How the Stock Market Works

Two women discussing stock portfolio allocation with laptop in front of them

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The stock market is where you can buy, sell, and trade stocks any business day. It's also called a stock exchange, and works like an auction where investors buy and sell shares of stocks.  

Stocks allow you to own a share of a public corporation. Stock prices usually reflect investors' opinions of what the company's earnings will be.

Traders who think the company will do well bid the price up, while those who believe it will do poorly bid the price down. Sellers try to get as much as possible for each share, hopefully making much more than what they paid for it. Buyers try to get the lowest price so that they can sell it for a profit later.

Where Is the Stock Market?

Two of the world’s largest exchanges are in the United States: The Nasdaq and The New York Stock Exchange. Combined, they are worth around $21 trillion in market capitalization—the value of all its shares.

Each exchange matches buyers with sellers, but they do it differently. The NYSE matches the highest bid for the lowest sales price, with a market maker for each stock who fills in the gap to ensure smooth trading. At the Nasdaq, buyers and sellers trade with a dealer instead of each other. It's done electronically, so trades happen in split seconds.

The United States is the world's financial capital because its financial markets are so sophisticated. As a result, information on companies is easy to obtain. This transparency increases the trust of investors from around the world. As a result, the U.S. stock market attracts more investors. That makes it even easier for a U.S. company to go public.

What Is a Stock Market Index?

The performance of the general U.S. stock market is tracked by its three principal indices: the Dow Jones Industrial Average or DJIA (stock prices of the top 30 U.S. companies), the S&P 500 (stocks of 500 large-cap U.S. companies), and the Nasdaq. Different components of the markets are also followed. For example, the Russell 2000 reports on 2,000 small-cap companies.

The major countries have their own stock exchanges and indices. The five biggest: London, Tokyo, Shanghai, Hong Kong, and Euronext exchanges. Indices track various aspects of markets. For example, the MSCI Index tracks the performance of stocks in emerging market countries such as China, India, and Brazil.

Why Invest in the Stock Market?

The stock market contributes to the U.S. economy. Investors who believe the economy is growing will invest in stocks, because a strong economy helps companies improve their earnings. It usually occurs along with the expansion phase of the business cycle. This is known as a bull market, which typically lasts two to five years. 

Most of the stocks traded are common stocks. But some investors buy preferred stocks. They pay an agreed-upon dividend at regular intervals and they don't have voting rights. They are less risky but they also offer a smaller return.

Stock market investing is considered the best way to achieve returns that beat inflation over time, and the returns, on average, outpace those of other investments, such as bonds or commodities.

You can make money in two ways—through trading and by holding. Some investors prefer to let their stock appreciate in value over time, and many companies also give a dividend payment each year to the stockholders, which provides extra value.

And unlike real estate, it's easy to buy stocks and just as easy to sell.

Risks of Stock Market Investing

The most significant downside is that you can lose your entire investment if the stock price falls to zero. If the company goes bankrupt, stock investors are paid after bondholders. For that reason, stock investing can be an emotional rollercoaster.

Fees can take a big bite out of your investment as well, and the potential for fraud is a serious concern. 

If investors think the economy is slowing or stagnant, they may instead invest in bonds, which are a safer investment, although they do come with their own risks. Bonds give a fixed return over the life of the loan, and typically do well during the contraction phase of the business cycle.

When stock market prices decline less than 10%, that's known as a stock market correction. When prices fall that much or more in one day, it's known as a stock market crash. A bad crash could even cause a recession. The history of stock market crashes shows this is a frequent occurrence.

When prices fall 20% or more, it's known as a bear market. These usually last 18 months. 

How to Invest in the Stock Market

There are at least eight ways for you to invest in the stock market

  1. The quickest and least expensive (although time-consuming to research) is to buy stocks online. Online or “discount” brokers like E-Trade, SoFi, or TD Ameritrade might not charge a fee, or charge fees only for certain types of orders.
  2. If you need more guidance at a reasonable price, join an investment club, which is a group of people who research and invest together. 
  3. A full-service broker will cost more but could be worth the price. He or she will give you professional recommendations and works at a large brokerage house. 
  4. Large investment banks, like Goldman Sachs or Bank of America Merrill Lynch, can provide financial planning in addition to executing trades. 
  5. A money manager charges the most but will do all the work for you. 
  6. Fee-only financial advisors charge an annual fee, usually 1% of assets, and can provide advice on selecting investments, or may trade for you.  
  7. Instead of buying individual stocks, you could buy them as part of an index fund or mutual fund
  8. The riskiest is a hedge fund. They may also invest in derivatives, which could increase the return but will also increase the risk.

Research any investment professional you’re considering hiring, to help prevent losing your money through fraud. 

Other Types of Financial Markets

The stock market is just one type of financial market. Before you invest, make sure you are familiar with them all:

Commodities are usually traded in futures options, which makes them more complicated. They include grains, oil, and the strangely-named pork bellies.

Foreign exchange is where people buy and sell currencies. It's very high risk because the values can change dramatically for no apparent reason and change very quickly.

Derivatives are very complicated securities that derive their value from the underlying asset, such as subprime mortgages. Individual investors should stay away. Even though they can offer huge returns, they can also deplete your entire life savings in a day.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors.