How Does The Stock Market Work?

The stock market offers investors the potential for significant returns, but it also comes with substantial risk. Historically, stocks have provided compelling gains by outperforming many other asset classes. However, they have also fallen into harsh bear markets and suffered notable losses. But what exactly is the stock market and how does it work? Let's explore these topics and others in this article.

History Of Strong Returns

Stocks are known for producing compelling returns. Consider the S&P 500 index, which is a benchmark group of stocks that contains the shares of blue-chip companies. It yielded an annual average of 11.69% between 1973 and 2016.^[1] While the aforementioned period offered positive returns the S&P 500 has produced less impressive results over a longer time frame. Historically, this benchmark index has yielded about 10% per year.^[2]

Considerations

While the aforementioned returns may sound promising, stocks have also been known to suffer rather significant declines in value. In 1987, the S&P 500 fell more than 20% on a single day, an event known as "Black Monday." Following this sharp drop, the index recovered and gained in value that year.

In 2008, the S&P 500 dropped upwards of 40%.^[3] It wasn't the only index to suffer sharp declines, as the Dow Jones Industrial Average lost more than half of its value between 9 October 2007 and 5 March 2009.

Even when the stock market is climbing, its annual returns can vary. For example, between 1926 and 2014, the S&P 500 generated returns between 8% and 12% only six times. The other years, the index produced yields that were either substantially higher or significantly lower.^[4]

What Investors Need To Know

Before investing in the stock market, there are several key things that investors should know. Investors can benefit greatly from doing their own research, and this article will help provide a solid foundation for anyone who is getting started with stock investing or simply looking to go over the basics.

What Is A 'Stock'?

A share of stock represents part ownership in a company's equity. By holding a share of stock, an investor receives the right to benefit from its profitability. This can come in the form of either rising value or dividends, the latter of which are regular payments made to the shareholders.

By owning a share of stock, an investor holds a small fraction of a company. For example, if a company has 200,000 outstanding shares, and a person owns 2,000 of those shares, they own 1% of the company.

Why Do Companies Issue Stock?

Many companies issue shares of stock because it is an effective way for them to raise funds.^[5] Armed with these financial resources, they can potentially fuel expansion. Businesses can also sell stock to raise funds for the purpose of hiring new employees or buying capital equipment.

To offer shares to the public, companies must hold an initial public offering (IPO). To hold one of these sales, businesses must complete several steps, including filing several documents with the U.S. Securities and Exchange Commission.^[6]

Instead of issuing shares of stock to raise the funds it needs, a firm could also borrow money, but this comes with its own drawbacks.^[7] Taking on debt will require a business to pay back the funds with interest, which can be significant. Past that, the company may have to post collateral before borrowing any money.

Trading Stocks

One quick way for investors to trade shares of different companies is to go through a stock exchange, a marketplace where interested parties can buy and sell these securities. Going through an exchange can help investors manage certain risks, as exchange operators require the brokers and other businesses they work with to abide by certain standards.

Some of these exchanges have established strong reputations. The New York Stock Exchange (NYSE), as well as its predecessor, the New York Stock & Exchange Board, have been around for a combined total of more than 200 years. While exchanges historically involved industry participants gathering in a physical location and arranging transactions in-person, the landscape has changed over time, and now exchange activity takes place electronically.

Investors should keep in mind that exchanges have varying requirements that companies must meet before listing their shares.^[8] Exchanges are responsible for creating their own standards, and investors can learn more about the specifics by visiting the websites of these financial institutions.

Also, exchanges decide their own requirements, and some are stricter than others. Investors can benefit from conducting their due diligence on any marketplaces where they are thinking about buying stocks.

Major Stock Exchanges

The NYSE is the world's largest stock exchange, with the stocks traded there worth US$22.9 trillion, roughly 40% of the total value of the global stock market.^[9] In 2017, more than half of all Americans had invested in stocks listed on the NYSE.

The second-largest stock exchange is the NASDAQ, which is home to a number of the world's largest technology firms.^[9] The stocks listed on this exchange had a market capitalisation of US$10.8 trillion as of November 2018.

How Are Stocks Priced?

Stock prices are a function of supply and demand. Investors who are interested in buying a stock make a "bid," which is what they are willing to pay. Sellers, in contrast, present an "ask," which is what they want in exchange for selling a stock.

If the "ask" is more than the "bid," the difference is called the bid-ask spread. In the event that such a disparity exists, the buyer and the seller will need to adjust until they can come to an agreement.

How To Buy Stock

Traders who are interested in purchasing stocks can do so through broker dealers. In addition, they can hire financial professionals like financial advisors or registered investment advisers to acquire these securities on their behalf.

In addition to purchasing individual shares of stock, traders can gain access to the stock market by buying similar securities like mutual funds and exchange-traded funds (ETFs). Both of these can help investors obtain broad exposure to the stock market far more quickly than individual share purchases would.

Summary

The stock market offers individual investors the possibility of compelling returns. At the same time, investors who put their money into this particular asset class may lose the entire value of their principal. Stocks have historically generated strong gains, outpacing many other asset classes, but they have also been known to suffer sharp losses during bear markets.

Before investing in these particular securities, traders can benefit greatly from building a basic foundation of knowledge, including what defines a stock, what the stock market is, how stocks are priced and the different ways an investor can gain exposure to this asset class.