How Do Stock Markets Work? Investing in stocks is a great way to make money and build wealth over a period of time. However, many people are still at a loss when it comes to understanding how does the stock market work? When it comes to investing in the stock market, a lot of people tend to avoid it because of the risks involved. A recent study shows that only 14% of American families are invested in stocks, and just 52% are invested in stocks through their 401(K) plan, usually in the form of mutual funds.
Like with most things that people don’t understand, fear of investing in the stock market is understandable. Fears tend to focus on the major declines in the market, such as during the financial crisis in 2008. From October 2007 to February 2009 the S&P 500 index lost 53% of its value. It did recover however, and those who held their investments or invested more, were rewarded, when by 2013 the S&P 500 was up by 88% from its 2009 low.
Recently, the COVID-19 pandemic also prompted losses in the stock market. Investors labeled March 9th 2020 as ‘Black Monday’ because there was a 12-13% decline in global markets. However, this was a short-lived bear market as stocks bounced back in April 2020 and gained through the rest of the year, hitting all-time highs through the later half of the year. The point being that if you’re not familiar with these events and were invested in the stock market, you would have likely panicked and sold during that time, causing losses and missing out on the gains afterwards.
The volatility of the stock market’s performance, plus all the confusing jargon that surrounds it, tends to discourage potential investors. Still, the stock market remains one of the best vehicles for building wealth. The first step towards becoming savvy with stock market investing is understanding how it works.
What is Stock?
A stock is also known as a ‘share’ or ‘equity’ of a publicly traded company. Although, private companies also issue shares, when people mention stocks they are generally referring to publicly traded stock. It represents a proportionate claim of a company’s assets and earnings. When someone becomes a shareholder, it means that they own a portion of a company.
How much of a company that a shareholder holds is equal to the number of shares held as a proportion of a firm’s total outstanding shares. For instance, if you buy 150,000 shares of a corporation with one million outstanding shares, it means that you have 15% ownership in it.
There are two types of stock: Common stock and preferred stock. Common stock is what is popularly referred to as “equities.” It refers to stock that’s typically held by founders, employees, and ordinary investors. These shares come with benefits; for instance, owners of such shares have voting rights.
Shareholders have a say in corporate meetings like AGMs (annual general meetings) or the board of directors’ election. Common stock is the type of stock that most investors buy and sell on the stock exchange.
Preferred shares come with a higher claim on assets and ownership, unlike common stock. For instance, in the event of liquidation, owners of preferred shares will receive dividends and be paid for their shares, before common shareholders. Preferred shares tend to have a fixed dividend, unlike common stock. Also, owners of preferred shares do not have any voting rights.
Common stock can be subdivided further depending on voting rights. Although the share structure for common shares generally dictate that all shareholders of common shares have voting rights, some companies have stock classes with different voting rights attached to each class. For example, Class A shares may have ten votes per share, whereas Class B may have one vote per share. This classification helps founders have control over their fortunes and strategic direction.
Why Do Companies Issue Stock?
One of the main ways that startup companies and other companies continue to expand into their next phase of growth is to obtain large amounts of capital. One way they get this capital is through selling shares (also known as equity financing).
As the company establishes itself, it will need more capital to facilitate its ongoing operations and outwork its strategic plans. The firm can do this through an initial public offering (IPO). This move changes the company’s status from a private firm with a few shareholders to a publicly-traded company with many shareholders. An IPO also allows early investors to partially cash out and usually receive a significant return for being early investors.
Once a company lists its shares on the stock exchange and trading commences, the price of the shares fluctuate, as investors and traders assess its price, based on a variety of factors.
How Does The Stock Market Work?
The stock works market similar to an auction in that buyers and sellers negotiate a price to buy and sell shares. This ‘auction’ used to be done physically in a stock exchange, however, all of the transactions now take place electronically through computer networks–which makes it faster than an auction and available to nearly anyone.
Stocks are added to an exchange through an initial public offering (IPO), which is when a private company offers a new stock issuance to the public. During an IPO companies target major investors like pension funds, mutual funds, hedge funds, and other institutional investors who manage large pools of funds. This is known as the primary market.
