Disclosure: This post contains affiliate links, which means we receive a commission if you click a link and purchase something that we have recommended. Please check out our disclosure policy for more details.
When it comes to the main pillars of financial wellness – earning, saving, investing and protecting – investing in the stock market can be the most intimidating of the bunch.
There’s a lot of confusing jargon to get your head around. The stock market can be volatile and has inevitable ups and downs. Plus, investing comes with a certain level of risk.
Because you might not be all that confident about how the stock market works, you might be putting off investing. Let’s make the thought of investing in the stock market less overwhelming.
In our stock market 101 guide, we’ll help you better understand how it works so you can make the best choices for you.
What Is The Stock Market?
Let’s start with a stock market definition, shall we?
In a nutshell, the stock market is where investors can buy and sell securities, or stakes in individual companies as well as exchange-traded funds (ETFs). The market concept is also used for the trading of other items like bonds and treasuries, but the stock market has the most public visibility.
Also known as a securities exchange, the stock market is subject to government regulation and has its own set of rules. The New York Stock Exchange (NYSE) and Nasdaq are the world’s biggest stock exchanges. Exchanges are the places and systems were stocks are traded.
Although the NYSE and Nasdaq are the world’s biggest exchanges and get the majority of the attention in the United States, there are other stock markets around the world including the London Stock Exchange, as well as Japan, Hong Kong, Shanghai, India, Australia and various locations throughout the European Union.
Analysts follow the performance of the overall market using what are called indexes. A securities market index indicates the performance of the stock market. These indexes work by measuring a weighted average value of a collection of securities.
Some of the major indexes are the Dow Jones Industrial Average (DJIA), the S&P 500 and the Nasdaq. When an index drops, it means the average value of all the stocks in the index is down from the previous business day.
Conversely, when an index is on the rise, it means that the average value of all the stocks in the index is up from the prior day. Other exchanges have indexes correlated with their performance as well. For example, the London Stock exchange has the Financial Times Stock Exchange 100 (FTSE).
These securities are chosen as a sample that reflects how the market in general is behaving. But because these indexes include companies from myriad industries, they are seen as solid indicators of how the U.S. economy is doing overall.
How Does The Stock Market Work?
You can think of a stock market as a safe and regulated auction house where buyers and sellers can negotiate prices and trade investments.
A stock market is a network of exchanges of sorts, and companies list shares on an exchange. Investors then purchase shares and buy and sell them among one another. Many of the investors are major funds controlling lots of money, but individuals can buy and sell through a broker like Acorns.
You might’ve watched scenes in movies or on TV shows where buyers and sellers are on the floor of the New York Stock Exchange fervently yelling, “Buy, buy, buy!” or “Sell, sell, sell!” Whereas historically the stock market has been a physical marketplace, such as the New York Stock Exchange and the American Stock Exchange, these days securities are more commonly traded through a collection of trading platforms.
Nearly all transactions these days are done digitally – not in person.
Although many stocks are listed on the exchange, public listing itself is not a requirement for stock sales. We’ll go over private stocks and over-the-counter markets a bit later on.
The Major Stock Exchanges
When you hear the word “stock exchanges,” these are the actual markets where company shares are traded.
If someone is referring to the stock market in the U.S., they’re often either talking about the NYSE on Wall Street or the Nasdaq (which stands for National Association of Securities Dealers Automated Quotations). They might also be discussing one of the major indexes, like the Dow Jones Industrial Average or the S&P 500 Index.
The NYSE and Nasdaq are the biggest markets in terms of market capitalization (which means the value of a publicly traded company), and is calculated by multiplying the total number of shares by its most current share price.
The top five stock markets in the world are:
- Tokyo Stock Exchange
- Shanghai Stock Exchange
- Hong Kong Stock Exchange
How The Economy Affects The Stock Market
There are many factors that affect how the stock market is doing, and whether it’s moving up or down: the political climate, social factors, interest rates, trends and shifts in what investors prefer.
So how does the economy affect the stock market?
If the general population feels as if the economy will soon be taking a turn for the worse, they tend to sell stock because bonds and treasuries offer a safer return. On the flip side, when people are feeling confident and optimistic about the economy, they tend to buy stock, taking more risk for greater reward.
From a high-level approach, when people feel good about the economy, they tend to buy more stock. When things are happening in the world make them feel unsure, they will be more conservative, and might gravitate toward lower-risk investments such as bonds and Treasury bills.
What Are Stocks?
At the most basic level, a stock is simply a share of ownership in a company or corporation. There are two types of stock: private and public.
