What Is the Stock Market and How Does It Work?
Definition: What is the stock market?
The term "stock market" often refers to one of the major stock market indexes, such as the Dow Jones Industrial Average or the Standard & Poor's 500.
When you purchase a public company's stock, you're purchasing a small piece of that company. Because it's hard to track every single company, the Dow and S&P indexes include a section of the stock market and their performance is viewed as representative of the entire market.
You’ll usually buy stocks online through the stock 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 the stock market — for the most part, it’s open to anyone.
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." In June 2021, the SEC launched a public service campaign to encourage new investors, particularly those in historically underserved communities, to use the stock market to build long-term wealth.
You might see a news headline that says the stock market has moved lower, or that the stock market closed up or down for the day. Most often, this means stock market indexes have moved up or down, meaning the stocks within the index have either gained or lost value as a whole. Investors who buy and sell stocks hope to turn a profit through this movement in stock prices.
How does the stock market work?
The concept behind how the stock market works is pretty simple. The stock market lets buyers and sellers negotiate prices and make trades.
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, and the exchange tracks the supply and demand of each listed stock.
That 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.
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 of 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.
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 stock 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 stock 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?
If you have a 401(k) through your workplace, you may already be invested in the stock market. Mutual funds, which are often composed of stocks from many different companies, are common in 401(k)s.
You can purchase individual stocks through a brokerage account or an individual retirement account like an IRA. Both accounts can be opened at an online broker, through which you can buy and sell investments. The broker acts as the middleman between you and the stock exchanges.
No brokerage account? Learn how to open one. 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.