How the Stock Market Works

how does the stock market work
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The stock market works like an auction where investors who buy and sell shares of stocks. These are a small piece of ownership of a public corporation. Stock prices usually reflect investors' opinions of what the company's earnings will be.

Traders who think the company will do well bid the price up, while those who believe it will do poorly bid the price down. Sellers try to get as much as possible for each share, hopefully making much more than what they paid for it. Buyers try to get the lowest price so that they can sell it for a profit later.

How to Invest in the Stock Market

Average investors can't trade on the stock market directly. Instead, they must hire a broker-dealer to execute the trades. There's a wide variety of choices:

  • Fee-only financial advisers who charge an annual fee, usually 1 percent of assets.
  • Online dealers like E-Trade, who charge a small fee per transaction. 
  • Large banks, like Goldman Sachs or Well Fargo Advisers, provide financial planning in addition to executing trades. 
  • Small brokers who just execute orders. 

Many investors buy stocks through mutual funds. These are companies that buy a collection of stocks. The investor buys shares in the mutual fund instead of owning the stocks themselves. They take advantage of the mutual fund manager's expertise. Since there are so many stocks, this diversified investment has a lower risk than a single stock.

Most of the stocks traded are common stocks. But some investors buy preferred stocks. They pay an agreed-upon dividend at regular intervals and they don't have voting rights. They are less risky but they also offer a smaller return.

Where Is the Stock Market?

The two largest exchanges in the world are both in the United States. The New York Stock Exchange lists 2,400 companies. Combined, they are worth around $21 trillion in market capitalization. That's the value of all its shares. The NYSE is located on Wall Street. The Nasdaq has 3,800 companies with a market cap of $11 trillion. in Times Square.

, but they do it differently. The NYSE is a true auction house. It matches the highest bid for the lowest sales price. There is a market maker for each stock who will fill in the gap to make sure trades go smoothly. At the Nasdaq, buyers and sellers trade with a dealer instead of each other. It's done electronically, so trades happen in split seconds.

A third exchange, the BATS Global Marketplace, was formed to create a more efficient technology. Its goal was to avoid a flash crash like the one that hit the NASDAQ in August 2013.

to serve specific types of traders. For example, "Dark Pools" like Liquidnet, cater to high-volume, frequent traders like hedge funds. Dark Pools hide their client's strategies from the competition. They not only ensure their anonymity but can also match up large orders to avoid suspicion. 

The major countries have their own stock exchanges for their domestic corporations. The are the London, Tokyo, Shanghai, Hong Kong, and Euronext exchanges.

Current Stock Market

The stock markets use indices to report their current conditions. The top three are the Dow Jones Industrial Averages, the S&P 500 and the Nasdaq. The tracks the stock prices of the top 30 U.S. companies. The tracks the stocks of 500 large-cap U.S. companies. The tracks the stocks on its exchange. Each of these also has many smaller indices that track specific aspects of the companies they track. For example, the tracks the largest stocks on its exchange.

Each exchange around the world has an index that reports on its current status. The indices for the top five exchanges are the , , , , and the .

In addition, that report on various types of companies listed on the exchanges. The reports on 2,000 small-cap companies. The MSCI Index reports on emerging market companies.

Advantages 

Companies sell stocks because it's a good way to get an enormous sum of financial capital. However, the company itself must be generating a lot of income to make it worthwhile. Issuing an Initial Public Offering is very expensive. After that, there is no privacy, as investors review the company's profits and strategy every quarter. The other ways of obtaining financing are private, through personal loans or private investors, or through bonds, which are loans traded publicly. The advantage of stocks vs. bonds is that a stock doesn't require a monthly repayment of interest.

Individuals use the stock market because the returns, on average, outpace those of other investments, such as bonds or commodities. Stock market investing is an excellent way to make sure your investments do better than inflation.

The Stock Market Isn't the Economy But Does Affect It

The stock market contributes to the U.S. economy. If investors believe the economy is growing, then they will invest in stocks. That because a strong economy helps companies improve their earnings. That's known as a bull market. It usually occurs along with the expansion phase of the business cycle. Most commodities also do well. That's because expanding businesses will demand more oil, copper, and other natural goods. The most recent bull market occurred from March 2009 until August 2013.

If investors think the economy is slowing or stagnant, they will invest in bonds, which are a safer investment. That's because bonds give a fixed return over the life of the loan. Bonds do well during the contraction phase of the business cycle. When bonds do well, stocks lose value. That's known as a bear market, and it typically lasts 18 months. The last bear market was from December 2007 to March 2009. For more, see Dow Closing History.

If there are threats to the global economy, investors also move toward gold and other safe havens. That usually happens along with a stock market correction, when share prices drop 10 percent or more. It's even more apparent in a stock market crash when stocks can lose that much in a day. A bad crash could even cause a recession. The history of stock market crashes shows this is a frequent occurrence.