Have you ever wondered how the stock market works? A lot of people who have been investing for years aren’t entirely sure of the answer to that question. Similar to computers, it’s possible to use the stock market without knowing how it works.
But knowing how the stock market works can help you understand the significance of why a stock is trading on a certain exchange, and how that impacts your investing activities there.
The stock market is a facility where public companies sell their stock to both individuals and institutions. It serves as a way of raising capital. Companies often prefer raising capital through the issuance of stock rather than through debt. It means the company doesn’t have to pay interest, nor do they need to repay the principal at the end of the term.
A stock represents a share of ownership in a company. It gives investors an opportunity to receive dividend income – if it’s paid on the stock – as well as to get the benefit of capital appreciation from higher future prices.
Once a stock has been issued by a company, it will trade in the stock market. Individuals and institutions will be able to both buy and sell that stock. The issuing company can even repurchase its own shares.
A common misconception about the stock market is that it’s often described as a single entity, as in “the stock market”. But there are actually dozens of stock markets around the world.
According to Statista, the 10 largest stock exchanges in the world are as follows (where the word “group” is in the name, two or more exchanges may be included):
As you can see from the screenshot above, the New York Stock Exchange (NYSE) and the NASDAQ are by far the largest stock exchanges in the world by market capitalization. (Market capitalization is the total value of all stocks issued by all companies participating in a given stock market.)
The reason there are many different stock exchanges is because each serves a specific purpose. The most obvious is foreign stock exchanges. Each exists primarily to facilitate trading of stocks within the country where the market is located.
But even within the US, different stock exchanges serve different purposes.
For example, the New York Stock Exchange is considered an auction exchange. Brokers and traders are physically present on the trading floor. There, they buy and sell stocks through competitive bids and offers.
The NASDAQ, however, is an electronic exchange. Unlike the New York Stock Exchange, there’s no trading pit where brokers and traders congregate to trade securities. Instead, trading is handled through an electronic platform. Buyers and sellers essentially trade online, though as an individual investor the process is handled through a brokerage firm.
With the expansion of the Internet and online investing, electronic exchanges are becoming more common. They often supplement auction exchanges.
Finally, there’s the over-the-counter market (OTC), which are actually not organized stock exchanges. OTC accommodates small companies that don’t qualify to be listed on larger exchanges. However, once a company reaches the financial qualifications required by the bigger exchanges, they can move on to those platforms.
As discussed earlier, stock exchanges are where companies, individuals and investors come to buy and sell shares of company stock. Mechanically, the process is more involved.
On an auction exchange like the NYSE, market specialists deal in specific stocks, facilitating buying and selling. They’re the people who “make a market” in each stock trading on the exchange.
More specifically, trades work on a “bid” and “ask” basis. The bid is the price at which an investor is willing to buy a stock. The ask is the price at which a seller is willing to sell the stock. The bid and ask prices are matched each time a transaction is completed.
As an investor, you don’t see this happening. You simply make a trade online through your broker, and the transaction is completed in a matter of minutes. But your broker works with those market specialists to create the seamless investment flow that individual investors enjoy.
While the bid-and-ask process is the technical methodology for setting stock prices on a day-by-day basis, the ultimate market driver is supply and demand.
Supply and demand itself is driven by a complex mix of factors, including the following:
Any of the factors above can cause greater demand for a particular stock, causing the price to rise. It also can also cause interest in the company to dry up, resulting in a decline in its stock price.
This is why following the news specific to any company is so important when deciding which stocks to invest in.
The factors discussed above are specific to every public company and the industry it operates in. But there are also factors beyond the company and its industry sector that drive stock prices. Those center on forces that impact the entire market, and flow down to individual stocks.
It’s important to understand that stocks don’t operate in a vacuum. Factors affecting the nation and the world at-large also cause major shifts in the performance of the stock markets and individual companies within them.
If you look back over the past 20 years – or any given 20-year timeframe in history – you’ll see a distinct pattern of boom and bust in the stock market. In just the past 20 years, there have been two stock market crashes (2000 to 2002, and 2007 to 2009), plus a mini crash in February and March of 2020. But after each of those downturns, the stock market reached successive record price levels.
As much as investors and stock promoters would love to ignore the boom-and-bust factor in the market, it’s a perfectly normal cycle. During a boom – commonly referred to as a bull market – most stocks rise in price. During a bust – commonly referred to as a bear market – most stocks fall in price.
