How does the stock market work? A beginner’s guide

The stock market is an important part of the U.S. and global economy. Many of us are connected to the stock market in some way – often through retirement accounts like 401(k)s, pensions or other investment accounts.

The stock market may seem like something best left to the financial pros. Once you have a better idea of how it works, though, you’ll more clearly understand how it affects the entire economy (and you personally). When you understand the market, you may feel more empowered to start investing and grow your wealth.

What is the stock market?

The stock market is a broad term that refers to the buying and selling of stocks, also known as equities. Many people refer to the stock market simply as “Wall Street,” but in reality, it’s far larger than a single location. Indeed, the stock market encompasses individual stocks, the exchanges where people buy and sell them, and the indexes that measure their performance.

You might be participating in the stock market and not even know it. If you have a 401(k) or another retirement plan through your employer, for example, there’s a good chance you have some exposure to the stock market.

As mentioned, the stock market plays a key role in the economy. First, companies sell stock – small shares of ownership – often to raise capital to grow their business. Meanwhile, investors buy these shares as a way to profit from a company’s success.

There’s often – but not always – a relationship between the stock market’s performance and the overall economy.

History of major global stock markets

The concept of the stock market as we know it today is often traced to 1602, when modern stock trading emerged at the Amsterdam Stock Exchange. The Dutch East India Company is widely credited as the first company to issue shares (and bonds) to the public, with other companies eventually following suit.

Nearly 200 years later, the Philadelphia Stock Exchange was founded in 1790, and the New York Stock Exchange (NYSE) was established in 1792. The NYSE’s history begins with the signing of the Buttonwood Agreement by New York City stockbrokers – an early milestone often linked to the beginnings of Wall Street trading. The London Stock Exchange came a few years later, in 1801. By the late 1800s, major exchanges had also developed in China and Japan.

Of course, the way people trade stocks today looks very different than it did in the 17th, 18th and 19th centuries. What began with brokers meeting in coffeehouses to trade securities evolved into organized trading on the floors of major stock exchanges. By the late 1800s, orders and market information could be transmitted by telephone. Fast-forward to today, and much of that activity happens online.

How the stock market works

The term “stock market” brings to mind the image of a physical market where investors can buy shares of well-known companies. And it’s true that, historically, stocks were bought and sold in physical locations, like on the floor of the NYSE.

But today’s stock market looks very different: It technically exists in both primary and secondary markets across a series of exchanges, with the majority of trading taking place online.

Primary vs. secondary markets

The stock market comprises both primary and secondary markets. A primary market refers to the first time a company offers new shares. An initial public offering (IPO) – when a private company “goes public” by issuing its first public shares – is part of the primary market. Corporations issue public shares as a way to raise capital.

A secondary market refers to the resale of shares among investors, such as on a major stock exchange. For example, let’s say a company you follow goes public, and you buy shares in the IPO. That’s the primary market. Later on, you decide to resell those shares through your brokerage account. That transaction takes place in the secondary market. Typically, the company that issued the shares doesn’t receive the proceeds from those secondary-market trades.

Secondary market trades take place on a stock exchange. The two largest U.S. stock exchanges are the NYSE and the Nasdaq, but there are dozens more throughout the United States and the rest of the world – including the Shanghai Stock Exchange, Tokyo Stock Exchange and Euronext.

Key participants in the stock market

Every purchase on the stock market involves at least two parties: a buyer and a seller. A stock market transaction begins when buyers and sellers place trade orders. There are various types of orders, including market orders, limit orders and stop orders. The difference between these has to do with the pricing parameters the buyer or seller has put in place.

Every sale has both a bid price and an ask price. The bid is the amount a buyer is willing to pay for the stock, while the ask is the amount the seller is willing to accept for it. If the ask is higher than the bid (which is usually the case), there’s a bid-ask spread, and one side has to adjust for the trade to go through.

In addition to buyers and sellers, many other participants play important roles in the market, including broker-dealers, clearing agencies, regulators, transfer agents and other market intermediaries.