A public corporation is one that issues stock that the general public can buy and trade on stock market exchanges. Rather than stocks held by those in the company, these public stocks are owned by shareholders who are part of the general public.
When you hear a company going public, that means it’s listing on the stock market. It does what’s called an initial public offering (IPO).
The company that’s going public, along with an underwriter that’s an investment bank, will make a specific number of shares available for a certain price. For instance, when Beyond Meat (stock symbol BYND) went public in early May 2019, it was priced at $25 a share with an implied market valuation of $1.46 billion.
When it comes to private stocks, the general public doesn’t have access to them. These shares are generally limited in number. The stock is usually held by a small number of people, and they’re not traded publicly on any exchange.
Shares might only be given to employees and internal investors, such as managers. For example, the grocery store chain Publix is a privately owned company. Shares are only made available to its store associates and the board of directors.
Types Of Public Stocks
Once a company has gone public and people have bought initial shares, there are a few ways you can make money as an investor:
Common stock is the type of stock people think of when they are referring to stocks. It’s the most basic way to have ownership of a corporation. When you own a share of a common stock, you have a proportionate stake in the company that depends on how many shares you own.
You can make money in one of two ways:
- Through cash dividends. These may be offered by companies when the corporation is profitable, and income is greater than its expenses. When this happens, a company is able to pay dividends to their shareholders.
- Through the market price of a share. When the price goes up, the shareholder can make money by selling shares.
When you own common stock, you usually have voting rights. You can vote on who is elected to a company’s board of directors, among other issues. How many votes you can cast depends on how many shares you own. You can vote either by proxy or by attending an annual meeting.
With preferred stock, you receive a fixed dividend per share that a company needs to distribute before there’s a payout to shareholders of the common stock.
If you’re a shareholder of a preferred stock, you’re guaranteed a dividend for as long as you hold it. A downside of holding preferred stock is that you rarely get voting rights.
Note that the dividend is paid at a fixed rate, and preferred stock is a type of fixed income. A company offering preferred stock rarely pays out extra income from the stock other than the dividend. If you want a more reliable stream of income, you might be attracted to preferred stock.
Classes Of Stock
When you hear a reference to a Class A stock versus a Class B or Class C stock, it’s referring to how many voting rights a shareholder has. Shareholders of a Class A stock have more say than a shareholder of a Class B stock.
Here’s the thing: a company can create different classes of stock, and they can also determine how much voting power you have for each of the different classes. A company can also determine how much the stock is worth in comparison to its Class A stock, which is the common stock.
The market participants who buy and sell stocks are going to depend on which stock market you’re referring to. There are actually three different types of market on which companies, investors and their brokers can buy and sell shares. Let’s run through the market participants in each of these.
The primary market is where companies directly sell shares of stock to investors. This happens when a company first goes public in an IPO, but it also could happen if the company later decides to raise more money by making more shares available at a given price in a new round of funding.
Typically, companies aren’t selling to individual investors at this point. They often sell to major institutional investors like pension boards, hedge funds and mutual funds that manage money for large groups of people.
If these funds buy hundreds or thousands of shares, the sale tends to go fairly quickly. This is preferable for companies who want the quick infusion of cash that can come with a stock offering.
For the average investor from the public to get involved, it’s necessary to go down a level and talk about the secondary market.
The secondary market is just between investors, and it doesn’t involve companies.
Hedge funds, pensions and other institutional investors still participate, but this is also where individual investors can buy stock whether it involves buying shares of individual companies or a mix of them in an exchange-traded fund. It’s the secondary market where people can make investments without spending hundreds of thousands of dollars in shares.
Typically, the price of the stock based on people buying and selling it is publicly listed on an exchange, but it doesn’t have to be.
Over-The-Counter (OTC) Markets
The major stock exchanges like the NYSE, Nasdaq and London Stock Exchange have certain requirements that companies must meet in order to be eligible for listing. These include the public filing of certain financial information as well as outlook forecasts along with needing to maintain a certain share price.
If companies cannot or are unwilling to meet these standards, they have the option of going with an over-the-counter (OTC) stock sale. Rather than being publicly listed on an exchange, you typically find investor information on places like a company website.
When you buy and sell OTC stocks, there is no public price and each transaction is completed between individuals. This is where the concept of market makers comes in.
If you’re looking to sell stock, one individual might be willing to buy from you at a certain price, and if you’re looking to buy from them, it’s a different price. Brokers and others who act as market makers make money on the difference between these bid and ask prices.
The downside to OTC markets is that there’s no one set public price, so the market isn’t as transparent. You have to trust who you’re dealing with, and be aware they could be acting on information you don’t have.
