How the stock market works

Understanding how the stock market works can help you invest smarter.

  • By Coryanne Hicks,
  • U.S. News & World Report
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The stock market is the magic beans of retirement. It takes your $500 per month and turns it into a $1 million nest egg by retirement.

While to the untrained observer, such financial growth can genuinely look like magic, savvy investors know this magician's secrets and how to make the most of how the stock market works behind the curtain.

What is the stock market?

"The stock market is where investors and traders buy and sell shares of company stock and exchange-traded products, like ETFs," says Ronan Ryan, president and co-founder of IEX, a technology company that operates a U.S. exchange designed to level the playing field for mutual fund and pension investors.

The stock market is comprised of various stock exchanges, like the New York Stock Exchange and Nasdaq.

"Individual stocks will trade on one of these exchanges, but not both," says David Kass, clinical professor of finance at the University of Maryland. "Generally, the NYSE will list older, larger and more established companies while Nasdaq will list younger, smaller and more high-technology companies."

Outside the U.S., foreign company stocks trade on their own country's exchanges, like the Tokyo Stock Exchange or Shanghai Stock Exchange. U.S. investors can buy stocks directly on a foreign exchange, but it's generally easier to buy American depositary receipts (ADRs), which represent shares of a foreign company issued by U.S. banks and trade on American exchanges.

Stocks that don't meet the requirements for trading on a stock exchange are bought and sold on over-the-counter markets, where they trade directly through broker-dealers as opposed to an open exchange.

These markets and stock exchanges make up what's called the secondary market, where investors buy and sell shares among themselves. Before investors can trade stocks in the secondary market, though, the shares must be made public.

A company's stock becomes available on a stock exchange after its initial public offering (IPO). If you buy company stock in an IPO, you're buying on the primary market. When you turn around and sell your IPO shares, you do so on the secondary market.

The performance of this secondary market element of the stock market is tracked through various stock market indices, like the Dow Jones Industrial Average (.DJI) or the Nasdaq composite (.IXIC). When the media or financial experts talk about how the stock market is performing, they're referring to one of the major stock market indices. And when they say, "Wall Street closed at record highs today," they're referring to the record-breaking highs of these indices.

How does the stock market work?

"Public companies rely on the market to raise capital, and look to their stock price for information about what investors believe about their business and prospects," Ronan says. Meanwhile, investors "rely on the market for investment opportunities" to allocate their capital.

"The idea of a stock market is to align the interests of the entire trading ecosystem – from public companies to investors to brokers to exchanges," he says. "Ideally, stock markets allow the investing public to participate in the growth and development of enterprises engaged in all the different sectors of the economy."

For investors, the stock market works like an auction where buyers place bids and sellers offer asking prices for shares of stock. When the bid equals the ask, a trade occurs.

The difference between what buyers are willing to pay and sellers are willing to accept is called the bid-ask spread. A smaller bid-ask spread indicates a more liquid, or easily traded, security.

A stock's price represents what the cumulative market of buyers and sellers consider its value to be. As with everything in the economy, it's largely dictated by supply and demand. When there are more sellers trying to offload their stock than buyers interested in purchasing, the price falls. If prices on all or most stocks drop significantly and suddenly, a stock market crash occurs.

"A stock market crash is a large percentage decline in the overall market in a very short period of time," Kass says. "For example, on Oct. 19, 1987, the Dow Jones Industrial Average dropped by 22.6% in one day. That was the largest one-day percentage decline in many decades."

Although the stock market averages 9% to 10% annual returns, investors can't forget that stocks are risky. "They could decline by as much as 30% or more in a single year," Kass says.

How does investing in stocks work?

A stock represents a share of ownership in a publicly traded company. If you own a share of Apple (AAPL), you have an ownership stake in Apple. This grants you the right to vote on Apple's corporate policy and a claim to a portion of its profits.

Investors typically buy stock in a company in the hopes that the share price will increase over time, as noted in the "buy low, sell high" axiom. But share price appreciation isn't the only way to make money in the stock market.

How do you make money in the stock market?

The most recognized means of making money in the stock market is by selling stock for more than you bought it. This is called capital appreciation. If you buy a share of Apple for $200 and sell it for $250, you've made $50 in capital gains. But to realize your gains, you have to sell your shares. So while you've made $50, you can no longer participate in any future growth or payments to shareholders that Apple may make.

Another way to make money in the stock market is through dividends. Dividends are payments companies make to their shareholders, usually on a quarterly basis. As long as you hold Apple stock, you are entitled to any dividends it pays.

You can take those dividends as a cash payment or reinvest them to buy more shares of Apple and increase your holding, which will earn you more dividends in the next round of payments since they're paid on a per-share basis.

Many investors make money in the stock market simply by investing in companies that pay regular and increasing dividends.

Note that not all companies pay dividends, and even those that do have no obligation to continue. Like a company bonus, dividends are not guaranteed.

How do beginners buy stocks?

There are a few ways investors can buy stocks:

  • Through a broker-dealer
  • Through a robo advisor
  • In an exchange-traded fund or mutual fund

To buy stock through a broker, you'd need to open an account with an investment company. You can own stock in a non-retirement brokerage account or individual retirement account (IRA). Once you have your account, you place the trade through the firm's website or mobile app.

"Shares can be bought and sold at the market price or for a price limit," Kass says.

The market price is the prevailing price the stock is trading at currently. A market trade, then, is one that is executed at the next available price.

A limit trade is one where you set the price you're willing to buy or sell at. Your trade won't be executed unless that limit is met or exceeded. So a limit order to buy at $100 per share would only go through if the stock price drops to $100 or below. And a limit order to sell at $100 only occurs if the stock prices rises to $100 or more.

Robo advisors are an alternative to larger brokers but often have a much smaller selection of stocks. Some robo advisors, like Stash, let you buy fractional shares of the companies they offer. So if you can't shell out over $1,500 for a full share of (AMZN), you can buy $5 worth and grow your position over time.

If you're just starting to invest or are investing with little money, the best way to buy stocks may not be by investing individually but rather to buy in bulk through an ETF or mutual fund. Funds pool hundreds or thousands of stocks into a single investible entity. Investors who buy shares in a fund get a proportional share of all the stocks in the fund.

Technically, if you buy Apple through a fund, you don't own Apple directly; you own a share in a fund that owns Apple. But if you buy Apple through a fund, you also get a share in a fund that owns many other companies, making you far more diversified than if you just owned just Apple. Plus, most funds trade for less than the price of one share of Apple.

Regardless of how or where you invest, remember that stock prices are volatile.

"Investors should have a long time horizon of many years," Kass says. "For most investors I recommend a low cost S&P 500 index fund (.SPX), such as that offered by Vanguard."

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