What Is The Stock Market, And How Does It Work?
First things first. The phrase “the stock market” is inherently incorrect because implies that there is only one such market, where in fact, there are many. And before getting into what stock markets are, let’s define what a stock is.
If you own a stock, you actually own a piece of that company. For example, if you own a share of Starbucks stock, congratulations, you are a part-owner of Starbucks. But how do you buy that stock in the first place? You have to go to the stock market to do that.
A stock market is a place where people buy and sell stocks. Those happen on any one of many sites, both physical and virtual, that are known as exchanges. The two best known exchanges in the U.S. are the New York Stock Exchange (NYSE) and the Nasdaq, but there are also fourteen others that handle stocks.
When people say things like, “the stock market was up/down today,” they are referring to the “stock market” as a single entity. They are talking about how all of the stocks are doing.
In that context, what most people are referring to are what are known as “indexes,” such as the Dow Jones Industrial Average, the Nasdaq Composite, and the S&P 500. In each case, the index comprises of a basket of stocks that are averaged to give a sense of the overall performance of the market. Obviously, if you hold stock in only one or two companies, the performance of an index tells you nothing about how your stocks did, but it does give a sense of the general mood among traders and investors.
The nature of the indexes varies, but the Dow contains only 30 of the largest, most significant U.S. stocks, while the S&P 500, with 500 components as its name implies, represents a much broader selection of large companies. The Nasdaq is more oriented towards tech names and includes some slightly smaller companies. The mainstream media, and therefore the public, is most aware of the Dow, but market insiders tend to pay more attention to the S&P 500, where its broader base makes it more representative.
How Does the Stock Market Work?
The exchanges I mentioned above, including the New York Stock Exchange (NYSE) and the Nasdaq, are where the price of the stocks that make up the indexes are set, or rather arrived at. Those looking to buy place an order through an intermediary known as a “broker,” stating what they are prepared to pay per share and how many shares they wish to buy. That order is known, in market jargon, as a “bid.”
Similarly, those that own stock that they are looking to sell place an order stating how many shares they are looking to sell and at what price, which is known as an “offer” or “ask” price.
When buyers and sellers agree on a price, the exchange matches them and that is posted as the price of the stock. The prices you see, therefore, are simply the last price at which a sale occurred.
Influences on the Stock Market
There are many factors that go into the decisions of traders and investors about where to buy and sell individual stocks. The most important are the profitability of the company, and/or its prospects for profits in the future.
Fluctuations in “the market” in a more general sense are simply the sum of all those individual stock decisions, but there are things that dictate the direction of the market in general. To understand them you must understand one thing: the market is a forward-discounting mechanism.
In layman’s terms, traders are always looking forwards. They use past price action in the form of charts to inform their decisions to sell or buy, but what decides whether they make the right decision or not is what will happen in the future.
Obviously, the future isn’t known, but some things are used to determine the likelihood of a stock’s price moving up or down. Many of those things, such as economic strength and political stability affect all stocks, so changes in things like economic conditions, political stability, and geopolitical stability can cause widespread buying or selling, and thus broad market moves.
How do You Buy Stocks?
You need two things to participate in the stock market, money and a broker. For most people, those two things are combined in a retirement account. They, and often their employer, contribute to an account at a brokerage that is then invested, usually at least partly in stocks, for their retirement.
If you want to participate more actively in the market though, your retirement account is not the best place to do it, nor are your retirement funds the best thing to do it with, because losses, sometimes substantial losses, are always a possibility.
To get started you will need a brokerage account. Not that long ago, that meant using, and paying for, a person at a brokerage firm to give you information and advice and, more importantly, to place trade orders on your behalf.
Now, though, information is freely available online, as is a brokerage account with relatively low trade fees. It is easy to open one, but that doesn’t mean that it should be done without thought. Not only do fees vary considerably, the available tools and advice and speed and closeness to your order of execution can also do so. Researching and asking questions before you open and fund an account is therefore essential.
The stock market is not a place. It is many places and many computer systems that make up a network to facilitate the buying and selling of shares in public companies. Investing can be confusing, with a lot of jargon, and stocks can make moves that seem to defy logic and explanation, but taking part in a disciplined, limited way can be both fun and profitable. Hopefully, if you are looking to do that, you now know a little more about what the market is and how it works.