How Does the Stock Market Work?

A stock market is a place where companies raise capital by selling shares of

stock (also known as 'equity') to investors. Most stocks
give shareholders voting rights and a residual claim on corporate earnings in
the form of capital gains and dividends.

Stock markets also allow existing shares of publicly traded companies to

change hands, where individuals and institutions can invest in companies to
potentially profit from their success or speculate on shorter-term price
movements. They play a crucial role in price discovery, as the collective
actions of buyers and sellers determine the market value of companies.
Moreover, stock markets promote corporate transparency and accountability,
as public companies must adhere to regulatory standards and disclose
financial information to shareholders.

Through their functioning, stock markets serve as important economic

indicators, reflecting investor sentiment and a barometer of overall economic
health. When stock prices rise, it often signals investor confidence in the
economy, while falling prices may indicate concerns about economic
stability.

Key Takeaways

 Stocks represent ownership equity in a firm, and many give

shareholders voting rights, as well as a residual claim on corporate
earnings in the form of capital gains and dividends.

 Individual and institutional investors come together on stock

exchanges to buy and sell shares in a public venue.

 Share prices are set by supply and demand as buyers and sellers place
orders.

How Do Stock Markets Work?

Stock markets are organized platforms where buyers and sellers come
together to trade shares of publicly listed companies. At their core, these
markets operate on the principle of supply and demand, with share prices
fluctuating based on companies' perceived value and overall market
conditions. When more people want to buy a stock than sell it, the price
typically rises, while the opposite is true.

Stock markets facilitate both a primary and a secondary market. The primary
market is where new stocks are first issued through initial public offerings
(IPOs). Here, companies sell shares directly to investors, raising capital for
business operations or expansion. Once these shares are in circulation, they
enter the secondary market, where most daily trading occurs. In the
secondary market, investors trade existing shares among themselves, with
the company no longer directly involved in these transactions.

Stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ,
provide the infrastructure for these trades to take place. They maintain
orderly markets, ensure compliance with regulations, and disseminate real-
time price information. Modern stock markets largely operate electronically,
with sophisticated computer systems matching buy and sell orders almost
instantaneously.

Various market participants play important roles in the functioning of stock

markets. These include:

 Individual and institutional investors (like mutual funds and pension

funds) who own shares

 Traders who buy and sell over short time horizons

 Market makers (MMs) who provide liquidity

 Brokers who facilitate trades

Additionally, regulatory bodies oversee market operations to protect

investors and maintain market integrity. Together, these elements create a
complex ecosystem that enables efficient capital allocation and provides
opportunities for investment and wealth creation.

How Do Stocks Work?

When a company wants to raise capital, it divides what it believes to be the

total amount of capital needed into slices of ownership with a specific value.
These slices are called shares and usually represent a percentage of
ownership in a company. Commonly, but not always, these shares come with
voting rights and the potential to receive a portion of the company's profits
through dividends or capital appreciation. The shares issued by the company
to shareholders are called outstanding shares because investors, not the
corporation, hold them.

The total value of a company's outstanding shares is known as its market

capitalization, which fluctuates based on the current stock price and the
number of shares issued.
Market capitalization rises and falls with the current market price of the
shares and reflects the value placed on a company by the market.

Why Stock Markets Are Important

Stock markets are integral to modern economies. They provide companies

with access to capital by allowing them to sell shares to the public, enabling
businesses to fund growth, innovation, and expansion. The influx of capital
received from IPOs drives economic development, job creation, and
technological advancement, benefiting society as a whole.

Beyond capital raising, stock markets facilitate the efficient allocation of

resources. They do this through the price discovery process, where the prices
of stocks are determined in real time by the collective actions of buyers and
sellers. This mechanism helps ensure that capital is directed towards the
most promising and productive enterprises. Investors, through their buying
and selling decisions, signal which companies they believe will succeed and
grow—and those which may not. This dynamic process helps allocate
resources to their most efficient uses, promoting overall economic efficiency.

For investors, stock markets provide opportunities to grow wealth over time.
By purchasing shares, individuals and institutions can participate in the
financial successes (or failures) of companies. Access to stock markets allows
a broad range of people to build financial security and work towards long-
term goals such as retirement or education funding. Today, many individuals
rely on stock investments to fund future goals such as retirement savings,
college tuition, and even healthcare spending.

Stock markets also serve as barometers of broad economic health and

investor sentiment. Market indices, such as the S&P 500 or Dow Jones
Industrial Average, provide snapshots of overall market performance, often
reflecting broader economic trends and expectations. Policymakers,
businesses, and individuals frequently use these indicators to inform
decision-making, from monetary policy and business strategies to personal
financial planning.

