What Is The Stock Market And How Does It Work?

Investing in stocks allows individual investors to own a slice of a publicly traded company and trade or sell the stocks on the public market – the stock market.

To confidently launch into investing and start buying stocks, you should know what the stock market is, learn the different types of stock you can buy and how the stock market works. We’ll supply the tips and strategies you’ll need to become a savvy investor.

What Is The Stock Market?

The stock market is a public market for investors to buy and sell company shares. By definition, it usually refers to major stock market indexes – like the S&P 500, Nasdaq Composite and Dow Jones Industrial Average – that track the stock performance of many companies, making it easier for investors to keep an eye on stock prices.

Stock market exchanges include a portion of the stock market – typically the biggest or most significant companies. How well they do is usually seen as representative of the entire market.

The U.S. Securities and Exchange Commission (SEC) oversees the stock market to protect investors and ensure fair, transparent practices.

Types Of Stocks

The stock market has two types of stocks: common stock and preferred stock. Although you buy and sell them the same way, there are important differences between common and preferred stock.

Common stockholders have voting rights in a company’s shareholder meetings and can offer input into issues such as who is eligible to join the company as a board member.

Preferred stockholders don’t have voting rights but receive dividends (a portion of a company’s profits) before common stockholders – a bonus if the company earns more profits.

Stock Market Index

A stock market index tracks the performance of groupings of similar stocks, like energy stocks or industrial stocks. Below, we’ve listed the most popular stock market indexes used to represent the U.S. stock market:

• Dow Jones Industrial Average (DJIA): Tracks the performance of U.S. industrial stocks
• S&P 500: Tracks the stock performance of the 500 largest U.S. companies
• Nasdaq Composite: Tracks the stock performance of the more than 3,000 companies listed on the exchange

When you buy a share of an index fund, you aren’t buying the entire index. You’re purchasing a percentage of all of the stocks in the index.

Stock Exchange

The stock exchange is a marketplace for investors to buy and sell company shares. It promotes stock trading through services, tools and systems. A stock exchange is a specific platform for stock trading, and the stock market is the general operation of trading stocks and includes stock exchanges, over-the-counter markets and electronic trading systems.

The New York Stock Exchange (NYSE) and Nasdaq are the two largest exchanges in the world. Each is worth around $21 trillion, and both are in New York City – the Nasdaq in Times Square and the NYSE on Wall Street.

How Does The Stock Market Work?

Now that you have an understanding of the stock market, let’s explore how it works.

The stock market works through a network of exchanges, like Nasdaq and the NYSE, that track the supply and demand of listed stocks. Stock exchanges operate much like auction houses. Buyers and sellers negotiate and place orders on stocks to make trades.

To list stock on an exchange, a company goes through an initial public offering (IPO). Once the stock is listed, investors can buy shares, and the company can use the funds to grow its business.

Some stock exchanges, such as the NYSE, work like an auction where investors (or bidders) interact directly with the investor selling the stock. Other exchanges, like Nasdaq, have buyers and sellers work with a dealer instead of directly with each other.

The price for each stock is determined by the supply and demand – or how much stock investors are willing to buy or sell. Most of these calculations are done using computer algorithms. Stock sales or purchases must go through licensed brokers who route the orders to designated market makers (financial institutions that provide liquidity in the market).

How Does The Stock Market Work?

Now that you have an understanding of the stock market, let’s explore how it works. The idea is that stock exchanges operate much like auction houses, where buyers and sellers can make trades and negotiate prices for stocks.

As mentioned, the stock market works through exchanges like the Nasdaq and NYSE. Companies will list their stock on one of these exchanges – it goes through a process called an initial public offering, or IPO. Once the stock is listed, investors can then buy its shares and the company can use the funds to grow its business. The exchange then tracks the supply and demand of listed stocks, and investors can trade among themselves.

Some stock exchanges, such as the NYSE, work like an auction where the bidders interact directly with the seller. Others, like Nasdaq, have buyers and sellers work with a dealer instead of directly with each other.

The price for each stock is determined by the supply and demand – or how much stock investors are willing to buy or sell. Most of these calculations are done through computer algorithms. Stocks can only be bought and sold by licensed brokers through designated market makers.

How Do You Invest In The Stock Market?

Now that you know how the stock market works, here are some different ways you can invest in it:

• Retirement plans: Many people invest in the stock market through their retirement accounts, such as a 401(k) or IRA. Most retirement accounts offer mutual funds, which typically bundle stocks and let you pool money with other shareholders to invest in stocks together.
• Individual stocks: To buy stocks, you must open a brokerage account through an online broker or a robo-advisor. You can work with a financial advisor if you need guidance. They can walk you through online brokerage options and make investment recommendations based on your goals and risk tolerance (how much you’re willing to risk losing if your stocks don’t do well).
• Index funds, mutual funds, ETFs: Some investors opt for funds with different securities, like index funds, mutual funds and exchange-traded funds. These securities allow investors to diversify their investment portfolio. Some investors allow professional fund managers to choose the individual securities they invest in.

These options are intermediaries between you and the stock exchanges. If you work with a broker or financial advisor, you may need to pay fees so they can help you purchase stocks.

Something else to always keep in mind is that all investments have risks – and the risk is losing the money you invested. But you may potentially reap rewards from your investments, too. That’s why you must assess the pros and cons of an investment before putting money toward it. Consider investing in stocks or mutual funds if you’re interested in long-term investments.

Stock Market FAQs

Here are some questions investors and would-be investors frequently ask about stock markets and securities.

How does the stock market work for beginners?

A stock market allows individual and institutional investors to buy, sell and exchange securities. You can buy shares in publicly traded companies or buy shares of fund-based investment vehicles. Beginner investors should familiarize themselves with the specific rules of buying and selling by investment type.

How do I make money from stocks?

You can make money by buying securities and selling shares at a higher price. Another way to make money on stocks is to buy stock in companies that pay dividends. You can reinvest dividends or collect the cash.

Are there other types of markets?

There are markets for many assets, including derivatives, commodities, over-the-counter (OTC), foreign exchange (Forex) and cryptocurrencies. These markets are usually more appropriate for experienced investors.

The Bottom Line: Knowing How The Stock Market Works Can Create Greater Wealth

Investing in stocks can be challenging, but beginners have many options to get started. To successfully launch into buying and selling stocks, do your homework. Research individual stocks or opt for investment funds to easily diversify your investments.

If you need help keeping track of your investments, download the Rocket Money℠ app today to get a birds-eye view of your finances.