Guide: How the stock market works
The stock market is place where people can buy and sell shares in public companies which represent ownership of a small part of a company
It provides a transparent place to easily buy and sell shares in a company and is regulated to improve the security of your investments
You can buy shares in many different companies on a stock exchange but also other investment instruments like bonds, exchange-traded index funds, mutual funds, or options
What is the stock market?
The "stock market" is a term generally used to describe a stock exchange or all the stock exchanges. A stock exchange is a place where stocks in publicly traded companies are bought and sold by the market participants.
But note that the terms “stock market” and “stock exchange” are often used interchangeably.
I said the stock exchange was a "place" and traditionally it was a physical place where brokers turned up to buy and sell stocks on behalf of their clients. For example, the New York Stock Exchange has a physical building on Wall Street in New York.
There are a number of stock exchanges in the United States but they also make up part of the financial markets around the world such as the London Stock Exchange. But in modern times, most trading is done online and individuals can even now trade from the comfort of their own home.
Stock exchanges are regulated by the SEC to ensure they operate in compliance with the laws regarding the buying and selling of investments.
What are stocks?
A stock is a financial instrument that represents the ownership of a part of a company. Individual units of stock are called "shares" which entitles the owner to a proportion of the corporation's assets and profits equal to how much stock they own.
Some places will define stocks and shares slightly differently, but most people will use the terms "stock" and "share" interchangeably. If you're new to all this then they mean the same thing.
So if a public company had 1,000 shares, and you owned 100 of those shares then you would own 10% of the company. So you would be entitled to 10% of any profits that are paid out as dividends.
If the company was shut down then you would be entitled to 10% of the value of the assets of the company.
I use this as a simple example but a company like Apple has over 17 billion shares. This number can change over time as the company issues more stock or buys back stock.
The market capitalization of a company is the total number of available shares for a particular stock multiplied by the latest trade price. So if Apple had 17 billion shares and they last traded at $150 then their market capitalization would be $2.55 trillion.
There can be different types of shares available such as preferred stock which will get preferential benefits or common stock which won't.
How the stock market works
The stock market is a place of trade. It's a place where you can buy and sell individual shares in a company. So if you wanted to buy a small percentage of Apple then you could buy 1 share (OK, a very small percentage).
Trading platforms will show you information on current stock prices, latest trades, who currently wants to sell and who currently wants to buy.
If you want to buy a particular stock then you will make a "bid" to buy a certain number of shares at a certain price. Maybe 100 shares at $10 for a trade that will cost you $1,000.
If you are selling individual stocks then you will "ask" for a certain price to sell a certain number of shares. You might ask for $11 per share to sell 100 shares for a total of $1,100.
When the bid price and the ask price match, a trade will occur. So if the person selling dropped their ask price down to $10 per share, then the person buying would buy 100 shares at $10 per share. The trading systems manage all of this automatically.
If someone wants to buy immediately, they will put in their bid at "market price". The trading system will then execute their trade immediately at the current lowest price being offered. It works the same on the other side.
If you want to sell right now then you set your ask at market price and you'll get the current highest price that people have bid.
What I've just described is the secondary market where existing shares are bought and sold. Companies also use the stock market to raise money for new investments.
They will create new shares and sell them on the primary market usually through an Initial Public Offering or IPO. Once the shares have been created and sold on the primary market, they can then be traded to others on the secondary market.
Other types of securities
So far, we've kept it simple and really just talked about your everyday common stock. This is the main thing that people will invest in but just be aware that there are other types of securities that are often traded on a stock exchange.
Stocks are typically a type of equity security as buying a share gives you ownership of part of the equity in the company.
Exchanges also trade in debt securities. These are things like bonds traded on a bond market, where you are effectively loaning money to the company and they pay you interest.
These can be much safer investments, especially if they are issued by a financially secure organisation like the US Federal Government. Bonds will typically have a rating to give you an idea of how secure they are.
A derivative is another type of security and this is where the instrument being traded is a derivative of another security. An example of this might be an "option" where you have the option to buy or sell a stock at a particular price at a particular time.
So that asset is derived from the underlying stock you buy or sell. Derivatives also includes futures, forwards and swaps.