It can help to know the causes of those booms and busts, though it’s not possible to know how long or extensive either will be. Those unknowns are typically the very forces that create the volatility in the first place, especially during market busts.
There’s a fairly long list, but below are the most common:
The factors above are the primary reason why investment advisors recommend having a diversified portfolio. Having at least some of your portfolio allocated in cash, bonds, real estate, and other asset classes can help reduce volatility, especially in bear markets.
Volatility aside, there are several compelling reasons to invest in stocks.
With interest rates on savings accounts, money markets and certificates of deposit currently paying substantially less than 1%, you’ll never get rich with safe investments.
Stocks, as measured by the performance of the S&P 500, have provided average annual returns of about 10%. That’s based on information going back all the way to the 1920s.
No, stocks won’t produce reliable 10% annual returns. You may get 20% one year, followed by a 10% loss the following. But over 20 or 30 years, history suggests you should be able to fully expect your returns to be right around 10% per year.
People typically tend to think of inflation as rising prices. But what it really means is a reduction in purchasing power. Unless your portfolio can at least keep up with the rate of inflation, it will be worth less in the future than it is now.
According to the Bureau of Labor Statistics, inflation has been averaging around 2% per year for the past 20 years. If you’re earning less than 1% on safe savings, then you’re actually losing money against inflation.
Because of the higher return they provide, stocks represent a true long-term inflation hedge. An average annual rate of return of 10% will generate an 8% real rate of return, after accounting for a 2% inflation rate.
Put another way, by investing in stocks, you’ll have real opportunity to increase your net worth despite inflation.
Depending upon how you invest, stocks provide two important tax advantages.
The first is lower income taxes on long-term capital gains. If you hold an investment for more than one year, you’ll pay less in taxes on the gain than you will or other types of income.
In fact, a married couple with an income of no more than $80,800 will pay no tax on long-term capital gains in 2021. The tax rate will be just 15% on incomes up to $501,600. And on incomes exceeding that amount, the maximum long-term capital gains rate will be just 20%.
These tax rates compare favorably with the tax range of between 10% and 37% on all other types of income.
But an even bigger advantage can be had if you have a tax-sheltered retirement plan, like an IRA or a 401(k) plan. Investments held in such a plan are tax-deferred, so you’ll pay no tax whatsoever on long-term capital gains, short-term capital gains, and stock dividends.
You can invest in the stock market, either by investing in individual stocks, or by investing through funds. Funds can be either exchange traded funds (ETFs) or mutual funds.
Both ETFs and mutual funds come in two basic flavors – index funds and actively managed funds. Index funds are designed to track the performance of an underlying index, like the S&P 500 index.
Actively managed funds, as the name implies, are invested based on what the investment manager feels will be the best mix of stocks at any given point in time. It’s an attempt to outperform the market, rather than merely match is, as is the case with index funds.
You can invest in either individual stocks or funds through popular brokerage firms, like Fidelity and Charles Schwab. Best of all, most brokers today charge no commissions for buying and selling stocks and ETFs.
If you don’t feel comfortable choosing your own stocks and funds, you can invest through automated online investment platforms, commonly referred to as robo-advisors. All you need to do is invest your money, and the robo-advisor will design a portfolio for you, rebalance it periodically to keep it within target allocations, and reinvest dividends.
Here are two examples of robo-advisors:
One of the most popular robo-advisors is Betterment. You can open an account with no money, and begin investing as you accumulate funds. They charge an annual advisory fee of 0.25%, which means you can have $10,000 managed for just $25 per year.
If you like the robo-advisor concept, but you’d like to choose your own stocks and funds, you can invest through M1 Finance. You’ll invest using a method referred to as “pies”. Each pie can hold up to 100 individual stocks and ETFs, and can be created with as little as $100.
You can either use pre-built pies provided by M1 Finance, or create your own – with the stocks and funds of your choice. M1 Finance will then manage your pies for you. Not only are there no trading fees for the stocks and funds in your pies, but there’s no management fee, either.
Humans have been using markets for thousands of years. The stock market is similar to any other market where buyers and sellers can come together to transact assets.
Traditionally stock markets were physical locations where investors would place buys and sells in an auction order process. Now, most trading is done electronically using technology to place trades and match buyers and sellers.
Learning how the stock market works may be more information than you need. But if you’re going to become a committed, long-term investor, you should have at least a basic idea how the markets you’ll be investing in actually work.