Demystifying the Stock Market – Basics and Mechanics Explained

How the market works

When you purchase a public company’s stock, you’re purchasing a small piece of that company.

The stock market works through a network of exchanges — you may have heard of the New York Stock Exchange or the Nasdaq. Companies list shares of their stock on an exchange through a process called an initial public offering, or IPO. Investors purchase those shares, which allows the company to raise money to grow its business. Investors can then buy and sell these stocks among themselves.

Buyers offer a “bid,” or the highest amount they’re willing to pay, which is usually lower than the amount sellers “ask” for in exchange. This difference is called the bid-ask spread. For a trade to occur, a buyer needs to increase his price or a seller needs to decrease hers.

This all may sound complicated, but computer algorithms generally do most price-setting calculations. When buying stock, you’ll see the bid, ask, and bid-ask spread on your broker’s website, but in many cases, the difference will be pennies, and won’t be of much concern for beginner and long-term investors.

The stock market is regulated by the U.S. Securities and Exchange Commission, and the SEC’s mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Historically, stock trades likely took place in a physical marketplace. These days, the stock market works electronically, through the internet and online stockbrokers. Each trade happens on a stock-by-stock basis, but overall stock prices often move in tandem because of news, political events, economic reports and other factors.

List of the best online stock brokers for beginners

What is the point of the stock market?

The point of the stock market is to provide a place where anyone can buy and sell fractional ownership in a publicly traded company. It distributes control of some of the world’s largest companies among hundreds of millions of individual investors. And the buying and selling decisions of those investors determine the value of those companies.

The market lets buyers and sellers negotiate prices. This negotiation process maximizes fairness for both parties by providing both the highest possible selling price and the lowest possible buying price at a given time. Each exchange tracks the supply and demand of stocks listed there.

Supply and demand help determine the price for each security, or the levels at which stock market participants — investors and traders — are willing to buy or sell. This process is called price discovery, and it’s fundamental to how the market works. Price discovery plays an important role in determining how new information affects the value of a company.

For example, imagine a publicly traded company that has a market capitalization (market value) of $1 billion, and trades at a share price of $20.

The keypoint

Now suppose that a larger company announces a deal to acquire the smaller company for $2 billion, pending regulatory approval. If the deal goes through, it would represent a doubling of the company’s value. But investors might want to prepare for the possibility of regulators blocking the deal.

If the deal seems like a sure thing, sellers might raise their asks to $40, and buyers might raise their bids to meet those asks. But if there’s a chance the deal won’t be approved, buyers might only be willing to offer bids of $30. If they’re very pessimistic about the deal’s chances, they might keep their bids at $20.

In this way, the market can determine how a complicated piece of new information — a takeover deal which might not go through — should affect the company’s market value.

What is the stock market doing today?

Investors often track the stock market’s performance by looking at a broad market index like the S&P 500 or the DJIA. The chart below shows the current performance of the stock market — as measured by the S&P 500’s closing price on the most recent trading day — as well as the S&P 500’s historical performance since 1990.

Stock market data may be delayed up to 20 minutes, and is intended solely for informational purposes, not for trading purposes.

What is stock market volatility?

Investing in the stock market does come with risks, but with the right investment strategies, it can be done safely with minimal risk of long-term losses. Day trading, which requires rapidly buying and selling stocks based on price swings, is extremely risky. Conversely, investing in the market for the long-term has proven to be an excellent way to build wealth over time.

For example, the S&P 500 has a historical average annualized total return of about 10% before adjusting for inflation. However, rarely will the market provide that return on a year-to-year basis. Some years the market could end down significantly, others up tremendously. These large swings are due to market volatility, or periods when stock prices rise and fall unexpectedly.

If you’re actively buying and selling stocks, there’s a good chance you’ll get it wrong at some point, buying or selling at the wrong time, resulting in a loss. The key to investing safely is to stay invested — through the ups and the downs — in low-cost index funds that track the whole market, so that your returns might mirror the historical average.

How do you invest in the stock market?

You’ll usually buy stocks online between 9:30 AM and 4 PM ET through the market, which anyone can access with a brokerage account, robo-advisor or employee retirement plan.

You don’t have to officially become an “investor” to invest in — for the most part, it’s open to anyone.

If you have a 401(k) through your workplace, you may already be invested in the market. Mutual funds, which are often compose of stocks from many different companies, are common in 401(k)s.

» You don’t have to buy 9:30-4: Learn more about options for premarket trading and after hours trading

You can purchase individual stocks through a brokerage account or an individual retirement account like an IRA. Both accounts can open at an online broker, through which you can buy and sell investments. The broker acts as the middleman between you and the stock exchanges.

Online brokerages have made the signup process simple, and once you fund the account, you can take your time selecting the right investments for you.

With any investment, there are risks.

But stocks carry more risk — and more potential for reward — than some other securities. While the market’s history of gains suggests that a diversified stock portfolio will increase in value over time, stocks also experience sudden dips.

To build a diversified portfolio without purchasing many individual stocks, you can invest in a type of mutual fund called an index fund or an exchange-traded fund. These funds aim to passively mirror the performance of an index by holding all of the stocks or investments in that index. For example, you can invest in both the DJIA and the S&P 500 — as well as other market indexes — through index funds and ETFs.

Stocks and stock mutual funds are ideal for a long time horizon — like retirement — but unsuitable for a short-term investment (generally defined as money you need for an expense within five years). With a short-term investment and a hard deadline, there’s a greater chance you’ll need that money back before the market has had time to recover losses.