The secondary market focuses solely on trading among investors. This is where individual investors buy shares of individual companies. Hedge Funds, pensions, and other institutional investors also participate in the secondary market.
Most people don’t realize it but the secondary market is what most people are thinking of when they talk about stocks and the stock market. It includes the New York Stock Exchange (NYSE), Nasdaq, and all other major exchanges worldwide.
How Stock Prices Are Set
Stock prices can be volatile as they are fundamentally controlled by the law of supply and demand. Some of the factors that shape the demand for a stock include world events, investors’ confidence, company profits, plus many others. The most common way that share prices are set is through an auction process where buyers place ‘bids’ and sellers place ‘offers’. A bid is a quoted price from an investor who wishes to buy the stock. An offer (or ask) is the price at which someone wishes to sell. A trade is made when the bid and ask match.
As mentioned, the law of supply and demand affects shares. When the number of buyers who want to buy stock exceeds the sellers, the prices go up. The reverse is true; when there are more sellers than the buyers, the prices decrease.
Still, there’s more to the share price, and it would be best if you avoid investing based on emotions. Market commentators frequently comment on the state of emotions in the stock market, which oscillate between fear and greed. Some people get emotional and want to buy shares once they experience a huge gain, thinking that prices will continue to rise, but buying at a time like this is risky.
A good example of this is the recent run-up of the price of Gamestop Corp (GME) stock. The price of these shares peaked in January 2021 after individual investors drove the price up. Traders holding short positions rushed to buy more stock in a bid to cushion themselves from the losses. These actions triggered a frenzy of buying that increased the prices of the stock. But now, those shares have lost a significant amount of value and there are a lot of investors who are sitting on large losses as they bought at the peak.
A way that investors track the performance of the stock market is through watching a ‘market index’ such as the Dow Jones Industrial Average, also known as the ‘Dow’ market index. The Dow tracks the the performance of the 30 largest, industrial companies (by market capitalization) listed on stock exchanges in the US.
There are a number of indexes that follow various companies which represent different aspects of the economy and different industries. The S&P 500 follows the 500 largest companies which make up a cross-section across the 11 sectors of the stock market. The Nasdaq index on the other hand includes all of the stocks that are listed on the Nasdaq exchange. The Nasdaq tends to be referred to as the tech index as the majority of the largest tech companies are listed on the Nasdaq, such as Amazon, Facebook and Alphabet (Google).
What Is The Stock Exchange?
The stock exchange is a secondary market where buyers and sellers transact. It is important to note that companies do not buy and sell stock as part of their day-to-day operations. Investors do not buy the stock directly from the company they’re investing in. Rather, they buy the shares from another shareholder. Likewise, when selling shares, an investor doesn’t sell them back to the company; they are sold to another investor. Some of the main stock exchanges where shares are bought and sold in the US are New York Stock Exchange (NYSE) and the Nasdaq.
There are also other major stock exchanges throughout the world, many of which are connected electronically, such as Japan’s Nikkei, Australia’s ASX, Canada’s TSX, London’s FTSE, and many others.
A more loosely regulated over-the-counter exchange which is also referred to as a bulletin board and goes by the acronym OTCBB. However, these stocks tend to be riskier as the companies listed do not comply with strict regulations, as is the case in major exchanges.
Why Invest In The Stock Market?
History shows that over time the stock market generates investment returns that are superior to those from most other asset classes. Stock returns come in the form of dividends and capital gains. A capital gain occurs when you sell a stock at a higher price than the price you initially paid for it. Alternatively, a dividend is the share of profit that a firm distributes to its shareholders in the form of a cash payment.
Most retail investors are attracted to stocks from popular consumer companies, such as the fabled FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). Although these companies offer some tantalizing prospects, the truth is that you won’t always get high returns and it’s important to build a balanced portfolio that meets your risk profile and investment objectives.
If you are an investor with lower tolerance for risk or are getting closer to retirement when you’re going to want a steady stream of cash flow, then you should opt for stocks that have a long-history of paying substantial dividends. To track the market and the price of various stocks, check out websites such as Google Finance or Yahoo Finance.