Major Stock Exchanges

Stock exchanges date back to the 17th century, with the Amsterdam Stock
Exchange, established in 1602, often cited as the world's first formal stock
market.1 However, the concept of trading company shares existed even
earlier, with the Roman Republic having a system for trading shares
in publicani companies.2 As commerce and industry grew, so did the need
for organized markets to facilitate the trading of securities.

In the United States, the first U.S. stock exchange was the Philadelphia Stock
Exchange (PHLX), founded in 1790, which still exists today.3 The more
famous New York Stock Exchange (NYSE) dates back to 1792, when 24
brokers signed the Buttonwood Agreement, establishing rules for trading
securities. The NYSE has since grown to become one of the world's largest
and most influential exchanges. The second major U.S. exchange, NASDAQ,
was founded in 1971 as the world's first electronic stock market. Today,
these two exchanges dominate the U.S. landscape, with the NYSE known for
its auction-based trading system and blue-chip stocks, while NASDAQ is
home to many technology and growth companies.

Internationally, several major exchanges also exist. The London Stock

Exchange, founded in 1801, is one of Europe's oldest and largest. In Asia,
the Tokyo Stock Exchange, established in 1878, is Japan's primary bourse,
while the Shanghai Stock Exchange, reopened in 1990 after a long hiatus,
has become increasingly important as China's economy has grown.456 Other
significant exchanges include the Hong Kong Stock
Exchange, Euronext (which operates markets in Amsterdam, Brussels,
Dublin, Lisbon, London, Oslo, and Paris), and the Frankfurt Stock Exchange.

In most developed countries, stock exchanges are formed as self-regulatory

organizations (SROs), nongovernmental organizations that have the power to
create and enforce industry regulations and standards. The advent of
electronic trading has revolutionized stock exchanges worldwide. Starting
with NASDAQ's electronic system in the 1970s, most major exchanges have
now either fully transitioned to electronic trading or operate hybrid systems.
This shift has dramatically increased trading speed and efficiency, reduced
costs, and improved market access for a wider range of participants. It has
also facilitated the rise of alternative trading systems (ATS) and dark pools,
challenging traditional exchanges and reshaping the global financial
landscape.

The original method of stock market trading was based on a manual system
known as the open outcry system, where traders used verbal and hand
signal communications to buy and sell large blocks of stocks in the trading
pit or the exchange floor.

Over-the-Counter Exchanges
There also exist several loosely regulated over-the-counter (OTC) exchanges,
which may also be referred to as bulletin boards (OTCBB). Shares listed OTC
tend to be riskier since they list companies that fail to meet the more strict
listing criteria of bigger exchanges. Larger exchanges may require that a
company has been in operation for a certain amount of time before being
listed and that it meets certain conditions regarding company value and
profitability.7

Top Stock Exchanges by Total Market Capitalization

(as of Q2 2024)

Exchange Location Market Cap ($

trillions)

NYSE U.S. $28.32

NASDAQ U.S. $26.62

Tokyo Stock Exchange Japan $6.93

Shanghai Stock Exchange China $6.32

India National Stock India $5.47

Exchange

Euronext Europe $5.17

Hong Kong Stock Exchange Hong Kong $3.98

Shenzhen Stock Exchange China $3.73

Toronto Stock Exchange Canada $3.24

(TMX)

Saudi Stock Exchange Saudi $2.71

(Tadawul) Arabia

Source: World Federation of Exchanges

(https://focus.world-exchanges.org/issue/september-2024/market-statistics)

Why Does the Stock Market Go Up and Down?

The stock market's movements are influenced by several factors that affect
investor sentiment and economic conditions. These factors can range from
macroeconomic indicators, such as interest rates, inflation, and GDP growth,
to company-specific news, like earnings reports, product launches, or
leadership changes. Political events, international trade policies, and
geopolitical tensions also play significant roles. When positive news or data
points emerge, investors are often more willing to buy stocks, driving prices
up. Conversely, negative news can lead to selling, causing prices to fall.

When the demand for a particular stock increases due to favorable news,
profit outlook, or investor optimism, its price tends to rise. Conversely, when
supply outweighs demand, often driven by negative sentiment or poor
performance, stock prices fall. A constant flux in supply and demand is the
essence of price discovery, where the collective actions of buyers and sellers
determine the fair market value of stocks based on available information.

