Understanding How the Stock Market Works

Investing

I cringe when I hear news commentators talk about “the market.” They often describe a mythical beast that can’t be tamed. It’s up, it’s down, it’s a bull, no it’s a bear!

Because of this coverage, stock market investing is often very misunderstood. Many Americans equate the stock market to “Wall-Street”, or insider trading, or rocket science that can’t be understood. These misconceptions often result in a costly mistake – failing to invest in equity markets altogether.

But none of that is true.

The market is usually just slang for the stock market. And when you hear people reference either, they are usually commenting on whether the market is up or down. If someone says that the market is up, they mean that the stocks that make up the market have increased in value for the day. So to better understand the stock market, let’s look at it’s composition.

What’s a Stock?

Stock represents ownership of a company. If you own stock in a company, you actually own a portion of that company. Because of that fact, you have the right (but not obligation) to attend the shareholder’s meetings, vote on important company decisions (like the board of directors), and you have a right to collect a share of any future company earnings. Most people choose to own stock for the last reason alone.

Company earnings can be retained for growth, or paid to shareholders. Typically, smaller firms and high-growth firms choose (with the permission shareholders) to reinvest the dividends to help the company grow faster. That usually leads to increased stock prices, and the possibility of greater dividends in the future. Other companies choose to consistently pay dividends each year to shareholders.

The driving force behind all stock ownership is the right to claim a portion of the earnings produced by a profitable company. Strong earnings lead to more investor interest, which leads to higher stock prices.

Stock Exchanges

Stocks are bought and sold through exchanges – with the major players being the the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotation System (NASDAQ). Each of these exchanges has its own rules and regulations that govern which companies can be listed on the exchange.

None if that really matters because don’t have to know which stock is listed on what exchange. If you invest in ETFs or index mutual funds through a fantastic company like Wealthfront, or use a discount online broker such as Optionshouse, it’s all done for you.

Indexes

Individual stocks are grouped together to form an index. The index is then tracked and often used as a general reference for overall stock prices.

For example, The Dow Jones Industrial Average (The DJIA or The Dow), The Standard & Poor’s 500 (The S&P 500), and the NASDAQ Composite Index (The NASDAQ) are all famous indexes that are often times quoted as a reflection of (you guessed it!) – “The Market.”

They are nothing more than a bundle of underlying stocks.

The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks in the U.S.

The S&P 500 is a stock market index composed of the 500 largest and most important companies publicly traded in the U.S. stock market.

The NASDAQ is both an index and an exchange. The stock market index is composed of the common stocks and similar securities listed on the NASDAQ exchange, and has over 3,000 components. It is highly followed in the U.S. as an indicator of the performance of stocks of technology companies and growth companies.

These indexes and many others are useful beyond market tracking. They form the basis of sound passive investing. Research shows that “index investing” outperforms active stock trading over the long haul. Index investing literally means buying shares of an ETF or mutual fund that is tied a specific index. So the investor owns a portion of each company inside that index. I’ll write more on index investing in an upcoming article.

Stock Pricing

Stock prices fluctuate each day based on trading. Temporary pricing is pretty basic supply and demand. If stock owners begin selling a stock, and other’s aren’t willing to purchase, it’s price will go down until it reaches a point when buyer demand increases to meet seller supply. If potential investors all want to purchase a stock, and none of the current stock owners are selling, the price will be driven up.

The important thing to remember here is that day to day stock pricing is volatile (difficult to predict and wild). The stock market moves up and down like a yo-yo. This should make you scared of trading, not investing. There is a huge difference. Trading involves temporary guesswork, it’s nothing but a gamble. Investing is a long term process that involves purchasing ownership in companies with the intent to hold for long periods of time. Research shows that investing is much more profitable than trading.

Investing is inherently tied to the true value of a company. Value is often determine by profits, growth, and other technical information. Well guess what, businesses can’t predict their future earnings or growth, which creates room for lots of speculation and volatility in the stock market.

If a company reports lower than expected quarterly profits or a temporary production setback, traders get scared and sell. If a company reports spectacular growth, traders want to buy, pushing prices higher.

This is how the market also behaves on the whole. If the economy reports slow growth or high unemployment, traders get uneasy and sell. This causes the entire stock market to drop. It doesn’t have anything to do with a specific company, it’s just knee jerk reactions by millions of people who are far too worried about trying to pick stocks and day trade. A habit which, according to research, results in huge trading costs and much lower overall returns than those who just buy and hold for the long run.

This is why a long term approach is crucial. There is no need to worry about temporary swings because the value of stocks have always increased as the earnings of the underlying companies have gone up. Earnings have historically grown pretty steadily here in the U.S, as have the dividends paid by successful companies. In fact, stock market returns have averaged more than 10% per year over the last century.

In summary, be an investor, not a trader. Long term investing is profitable. You don’t need to try to pick winning stocks or time the stock market. Simply choose a few good index funds and let your investments to grow. It works, and it’s easy enough.

I hope that understanding how the stock market works is no longer a mystery to you. Share your thoughts with a comment!

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Shaheen Somani
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Shaheen Somani

Very clear explanation…thank you so much

Matt Mecham
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Matt Mecham

Optimism plays a huge part when investing in the stock market. You have to believe that (regardless of what pundits, friends, and doom-and-gloomers say) the stock market will continue to function as it always has: a bumpy ride, but always with an upward trend. Keeping your savings in a bank is a losing strategy: inflation will nibble it away to nothing. In my opinion, buying and holding stocks (I prefer indexes) is one the best (if not THE best) ways to create wealth.

Asad Mujtaba
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Asad Mujtaba

Thank you. Very clear and good article I have ever read on stock marketing.
With best regards

Stefano
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Stefano

Nice clear cut article, good read

ncognito88
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ncognito88

Yea you kept it simple and I like that. I like to play around with stocks I bought some YUM stock 4 or 5 years ago. Im a big Taco Bell fan and KFC and Pizza Hut aren’t to bad either. Ive more than doubled my return and don’t plan on selling. Im also one of the fb stock people that didn’t sell after the stock dropped and have been pleased with it as well.

madan ojha
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madan ojha

thanks Jacob ,for writing this great article about stock market ,this article will help all new investors who want to know about stock market basics and indepth studies about stock market ,i can say it is a complite article about stock markets.i will ask my fellow traders to read this awasome article..
keep it up…..

Brad @ RichmondSavers.com
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Brad @ RichmondSavers.com

Great exlanation Jacob — very clear and straightforward overview. I’m definitely going to refer people to this page in the future.

In your studies have you formulated an opinion on the best type of index fund investing: either weighted average or equal weight?

I don’t love that the 10-20 largest companies make up such a disproportionate percentage of an S&P 500 index fund, but that’s just off the cuff thinking without any research. I’d love to get your opinion…

Stuart@DailyMoneyBucket
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Great article Jacob. One of the best introductions to the stock market that I’ve read. There’s not much I can add, apart from a brief concern about quantitative easing. One of the strongest drivers of stock market prices is the extra liquidity caused by printing money. Governments around the world have printed so much money that stock prices no longer reflect the underlying earning abilities of the companies. Recently, when the US Federal Reserve hinted that it may eventually reduce the rate at which it prints money, the stock market plunged. It’s a bit like pass the parcel – everything… Read more »