How the stock market works: A beginner’s guide

The stock market is an important fixture of the U.S. and global economy. Nearly all of us participate in the stock market on some level, whether by working for a publicly traded company or by purchasing stocks through our investment accounts.

The idea of 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 even you personally). And when you understand the market, you may feel more empowered to start investing to 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 actively 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’re invested in the stock market.

As mentioned, the stock market plays a key role in the economy. First, companies sell stock as small shares of ownership, usually as a way to raise capital to further 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 direct correlation between the performance of the stock market and the state of the economy overall.

History of major global stock markets

The concept of the stock market as we know it today dates back to 1602 and the founding of the Amsterdam Stock Exchange. The Dutch East India Company became the first public company, with other companies eventually following suit.

Nearly 200 years later, in 1790 and 1792, the Philadelphia Stock Exchange and the New York Stock Exchange (NYSE) arrived. The latter officially started when a group of stockbrokers met on Wall Street to sign the Buttonwood Agreement – what would become the foundational document of the NYSE. The London Stock Exchange came a few years later, in 1801. By the late 1800s, major stock exchanges had made their way to 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 as stockbrokers meeting in local coffee shops to buy and sell securities evolved into official trading on the floors of major stock exchanges. By the late 1800s, trading was able to happen over the phone. Fast-forward roughly 150 years, and now much of that trading 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 their favorite 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 a type of primary market. Corporations issue public shares as a way to raise capital.

A secondary market refers to shares already publicly traded among investors. For example, let’s say your favorite company 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. The company that issued the shares doesn’t make money off secondary market sales.

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 the involved parties 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 spread, and one of the parties has to budge for the sale 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 others.

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:

Most stock indexes are weighted by market capitalization, meaning each company takes up a share of the index that’s generally proportional to its share of the market. As a result, there’s plenty of overlap across indexes. The S&P 500 and Nasdaq Composite, for example, share most of their largest companies.

Factors influencing the performance of the stock market

Microeconomic and macroeconomic factors impact the stock market. From a micro perspective, you might look at the performance of a specific company as to why the price of a stock is rising or falling. If that company has a poor earnings report, then it might see its stock price fall. A company that’s recently made a big, exciting 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 ultimately the most 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 DJIA to have some of its largest single-day drops ever. But once the immediate panic subsided, it was less than six months before major stock market indexes had reached new record highs.

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, however, directly from mutual fund companies, with sales closing only once at the end of the trading day.

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 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 utilize 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 you reach 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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