How Does the Stock Market Work?
The stock market is the most accessible investment market for everyday individuals. It’s a type of capital market, which connects investors and companies to facilitate the transfer of funds. It’s where public companies list equity shares and where investors buy and sell them.
The “stock market” isn’t so much a physical place anymore. While they might ring the bell at the New York Stock Exchange building every day, the days of ticker-tape buying and selling are practically over. Today, the stock market exists through brokerages. It’s through brokerages that retail and institutional investors buy and sell securities every day, to the tune of hundreds of billions of dollars. Here’s how it all works.
What is a Stock?
The stock market revolves around securities called stocks, which represent equity in a company. When a person purchases a company’s stock, they’re buying a fractional part of the company. This gives them access to that company’s wealth-generating abilities. Stocks rise in price as the value of a company increases and fall when its value falls. They’re tied to its performance.
As equity securities, stocks also afford investors benefits. For example, you might get voting shares that impact the company’s decision-making. Or, your stock might entitle you to a dividend that’s paid when the company outperforms expectations. Investors may look for these benefits as they choose which companies to buy stock in.
Types of Stocks
There are roughly 6,000 public companies listed on American stock exchanges. This number grows even higher when you consider international exchanges and over-the-counter (OTC) exchanges. But not all stocks are the same. There are a variety of unique criteria and stipulations that govern different stock types. A few of the most common stock types include:
- Common stock vs. preferred stock
- Micro-, small-, mid- and large-cap stocks
- Domestic vs. international stocks
- Growth, value and dividend stocks
- Cyclical vs. non-cyclical stocks
- Blue-chip stocks vs. penny stocks
The different types of stocks dictate how people invest in them. Often, the type of stock someone invests in ties into their risk tolerance.
For example, blue-chip stocks are often large-cap companies that pay a dividend and offer great stability, even during economic strife. They’re great for more defensive investors. Conversely, a small-cap growth stock may be more volatile since it represents a burgeoning company. There’s more risk involved with investing, but also more reward.
There are also different ways to invest in stocks outside of a direct investment. Index funds and ETFs, for example, are groups of stocks available at an aggregate price. They’re great for diversifying exposure.
How to Buy, Sell And Trade Stocks
There are many different wealth-building strategies present in the stock market. They’re dictated by risk, investment time horizon, economic conditions and investor sentiment, among other variables. At a high level, they’re broken into two schools of thought: investing vs. trading.
Investing is a long-term mindset. Investors tend to buy and hold shares of companies over time, adding to them regularly. The idea is that the stock market generally goes up over time, and that it’s impossible to beat the aggregate sum of the market’s gains. Investors sometimes choose to invest in dividend stocks as a way to generate even more earnings. Other times, investors hold through economic turbulence and “average down” by buying more while prices are low.
Trading is a short-term strategy that involves buying and selling securities over a short time horizon. Day trading happens over a single day, while some forms of pattern trading can last weeks or months. Traders seek to capitalize on price fluctuations. They’re looking to reap the profit of small gains and losses in share price. Traders seek to minimize time as a variable by selling positions quickly.
Buying into a position gives an investor access to the earning power of that company. Whether it’s for the day or for a decade, the goal of investing in the stock market is to leverage that earning power into personal wealth.
Key Stock Market Terms to Know
Getting involved in the stock market means exposing yourself to a whole new language. Here’s a look at some of the most common, highest-level terms affiliated with stock market investing:
- Bear market: When stock market prices are generally on the decline.
- Bull market: When stock market prices are generally on the upswing.
- Exchange: The venue that lists stocks for buying and selling.
- Index: A collection of stocks used to benchmark market or sector performance.
- Initial Public Offering (IPO): The first equity shares a company releases to investors.
- Moving average: The average movement of stock prices over a specified period of time.
- Sector: A portion of the stock market devoted to similar companies (tech, energy, etc.).
- Volume: The number of stocks traded for a specific company on a given day.
- Float: The total number of shares issued by a company available to trade on a given day.
Keep in mind these are market-specific terms. The world of stock market jargon is astronomical when you get into the actual buying and selling of stocks!
The Basic Functions of The Stock Market
Buying and selling stocks is a great way to build passive income in your life. To advance your knowledge of investing, sign up for the Investment U e-letter below. We provide investment education, stock trends and analysis that will help you gain a better understanding of the market.
The stock market serves a variety of functions. For companies, it’s a place to raise capital by issuing stock to eager investors. For investors, it’s a chance to build wealth by capitalizing on the success of companies you own equity in. The stock market is also where most people’s retirement funds are vested. The market is even an economic barometer. It’s a strong indicator of financial stability for companies, individuals and the country as a whole.