How the Stock Market Works

The stock market is not a single market but a number of stock exchanges scattered around the world where traders and investors buy and sell shares of publicly traded companies. Shares change in price constantly in response to the law of supply and demand.

A share of stock is a tiny ownership stake in a public corporation. The stock's price primarily reflects the expectations of stock investors and market analysts on the company's future earnings.

Traders who think a 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 stock exchanges are in the United States: the Nasdaq and New York Stock Exchange (NYSE). Combined, they are worth trillions of dollars in market capitalization, reflecting the value of all of the shares listed on the exchanges. As of the end of 2018, the NYSE reported its market cap as $28.5 trillion. As of the end of 2019, the Nasdaq reported its market cap as $9.8 trillion.

Each exchange matches buyers with sellers, but they do it differently.

  • The Nasdaq is a dealer market. Investors do not buy and sell directly to one another. The transactions go through a dealer.
  • The NYSE uses an auction method to set prices. Before the 9:30 a.m. opening bell on weekdays, investors enter their buy and sell orders. The orders are matched up, with the highest bid price paired with the lowest asking price. Buy and sell orders continue to flow in until 3:50 p.m.

U.S. financial markets are very sophisticated, and, 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 overall performance of the U.S. stock market is tracked over time by 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. Many components and sectors of the markets are followed by their own indices. For example, the Russell 2000 reports on 2,000 small-cap companies.

Other countries have their own stock exchanges and indices. The five biggest are the London, Tokyo, Shanghai, Hong Kong, and Euronext exchanges. Each exchange is tracked by an index, while global indices track stock performance across borders. 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 increase their earnings. The stock market is an important way for companies to raise capital to expand or start their businesses. So, an investment in the stock market is an investment in economic growth. Newer companies use an initial public offering (IPO) to sell their shares in established exchanges like the NYSE or the Nasdaq and raise capital to grow. Investors who take shares in IPOs can potentially profit as new companies become public.

A strong economy leads to an expansion phase of the business cycle. This is known as a bull market and it occurs when there is an increase of 20% or more across the broad market index for at least two months in a row.

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 typically offer a smaller return. Preferreds trade effectively like perpetual bonds with a fixed yield and offer some downside protection.

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.

Investors can make money in two ways—by trading and by holding. Investors who trade will buy and sell stock frequently, taking advantage of small ticks in price. Investors who buy and hold prefer to let their stocks appreciate in value over time. In many cases, the companies whose shares they buy reward them further with regular payments of dividends.

Risks of Stock Market Investing

The most significant downside is that you can lose your entire investment if the stock price falls to $0. If the company goes bankrupt, stock investors are paid last. 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%, it'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 crash can trigger a recession. The history of stock market crashes shows this is a regular occurrence.

When prices fall 20% or more, it's known as a bear market. A bear market lasts at least two months, although the average can be around 11 months and can reach lengths of as much as 20 months or more.

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 is to buy stocks online. Online or “discount” brokers like E-Trade, Merrill Edge, or TD Ameritrade charge no fees for trading stocks and small fees for some other purchases such as mutual funds. A new generation of app-based brokers including Robinhood and Acorns also has emerged. This is do-it-yourself investing, making it easy to place trades with a click on your iPhone or Android device. The free services offer no professional or individualized guidance.
  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. They will give you professional recommendations based on your goals, risk profile, and budget. 
  4. Large investment banks like Goldman Sachs or Bank of America-Merrill Lynch 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 annually and provide advice on selecting investments, or make the trades for you.  
  7. Rather than buying individual stocks, you could invest in one or more index funds or mutual funds. Many individual investors choose to so in order to gain access to a broad array of investments selected by professionals.
  8. The riskiest choice is a hedge fund. They may also invest in derivatives, which can increase the returns but will also increase the risks.

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 very quickly and dramatically for no apparent reason.
  • 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. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.