Derivatives are often seen as risky and that is very true if you don't know what you're doing. So before trying any derivative trading ensure you have done your research, understand what you are trading and seek professional advice if required.
Many stock exchanges now also trade index funds. An index is a grouping of stocks to represent a particular market or segment of the market. An index fund is a pooled fund of money that has been used to buy stocks that make up a particular index.
If the index fund is traded on a stock exchange then it is called an exchange-traded fund. This allows you to buy one share in an index fund, giving you a tiny piece of a lot of companies.
For example, if you buy a share in an S&P 500 index fund then you get a small piece of the 500 largest companies in the US.
"Don't look for the needle in the haystack. Just buy the haystack!"
~ John Bogle
Risks associated with the stock market
There are definitely risk associated with investing in the stock market. If you invest in a company that performs poorly, has some bad luck due to events beyond their control (like a pandemic) or makes the news for negative reasons then the value of your shares is likely to go down.
And as you are buying a tiny percentage of the company, you don't have a lot of control. You might be able to vote at shareholder meetings but most investors won't be able to make an impact due to owning such a small percentage.
The value of your shares can also be subject to the whims of the market. The value might go up just because people feel confident about the shares future potential but it could also go down if they aren't so confident.
The value of the shares is based on what people are willing to pay to buy them and what price people are willing to sell them. Not a fixed set amount.
If there is a stock market crash then the value of your portfolio will probably go down, even if the company you invested in hasn't really made any changes.
The timing of your investment is another risk. If you need to sell at a particular time as you need the money and you have to sell your shares at a lower price than what you bought them for then you could have a capital loss and lose money.
Investing and holding for the long term in a diversified set of growth stocks can help to reduce your risk but ultimately it will depend on the performance of the companies you invest in and the supply and demand for shares in the public companies you have invested in.
"Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."
~ Paul Samuelson
How to make money in the stock market
It is reasonably simple to set up a brokerage account that allows you to buy and sell shares online or through an App. Or you can use the Grow Today App and it will invest in the stock market for your automatically.
There are two common ways to make money in the stock market. The first is capital appreciation, or when the value of your shares goes up. This is where you buy a share and the stock price goes up and then you sell it for a higher price than you bought it for. This is called a capital gain.
So if you buy shares in a company for $1,000 and then sell them to someone else for $1,100 then you have made a $100 in capital gains. You will typically have to report the capital gain on your next tax return and pay tax on your gain.
The second common way to make money on the stock market is to get income. If you own shares in a company then you may get dividend payments, which is your percentage of the profits that the company has paid out to shareholders.
If a company is losing money or they are reinvesting any profits into future growth then you may no be paid a dividend. If you own a bond or other type of debt instrument then you may be paid interest.
"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."
~ George Soros
A glossary of key stock market terms:
Ask: is the price that a seller is looking to get per share for the shares they are trying to sell.
Bid: is the price that a buyer is willing to pay per share for shares they want to buy.
Bull market: is when the market is going up and investors are confident it will keep going up.
Bear market: is when the market is going down and investors expect it will keep falling.
Limit order: is when you place an order to buy or sell at a set price per share and that is your limit. The trade will only occur if someone matches the price you set.
Market order: is when you place an order to buy or sell immediately and the trade will take place at the current best price available.
Day order (or Good for Day): is where you put in an order and the ask or the bid is good for the rest of that trading day. If the order is not filled by the end of the trading day then the order is cancelled.
Market capitalization (or market cap): is the current value of a company calculated by multiplying the total number of available shares by the latest share price.
Initial Public Offering (or IPO): is when a company first issues its company's stock to the public and the company becomes listed on a stock exchange.
Dividend: The profits paid out by the company to the shareholders. Shareholders will receive their percentage of the profits based on the percentage of the company shares they hold.
Portfolio: is the total list of all shares you own in all companies.
Stock ticker: is usually a 3-4 letter code associated with a particular company to help identify them on the stock exchange.
The stock market (or stock exchange) is a place that enables the transparent and regulated buying and selling of shares in companies that are listed on that particular exchange.
This allows investors to buy a small portion of a company, or a share in the company, which entitles them a percentage of the profits and assets of that company.
Investing in the stock market is a reasonably simple way to get started in investing to add to your financial assets. It provides you access to diverse investment opportunities across countries, markets, sectors and individual companies.