Why Stocks Go Up And Down
There are a host of underlying factors that can affect whether a stock moves up or down. But the most essential, rudimentary concept is the basic law of supply and demand.
When there’s a high demand for a particular stock and few people holding that stock are selling, the price goes up. Conversely, if there’s a low demand with many sellers, it drives the price of a stock down.
Factors that drive demand boil down to data and a company’s performance and earnings, but it can also be partly due to speculation. For instance, how investors perceive and feel about the profitability of a company may determine if they are buying or selling. If a company is perceived as having a hotly anticipated new product come out, their stock may go up.
On the other hand, companies can also be adversely affected by economic conditions out of their control. For example, the stay-at-home orders in many states related to COVID-19 caused a drop in oil stocks because people not going anywhere caused demand for gas to crater and led to an oversupply of oil. As a result of COVID-19, people moved to protect their money.
Although there are plenty of reasons for stocks to go up and down on their own, sometimes overall market trends will help push them in one direction or another.
A bull market is defined as having a 20% uptick in stock prices after an extended period of falling stock prices. Bull markets happen because there is widespread optimism about the economy.
Generally, when people think things are going well, they tend to put more money into the stock market because there’s more opportunity for a higher return.
Once in a bull market, it remains that way until there’s a major downturn in the market. But eventually, what goes up must come down.
A bear market is represented by a 20% downturn in stock prices after an extended period of rising stock prices.
Generally, this is triggered by economic events that seem to signal economic distress. That could be for any number of reasons including trouble with trade, signs of deflation that would hurt consumer spending and layoffs affecting many sectors of the economy.
Whatever the reason for the stress, when people have financial worries, they tend to eschew the higher returns offered by investment in stocks in favor of investments with a guaranteed return like bonds, annuities and CDs.
The downside here is that there’s a chance that you might not make enough money off your investment to keep up with inflation in the event that the economy bounces back in relatively short order, but there is a sense of security in knowing that you’re not physically losing money.
With that said, the only way you make or lose money in stocks is by selling, so you could hold onto it and hope that over time, the market bounces back.
How To Read Stocks
An important part of understanding how the stock market works is knowing how to read stocks. But if you’ve ever tried to read a stock table, you’ll see a string of abbreviations and numbers. What do they all mean? Let’s break it down.
Each company has a trading symbol, which is usually abbreviated (for example, the symbol for Apple Inc. is AAPL). The first number you’ll usually notice on any major financial news outlet with a stock tracker is the current price of a share.
If you’re looking at a stock table, it usually includes the year-to-date (YTD) change. This is usually expressed as a percentage and shows how the price of a particular stock has changed since the beginning of the year.
You might also find the high and low prices within the last 52 weeks, and the dividend amount. A stock table or stock quote also can include the price of the last trade of the day, and also the net change, which is the change between the closing price of the current day in comparison to the closing price of the prior trading day.
What’s more, you can research a company that’s traded on the stock market in a number of ways:
- Go to a major financial publication to see how the stock price shifted over different periods of time.
- Hunt down corporate filings on the Securities and Exchange Commission (SEC).
- Find more information about a company on Morningstar or Bloomberg.
Using A Candlestick Chart
When trying to figure out how a particular stock is doing, there’s a lot of ways you can use existing data to gauge this.
For instance, a standard line graph shows the ups and downs of a stock’s performance. Then there’s a candlestick chart. Also known as a Japanese candlestick chart, it delves into greater detail by showing you the actual buying and selling patterns over a period of time.
Here’s how it works: one candle represents one day in the market. Each candle, or box, contains four prices for a given day – the open and close; the high and low.
If you’re looking at the candlestick or box itself (aka the candle or body), the top and bottom ends represent how much the stock moved between where it opened and where it closed. You might see upward movement represented as a green box, whereas a red box equals downward movement.
As for outside the box (aka the wicks), the vertical line equates to the high and low prices of a given day for that particular stock; this is the stock’s trading range for the day. As a candlestick chart is jam-packed with information, it usually is used to represent shorter spans of time.
And while a candlestick chart shows you patterns and how a stock moves and is performing, it doesn’t tell you why a stock moved the way it did.
Day traders use the movement of these charts and try to find patterns so they can pick stocks to buy for a short-term investment, while trying to sell before the stock goes down again.
The general problem with such an investment strategy is that it’s hard to get the timing of the market right. Additionally, the capital gains tax rate on any profits is higher if you hold the stock for less than a year.
It’s important to note that while it has its ups and downs, if you were to invest in the stock market over the course of many years, the S&P 500 index averages 7% growth after inflation. For this reason, many investors choose to take a long-term view of the stock market.
How Do You Invest In The Stock Market?
