance of the overall market.

Investors use indexes to benchmark the performance of their own portfolios and, in some cases, to inform their stock trading decisions. You can also invest in an entire index through index funds and exchange-traded funds, or ETFs, which track a specific index or sector of the market. 

Stock market information

Most investors would be well-advised to build a diversified portfolio of stocks or stock index funds and hold on to it through good times and bad. But investors who like a little more action engage in stock trading. Stock trading involves buying and selling stocks frequently in an attempt to time the market.

The goal of stock traders is to capitalize on short-term market events to sell stocks for a profit or buy stocks at a low. Some stock traders are day traders, which means they buy and sell several times throughout the day. Others are simply active traders, placing a dozen or more trades per month.

Investors who trade stocks do extensive research, often devoting hours a day to following the market. They rely on technical analysis, using tools to chart a stock’s movements in an attempt to find trading opportunities and trends. Many online brokers offer stock trading information, including analyst reports, stock research, and charting tools.

Bull markets vs. bear markets

Neither is an animal you’d want to run into on a hike, but the market has picked the bear as the true symbol of fear: A bear market means stock prices are falling — thresholds vary, but generally to the tune of 20% or more — across several of the indexes referenced earlier.

Younger investors may be familiar with the term bear market but unfamiliar with the experience: We’ve been in a bull market — with rising prices, the opposite of a bear market — since March 2009. That makes it the longest bull run in history.

It came out of the Great Recession, however, and that’s how bulls and bears tend to go: Bull markets are followed by bear markets, and vice versa, with both, often signaling the start of larger economic patterns. In other words, a bull market typically means investors are confident, which indicates economic growth. A bear market shows investors are pulling back, indicating the economy may do so as well.

Bull markets are followed by bear markets, and vice versa, with both, often signaling the start of larger economic patterns.

The good news is that the average bull market far outlasts the average bear market, which is why over the long term you can grow your money by investing in the stock market.

The S&P 500, which holds around 500 of the largest stocks in the U.S., has historically returned an average of around 7% annually when you factor in reinvested dividends and adjust for inflation. That means if you invested $1,000 30 years ago, you could have around $7,600 today.

Stock market crash vs. correction

A stock market correction happens when the stock market drops by 10% or more. A stock market crash is a sudden, very sharp drop in stock prices, like in October 1987 when stocks plunged 23% in a single day.

While crashes can herald a bear market, remember what we mentioned above: Most bull markets last longer than bear markets — which means stock markets tend to rise in value over time.


Final words about the Stock Market

You can’t avoid bear markets as an investor. What you can avoid is the risk that comes from an undiversified portfolio.

Diversification helps protect your portfolio from inevitable market setbacks. If you throw all of your money into one company, you’re banking on the success that can quickly be halted by regulatory issues, poor leadership or an E. coli outbreak.

To smooth out that company-specific risk, investors diversify by pooling multiple types of stocks together, balancing out the inevitable losers and eliminating the risk that one company’s contaminated beef will wipe out your entire portfolio.

But building a diversified portfolio of individual stocks takes a lot of time, patience and research. The alternative is a mutual fund, the aforementioned ETF or an index fund. These hold a basket of investments, so you’re automatically diversified. An S&P 500 ETF, for example, would aim to mirror the performance of the S&P 500 by investing in the 500 companies in that index.

The good news is you can combine individual stocks and funds in a single portfolio. One suggestion: Dedicate 10% or less of your portfolio to selecting a few stocks you believe in, and put the rest into index funds.

Understand what is the stock market is important, but if you need help MetaTrader 5 trading app, the most popular stock market simulator provides access to the largest stock markets in the world, plus research and analytics tools. Additional, use an Expert Advisor Generator to build automated strategies for the stock market. 

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Categories:  Investing