Sometimes, the price discovery mechanism can fall out of whack, leading to
price bubbles and crashes. A bubble occurs when stock prices rise
significantly above their fundamental or intrinsic values, driven by exuberant
market psychology, herding behavior, and speculative buying. For instance,
the Dot-com Bubble of the late 1990s saw technology stocks soar to
unsustainable levels, fueled by high expectations for internet-based
companies. When the bubble burst in 2000, it led to a sharp market decline
as investors realized the overvaluation.8

A market crash is a sudden and severe drop in stock prices, often triggered
by panic selling and widespread fear. The 2008 Financial Crisis is a prominent
example, where the collapse of the housing market and the failure of major
financial institutions led to a dramatic decline in stock prices
worldwide.9 Crashes can lead to significant economic repercussions,
including recessions and long-term market instability.

Despite their dramatic impact, both bubbles and crashes have historically
resolved themselves over time. Markets eventually find a new equilibrium as
investor confidence is restored, economic fundamentals improve, and
regulatory measures are implemented to prevent future excesses. This
cyclical nature of market movements underscores both the volatility and the
resilience of financial systems and the importance of maintaining a long-term
perspective in investing.

Market Volatility

Volatility in the market refers to the degree of variation in stock prices over a
given period. High volatility means that stock prices can change rapidly and
unpredictably, while low volatility indicates more stable prices.
Volatility is a natural part of stock markets and can be influenced by both
systemic factors, such as economic changes or political events, and specific
factors, such as company performance or sector-specific news. For investors,
volatility can represent both a risk and an opportunity. While high volatility
can generate significant gains, it also increases the risk of substantial losses.
Managing volatility is a key aspect of investment strategy, requiring careful
analysis and a long-term perspective.

Stock Market Indexes

Indexes represent aggregated prices of several different stocks, and the

movement of an index is the net effect of the movements of each
component. Major stock market indexes include the Dow Jones Industrial
Average (DJIA) and the S&P 500.

The DJIA is a price-weighted index of 30 large American corporations.

Because of its weighting scheme and the fact that it only consists of 30
stocks (when there are many thousands to choose from), it is not necessarily
the best indicator of how the stock market is doing.10 The S&P 500 is a
market-capitalization-weighted index of the 500 largest companies in the
U.S. and is a much more useful indicator.11

Indexes can be broad, such as the Dow Jones or S&P 500, or specific to a
certain industry or market sector. Investors can trade indexes indirectly via
futures markets or exchange-traded funds (ETFs), which act just like stocks
on stock exchanges.

A market index is a popular measure of stock market performance. Most

market indexes are market-cap-weighted, which means that the weight of
each index constituent is proportional to its market capitalization. Keep in
mind, though, that a few of them are price-weighted, such as the DJIA. In
addition to the DJIA, other widely watched indexes in the U.S. and
internationally include the following:

 S&P 500

 Nasdaq Composite

 Russell Indexes (Russell 1000, Russell 2000)

 TSX Composite (Canada)

 FTSE Index (United Kingdom)

 Nikkei 225 (Japan)

  Dax Index (Germany)

 CAC 40 Index (France)

 CSI 300 Index (China)

 Sensex (India)

How to Invest in the Stock Market for Beginners

Numerous studies have shown that, over long periods, stocks generate
investment returns that are superior to those from every other asset class.
Stock returns arise from capital gains and dividends.12

Many of us are already invested in the stock market, whether we realize it or

whether or not we play an active role in our investments. This happens
through participation in retirement accounts like 401(k)s or pension plans,
college savings accounts, or health savings accounts (HSAs).

To take a more active role in the stock market, you can also choose to hold
specific stocks, ETFs, or mutual funds. Understanding how to invest in the
stock market can help you make more informed decisions, maximize returns,
and manage risks effectively.

Choose Your Investment Strategy

There are several strategies you can adopt when investing in the stock
market, each with its own risk and return profile:

1. Buy-and-Hold: This passive strategy involves purchasing stocks and

holding them for a long period, regardless of market fluctuations. The
idea is that, over time, the stock market tends to increase in value, and
long-term investments will benefit from this upward trend. Buy-and-
hold strategies include investing in index funds over long time
horizons.

2. Growth Investing: Growth investing focuses on finding companies

expected to grow at an above-average rate compared to other
companies. These stocks may not pay dividends but have the potential
for significant capital appreciation.

3. Value Investing: Value investing involves selecting stocks that appear

undervalued. Value investors look for stocks that they believe are
priced lower than their intrinsic value and wait for the market to
recognize their true worth.
 4. Income Investing: This strategy emphasizes stocks that pay regular
dividends. It’s suitable for those seeking a steady income stream from
their investments.

While stocks can be classified in several ways, two of the most common
are by market capitalization and sector. Market cap refers to the total market
value of a company’s outstanding shares and is calculated by multiplying
these shares by the current market price of one share.