There are quite a few ways you can invest in the stock market. It depends on a number of things: Your time frame, target date, comfort level and tolerance for risk.
For instance, if you have more time to invest – we’re talking 30-plus years – and have a high comfort level with risk, your approach will be on the aggressive side. On the flip side, if you’re older and have less time to invest in the stock market, and aren’t as comfortable with risk, your approach will veer toward conservative.
Here are some types of investment accounts and vehicles to go about investing:
- 401(k): This is an employer-sponsored plan that is a defined contribution. A defined contribution means that the employer, the employee, or both make regular contributions to the plan. You can only open a 401(k) account if your employer offers such a plan.
- IRA: Whereas you have to go through an employer to open a 401(k) account, an IRA is a type of retirement account that you can open on your own. Note that IRAs aren’t an investment, but rather a type of account for your investments. The two main kinds are Roth IRAs and Traditional IRAs. The main difference is when you’ll be taxed.With a Roth IRA, you’re contributing after-tax dollars. The money in your account grows tax-free, and you won’t owe any taxes on your distributions.With a Traditional IRA, you’re putting in pretax dollars, which lowers your taxable income in the year you make your contributions. However, you’ll owe taxes when it’s time to take money out of your account.
- Buying Individual Stocks: You’ll need to understand industry trends, and stay afloat of news about companies you’re buying stocks in. You also need to buy these through stockbrokers, online or otherwise.
- Mutual Funds: A mutual fund is an investment program that pools funds from many investors to buy assets. The goal is to invest to achieve income or growth.Mutual funds are professionally managed, and the majority invest in a diversified portfolio made up of many types of assets such as stocks, bonds, and other securities.
- Index funds and ETFs: If a stock and a mutual fund had a baby, you’d get an exchange traded fund (ETF). Like mutual funds, ETFs hold a basket of assets, such as stocks, bonds, commodities and currencies, only they trade just like stocks.As for how their prices are determined, they’re determined by the forces of the market, and they’re traded throughout the business day on a stock exchange. These can be good for a beginning investor who isn’t sure what to buy. Services like Acorns will let you buy ETFs and index funds.
Set Your Budget
As they say, “It takes money to make money.” How do you know if you’re ready to invest? For one, you should have enough to cover your monthly expenses and bills, have some savings in case an emergency expense pops up, and have your debt repayments under control.
Next, figure out how much you can reasonably afford to budget for your stock investments. Ideally, a sound investment strategy means being able to invest continually for a long period of time. Even if it means starting small, or boosting your contribution amount to an employer-sponsored 401(k).
These days, there are a handful of online platforms and apps where you can get started with investing in the stock market with just five dollars. The important thing is to get the ball rolling now. That way when you have more money for investing, you’ll have carved out the inroads and developed the habits.
Diversification Is Key
When investing, you’ll want to keep diversification in mind. The point of diversification is that it protects your investments against risk. There will be times when the stock market overall is performing great, and other times when it will take a tumble.
However, there’s usually a bit of confusion as to what diversification is exactly. True diversification isn’t just about having a bunch of different types of investments in different accounts.
You’ll want to have a good mix of asset classes, such as stocks, bonds, and cash equivalents. Stocks are typically higher risk but have the potential for higher gains, and bonds are lower risk but also have lower gains.
Diversification means having different types of investments that respond differently to events happening in the world. This mix of investments also act differently depending on conditions in the market. And within each asset class, you might have a different set of investments.
Follow Your Interests
If you’re choosing to go the active investing route, consider companies and industries in which you have a natural interest. If you already have a finger on the pulse of these particular realms, it’ll be easier to know what’s going on with your investments. Are you ready to get started?
As an active investor, you’ll need to stay on top of what’s going on in the world, market trends, and economic and political shifts that could affect the performance of your investments.
To stay in the know, you can use research reports from stock advisory firms or stock brokerages, and subscribe to newsletters. While there’s no way to predict the future, the more research you do and knowledge you have, the better place you’ll be in to make informed decisions.
Are you more of a passive investor? If so, you’ll most likely be focusing on investing in securities such as mutual funds and ETFs that can provide gains in the long run. With this approach, you’ll want to try to match a broad market index. This means in terms of diversification, the returns, and low fees and costs.
Now that you understand what the stock market is and how it works, you hopefully won’t feel as overwhelmed or intimidated by getting started.
Remember, everyone’s financial situation is different. If you’re unsure whether a particular investment strategy is right for you, it’s best to rely on the counsel of financial advisors who can give you advice on your personal financial situation.
If so, subscribe now for tips on home, money, and life delivered straight to your inbox.