When Do Markets Open
What time does the stock market open in the U.S.? If you plan to become an active trader, it’s important to understand when the stock market opens and closes. The U.S. stock market, including the main stock exchanges like NYSE and Nasdaq, are open from 9:30 am to 4:00p.m E.T., from Monday through Friday.
Still, some trades occur outside the regular hours and occur over electronic communication networks (ECNS). These networks allow buyers and sellers to connect directly without the involvement of a middle person.
There are pre-market and after-hours trading sessions, also referred to as extended markets. For Nasdaq, the pre-market trading hours run from 4:00 am to 9:30 am Eastern Time Zone. Certain brokers have different pre-market and after-hours trading times, for instance, the T.D. Ameritrade permits pre-market trading from 8:00 am to 9:15 am. It’s important to note that volatility tends to be higher in after-hours periods.
When Do Markets Close
Overall, stock markets are closed for most of the holidays and all the federal holidays. The stock market is also closed over the weekends as well as the evening. The closing times for various stock markets vary across the globe. Some of the main stock market exchanges include:
- London Stock Exchange
- Australian Stock Exchange
- Tokyo Stock Exchange
- Shanghai Stock Exchange
- Toronto Stock Exchange
- Hong Kong Stock Exchange
Trading generally takes place from Monday to Friday each week. Canada’s Toronto Stock Exchange closes by 4:00 pm E.T. In Asia, trading hours for the main exchanges, like the Shanghai Stock Exchange and the Tokyo Stock Exchange, start at 9:30 am and close at 3.00 pm local time. The Hong Kong stock exchange starts at 9:30 am local time and closes at 4 pm.
In Europe, the trading hours start at 8 am and close at 5:30 pm local time.
How to Invest in Stocks
There are numerous ways to invest in the stock market. Some of the most common ways an investor may choose to invest, is to buy stocks directly through an exchange or indirectly, by investing in a mutual fund or ETF (Exchange Traded Fund). There are also various accounts such as a brokerage account or tax-advantaged accounts through which investors can buy and sell shares.
Buying and Selling shares
The process to buy or sell shares is fairly straight forward, and there are a number of brokerages which provide commission free trades such as WeBull. We have a complete how-to guide on how to get started investing in stocks here. Which provides all the information you need to get started.
Although the process to buy and sell shares is fairly straight forward, your individual investing strategy is the most important aspect to investing. Choosing the right strategy for your investment portfolio will help avoid losses and unnecessary risk taking. It’s important that your investing strategy aligns with your goals and that you’re not constantly buying and selling shares if your goals are long-term and retirement focused.
Risks of Stock Market Investing
There are a number of risks associated with investing but that doesn’t mean that you shouldn’t buy stocks. It’s a matter of understanding the risks and taking the necessary steps to mitigate the risks that can be mitigated. Here are some of the risks that should be considered.
One of the risks that investors can mitigate against is concentration risk. It’s important to not be overly concentrated in individual stocks, or just a few. Keeping a diverse portfolio is a way to reduce concentration risk.
Investing in stocks comes with the knowledge that the price of individual stocks can and will move up and down, just as the whole stock market changes as traders and investors buy and sell. A way that investors can somewhat mitigate volatility is to invest in large ‘blue chip’ stocks and larger mutual funds which are well diversified.
Credit risk is the risk that in the event of a bankruptcy or liquidation of a company that common stock shareholders will be last to be paid. This risk can be mitigated by investing in companies with low debt levels. It can be difficult to look at an individual company and understand whether it’s debt is too much, so comparing it to competitors in the same industry can help to provide a better picture of a company’s financials and debt load.
The Bottom Line
The general concept of the stock market is fairly straightforward and it’s even easier to get started in investing in stocks. The best part about investing in stocks is that you can start with only a small amount of capital. Although investing in stock indeed comes with risk, it remains one the best way to grow your wealth. It’s about managing the risks and building a portfolio that’s in line with your objectives and risk profile. The sooner you start investing in stocks, the better your chances of achieving financial freedom.
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