Large-cap companies are generally regarded as those with a market

capitalization of $10 billion or more, while mid-cap companies are those with
a market capitalization of $2 billion to $10 billion. Small-cap companies fall in
the $250 million to $2 billion range.13

The industry standard for stock classification by sector is the Global Industry
Classification Standard (GICS), which was developed by MSCI and S&P Dow
Jones Indices in 1999 as an efficient tool to capture the breadth, depth, and
evolution of industry sectors. GICS is a four-tiered industry classification
system that consists of 11 sectors and 24 industry groups. The 11 sectors
are:14

 Energy

 Materials

 Industrials

 Consumer discretionary

 Consumer staples

 Healthcare

 Financials

 Information technology

 Communication services

 Utilities

 Real estate

This sector classification makes it easier for investors to tailor

their portfolios to their risk tolerance and investment preference.
Conservative investors with income needs may weigh their portfolios
toward sectors with constituent stocks that have better price stability. They
may also look for attractive dividends through so-called defensive sectors
such as consumer staples, healthcare, and utilities. Aggressive investors may
prefer more volatile sectors like information technology, financials, and
energy.

Choose a Broker

Brokers act as intermediaries between you and the stock market, facilitating
the purchase and sale of securities. Today, it is quite easy to open a new
account at a broker, or to transfer an existing brokerage account to
someplace new. Often, accounts can be opened up online and funded within
minutes. Here are different types of brokers to consider:

1. Full-Service Brokers: Full-service brokers offer a wide range of

services, including investment advice, retirement planning, tax
guidance, and portfolio management. They typically charge higher fees
but provide personalized service and expert advice. Examples include
Merrill Lynch and Morgan Stanley.

2. Discount Brokers: Discount brokers offer fewer services compared to

full-service brokers but charge lower fees. They provide basic trading
services, research tools, and customer support. This option is suitable
for self-directed investors who prefer to make their own investment
decisions. Examples include Charles Schwab and Fidelity.

3. Online Brokers: These brokers operate primarily through online

platforms, offering a convenient and cost-effective way to trade stocks.
They provide a range of tools and resources for self-directed investors.
Online brokers often have lower fees compared to traditional brokers
and may even offer commission-free trading. Examples include
E*TRADE and Robinhood.

4. Roboadvisors: Roboadvisors use algorithms to create and manage

investment portfolios based on risk tolerances and goals. They offer a
hands-off approach to investing with lower fees compared to human
advisors. Roboadvisors are ideal for investors seeking a simple and
automated investment solution.15 Examples include Betterment and
Wealthfront.

5. Direct Stock Purchase Plans (DSPPs): Some companies offer

DSPPs, allowing investors to purchase shares directly from the
company without using a broker. These plans often have lower fees
and can be a cost-effective way to invest in specific companies.
Diversify Your Portfolio

Diversification is a key principle in risk management. By spreading your

investments across various asset classes, industries, and geographic regions,
you can reduce the impact of any single investment's poor performance on
your overall portfolio. Diversification can be achieved through:

 Mutual Funds and Exchange-Traded Funds (ETFs): These funds

pool money from many investors to buy a diversified portfolio of stocks
and other securities.

 Index Funds: These funds aim to replicate the performance of a

specific index, such as the S&P 500, providing broad market exposure
(many of these funds are mutual funds and ETFs).

 Individual Stocks: You can build a diversified portfolio by carefully

selecting stocks from different sectors and industries.

Monitor and Adjust Your Investments

Regularly monitoring your investments is essential to ensure they align with

your goals and risk tolerance. Over time, market conditions and personal
circumstances change, and your portfolio may need rebalancing.
Rebalancing involves adjusting your portfolio back to its original asset
allocation by purchasing or selling investments. This helps maintain your
desired level of risk and ensures that your investment strategy remains on
track.

Other Kinds of Asset Markets

While the stock market is one of the most well-known avenues for investing,
there are several other asset markets that offer different opportunities and
risks. Diversifying investments across various asset classes can help manage
risk and potentially enhance returns. Here are some other important asset
markets to consider.

Bond Markets

The bond market, also called the fixed-income market, involves buying and
selling debt securities. Bonds are essentially loans made by investors to
corporations, municipalities, or governments in exchange for periodic
interest payments and the return of the principal at maturity. The bond
market is often seen as a safer investment compared to stocks, as bonds
typically offer more stable and predictable returns.
Real Estate Markets

Real estate markets involve buying, selling, and leasing properties. It

includes residential, commercial, and industrial real estate. Real estate can
be an attractive investment due to its potential for capital appreciation,
rental income, and portfolio diversification. Investors can participate in real
estate markets through direct ownership of properties or indirectly via real
estate investment trusts (REITs) that own, operate, or finance income-
producing real estate.