Key stock market indexes

Among the most important features of the U.S. stock market – and many global stock markets – are stock market indexes, which track the performance of a specific collection of stocks. When you hear investors and analysts talking about “the market” being up or down, they’re usually talking about a specific market index. Not all indexes track the entire market – most don’t, in fact – but they can give us a good idea of what’s happening in the market as a whole.

The most well-known U.S. stock market indexes include the following:

Many major indexes are weighted by market capitalization, meaning each company’s influence is generally tied to its size. The Nasdaq Composite, for example, is market-cap-weighted, so larger companies have a greater impact on its overall performance.

Factors influencing the performance of the stock market

Microeconomic and macroeconomic factors impact the stock market. From a micro perspective, you might look at a specific company’s performance to understand why its stock price is rising or falling. If that company has a poor earnings report, it might see its stock price fall. A company that’s recently made a major announcement, however, might see its stock go up in price.

In contrast, a macro perspective accounts for the market as a whole. This whole-market view is important, and it can affect the economy in a multitude of ways.

For instance, political and global events impact the stock market’s performance. Consider March 2020, when the market fell sharply in response to the COVID-19 pandemic. Uncertainty affected investor sentiment, which caused the Dow to have some of its largest single-day drops ever. But once the immediate panic subsided, it was less than six months before the S&P 500 reached a new all-time high.

Generally speaking, the more optimistic investors are feeling about the economy, the higher the stock market goes, and vice versa. But there’s not always a direct correlation between the stock market and the overall economy.

What options are there for investing in the stock market?

As mentioned, buying stock means you’re buying a small piece of ownership in a company. By owning stock, investors can earn money in two different ways: capital appreciation (when the stock price rises) and dividend payments (when the company passes its profits along to shareholders).

The two primary types of stock are common stock and preferred stock. The former comes with voting rights at shareholder meetings and the potential to earn dividends. The latter doesn’t come with voting rights, but it offers priority dividends over common stock.

Stocks can be further categorized based on the type of company (blue-chip stocks, for example), the size of the company (small-cap versus mid-cap versus large-cap), the company’s projected growth or whether it pays dividends.

Investing in stock funds

While it’s certainly possible to buy stock in individual companies, many people choose to invest in stock funds instead. A stock fund is an investment product that includes stocks from many different companies. For example, you could invest in a fund that tracks the performance of the S&P 500. Similarly, you could invest in a technology index fund that gives you exposure to many different tech stocks.

Stock funds can be either mutual funds or exchange-traded funds (ETFs). Mutual funds and ETFs have a lot of similarities, including the diversification they can bring to your portfolio, but they also differ in several ways. For example, ETFs trade throughout the day on stock exchanges, just like stocks do. You buy mutual funds through many brokerages or directly from fund companies, but mutual funds generally trade once per day after the market closes.

Both mutual funds and ETFs can be either passively or actively managed. Actively managed funds have fund managers who actively buy and sell securities for the fund. The goal of actively managed funds is often to try to beat the market. Passively managed funds usually track the performance of an underlying index or portion of the market. The goal of passively managed funds is usually to match the performance of the market.

How to start investing in the stock market

Now that you understand the basics of how the stock market works, you may be considering investing in the stock market. Let’s cover what you need to know to set up your investment account to start investing.

How to buy stocks and stock funds: A step-by-step guide

You no longer have to call up a stockbroker every time you want to make a trade. In fact, a common way retail investors buy stocks and stock funds today is through an online brokerage account. Here are some basic steps to take to set up an investment account and start buying stocks and stock funds:

While setting up a self-directed investment account is one way to buy and sell stocks and stock funds, you can also use the services of a financial advisor.

Investment tips for beginners

For those investing for the first time, here are some tips that may be helpful to keep in mind.

The bottom line

The stock market allows corporations to raise capital while also allowing individual investors to own a small portion of public companies. Investing in the stock market comes with plenty of benefits, including both capital appreciation and dividends, and can help support your financial goals. But investing also comes with risks, so it’s important to take a measured approach and choose a portfolio that fits your needs and preferences.

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