Commodities Markets

Commodities markets involve trading raw materials and primary agricultural

products. Commodities can be divided into two main categories: hard and
soft. Hard commodities include natural resources like gold, silver, oil, and
natural gas, while soft commodities include agricultural products like wheat,
coffee, and cotton. Investors can access commodities markets through spot
markets for physical goods, as well as futures markets that trade contracts to
buy or sell a commodity at a predetermined price at a specific future date.

Foreign Exchange Markets

The foreign exchange (forex) market is the largest and most liquid financial
market in the world, involving currency trading. Investors and institutions
trade currencies to profit from fluctuations in exchange rates. The forex
market operates 24 hours a day, five days a week, and is influenced by
economic indicators, geopolitical events, and market speculation. Key
participants in the forex market include banks, hedge funds, corporations,
and individual traders.

Cryptocurrency Markets

A newer entrant is the cryptocurrency market, which involves the trading of

digital or virtual currencies or tokens that use cryptography for security and
are decentralized through blockchains. Cryptocurrencies operate on
decentralized networks based on blockchain technology. Bitcoin, Ethereum,
and Ripple are among the most well-known cryptocurrencies. These markets
are still highly volatile and speculative, offering the potential for significant
gains and losses. Investors can participate through direct ownership of
cryptocurrencies or non-fungible tokens (NFTs). They can also invest
indirectly via cryptocurrency ETFs, which hold crypto or are linked to crypto
futures.
Another option is to purchase a cryptocurrency issued by a decentralized
autonomous organization (DAO), which, in addition to potential capital
appreciation, gives the holder governance rights within the organization.

How Does Inflation Affect the Stock Market?

Inflation refers to an increase in consumer prices, either due to an

oversupply of money or a shortage of consumer goods. The effects of
inflation on the stock market are unpredictable—in some cases, it can lead to
higher share prices due to more money entering the market and increased
job growth. However, higher input prices can also restrict corporate earnings,
causing profits to fall. Overall, value stocks tend to perform better than
growth stocks in times of high inflation.

How Much Does the Stock Market Grow Every Year?

The S&P 500 has grown about 10.5% per year since it was established in the
1920s. Using this as a barometer for market growth, one can estimate that
the stock market grows in value by about the same amount each year.
However, there is an element of probability—in some years, the stock market
sees greater growth; in other years, it grows less. In addition, some stocks
grow faster than others.

What Is the Bid-Ask Spread in Stocks?

The bid-ask or bid-offer spread, the difference between the bid price for a
stock and its ask or offer price, represents the difference between the
highest price that a buyer is willing to pay or bid for a stock and the lowest
price at which a seller is offering the stock. If the spread is tight, then the
market in the stock is likely quite liquid. Meanwhile, if the bid-ask spread is
wide, the stock is illiquid and harder to trade.

How Do People Lose Money in the Stock Market?

Most people who lose money in the stock market do so through reckless
investments in high-risk securities. Although these can score high returns if
they are successful, they are just as likely to lose money. There is also an
element of psychology: An investor who sells during a crash will lock in their
losses, while those who hold their stock have a chance of seeing their
patience rewarded. Finally, margin trading can make the stock market even
riskier, by magnifying one’s potential gains or losses.

Why Might a Company Choose Not to List on a Stock Exchange?

There are significant costs associated with listing on an exchange, such as
listing fees and higher costs associated with compliance and reporting. There
are also burdensome regulations and disclosure requirements that may
constrict a company’s ability to do business. This is why most companies
choose to list on an exchange at a later, more mature stage.

The Bottom Line

Stock markets represent the heartbeat of the market, and experts often use
stock prices as a barometer of economic health. But the importance of stock
markets goes beyond mere speculation. They provide a structured and
regulated environment where companies can raise capital to fund innovation,
expansion, and operations, thereby driving economic growth. Exchanges also
enable investors to buy and sell securities, facilitating liquidity and price
discovery, which helps ensure that capital is allocated efficiently.

Additionally, stock exchanges promote corporate transparency and

accountability, as listed companies must adhere to strict disclosure
requirements. By reflecting investor sentiment and broader economic trends,
stock exchanges serve as crucial economic indicators, helping policymakers
and analysts gauge the health of the economy. In essence, stock exchanges
underpin the financial system, supporting both corporate development and
investor engagement, which are essential for economic stability and
progress.