How does the stock market work?

In a nutshell

Investing in the stock market is one of the most common methods of saving for the long term. As a stock market investor, you can buy and sell shares of publicly traded companies to match your goals and investment timeframe.

• The stock market prices shares of a company based on several factors including how much money the company makes now and how much the market thinks it will make in the future.
• Shares that pay a dividend can be a source of income and growth for investors.
• Based on the S&P 500 index since 1990, the average yearly return on investment has been 10.17%.
• Be aware: Past performance does not indicate future performance.

So how does the stock market work? In this article, we'll define what a stock is, how the market works, and how to make money from stocks.

What is a stock?

A stock is fractional ownership of a company. For every share that you own, that represents an interest in the profits, dividends and assets of that company. While it can be difficult to value or sell shares of a privately-held company, you can buy shares of publicly-traded companies very easily. Additionally, tracking the value of a publicly-traded company is simple, and you can do it using many websites or mobile apps.

Some companies distribute a portion of their profits to shareholders through dividends. These distributions are similar to the interest investors receive from certificates of deposit, bonds, or annuities. Other companies reinvest their profits into the company to try to accelerate the company's growth. Depending on your goals, owning one or both of these types of companies can be a good decision.

Stock ownership typically also provides voting rights on the direction of the company. Most companies hold annual meetings where investors cast votes on their board of directors and important initiatives. In general, you have one vote for every share that you own.

What is the stock market?

A stock market is a place where investors can buy or sell shares of publicly-traded companies. These platforms are called exchanges and examples include the New York Stock Exchange (NYSE) and the Nasdaq.

Investors can buy shares of individual stocks on these exchanges or purchase a mutual fund or ETF that mimics all or a portion of one of these exchanges. For example, you can buy a fund that matches the S&P 500 index (comprised of the 500 largest publicly-traded companies in the U.S.) or a "total stock market index" fund.

How does the stock market work?

The stock market serves different purposes for different participants of the market. Companies use the stock market to sell shares to raise money through an initial public offering (IPO) or secondary offerings (to raise additional capital). Additionally, companies may buy back shares when they have the extra money in order to raise their stock price.

Publicly-traded companies must report their financials each quarter and disclose material facts that impact the value of their stocks. Corporate officers and large shareholders must also disclose the purchase or sale of shares ahead of time. Because they are privy to non-public information that other shareholders do not have, this rule allows other investors to buy or sell before insiders can.

Investors use the stock market to buy and sell shares of stock in publicly-traded companies. You can buy individual shares of companies, or you can purchase them indirectly by buying shares of mutual funds or exchange-traded funds (ETFs), which own numerous companies in a pooled portfolio.

What affects the stock market?

A variety of factors affect the value of the stock market, including financial performance, future expectations, economic factors, or changes in demand. When a publicly-traded company releases its quarterly financials, the stock may go up or down, depending on how it performed versus analyst expectations. Additionally, many companies offer guidance on future expectations (e.g. profitability, revenue, expenses, regulations) which can affect investor attitudes towards the stock.

Depending on which industry the stock is in, it can perform differently based on the economic cycle. For example, consumers often cut back or eliminate discretionary purchases during a recession, but continue spending on basic goods like groceries and utilities. When the economy is growing, financial companies perform well as consumers and businesses feel more comfortable borrowing money to fund purchases of homes, cars, vacations and other goods.

As consumer tastes change, some businesses become less valuable because people start purchasing other goods and services. Kodak was one of the dominant camera film companies for many years before consumers started using digital cameras for the majority of their photos. This often happens as new technologies are created, new fads are adopted, or a scandal affects the company or product's reputation.

How are prices determined on a stock market?

Stock prices are determined by the factors described above, but the simple answer is supply and demand. In other words, how many people want to buy or sell a stock at any given time.

If there are more investors who want to buy a stock than there are sellers, the price increases. And the inverse happens when there are fewer buyers than sellers.

An investor's desire to buy or sell is generally influenced based on financial performance, future expectations, government regulations, the economy and other factors. And the magnitude of this information often determines how many buyers or sellers are acting at once.

How investor use metrics to determine a stock’s value

Experienced investors often look to stock valuation metrics when determining if a stock is fairly priced. Depending on where the stock's price is, it could be over- or under-valued leading an investor to buy or sell shares. Here are a few of the most common stock valuation metrics:

Price-to-earnings (P/E) ratio

This metric compares the company's stock price versus its earnings. The answer tells investors how much you are paying per dollar of past or future earnings. To calculate this metric, divide the stock price by its earnings per share.

Price-to-book ratio

The price-to-book ratio evaluates the company based on what value it would have if it stopped doing business today. This determines the worth of the company's operations against the net value (assets minus liabilities) of its assets. Calculate the price-to-book ratio by dividing the market value of all shares by the net value of their assets.

Debt-to-equity ratio

Investors use this ratio to understand how much debt the company is using to fund its operations. Too high of a ratio could signal trouble in case of a recession or a change in a bank's willingness to lend. Divide the company's liabilities by its equity to calculate your answer.

Free cash flow

This metric determines how much cash is available from a company’s revenue after paying for operating expenses and capital expenditures. It excludes interest payments and non-cash items (e.g. depreciation) that reduce net income.

Because each industry is different, it is best to compare a company's ratios against its peers instead of the overall market.

How does buying stocks work?

When you buy stock in a company, you become a shareholder. Your shares represent fractional ownership of that company. You are entitled to a portion of its profits (dividends) and assets (if the company goes out of business).

Most investors buy and sell stock through a brokerage account, a mutual fund or ETF, or through a direct purchase program. We'll assume that you're buying through a brokerage account, for this example.

After doing your research, you decide to purchase shares in XYZ Company. You can buy a specific number of shares or a set dollar amount.

A specific number of shares

You submit your order for 10 shares at the current market price of $100, which equals a $1,000 investment. If your brokerage account charges a commission, those fees are charged on top of your investment amount. Many brokerage accounts have waived commissions to be competitive in the marketplace.

Set dollar amount

You submit an order for $1,000. If the current market price is $100, you will buy 10 shares. For brokerage companies that charge a fee, that fee is deducted from your investment amount first, and the remainder is available to buy shares. Many brokerage firms allow you to buy fractional shares, which enables all of your money to be invested. If yours does not, then your purchase will be rounded down to the nearest whole number of shares.

To complete the transaction, the purchase amount is deducted from your account balance and the shares are added to your portfolio. The value of your portfolio will fluctuate along with the price of the stock.

What is stock market volatility?

Stock market volatility is the normal fluctuation in the price of individual stocks. Over long periods of time, the stock market generally increases in a relatively smooth trajectory. However, as you zoom in and look at shorter time periods, you'll notice greater volatility.

Most investors complain about "volatility" when the stock market is falling. However, volatility is both the unexpected increase and decrease in stock values. On average, stocks have historically increased about 10% per year from 1957 to 2021, as measured by the S&P 500 index.

However, when you look at the change for each year, rarely do you find stock market returns of 10%. Instead, you'll find performance well below or above this average. Deviations from the 10% average indicate stock volatility above or below what is expected.

Additionally, intra-year volatility is also common. From 2000 to 2020, the average intra-year pullback has been 15%. This means that, even when the stock market ends the year with a positive increase, its value can decline 15% from its peak throughout the following year.

How do you make money from stocks?

Investors can make money from stocks by buying low and selling high. Trading costs in the form of brokerage commissions, bid-ask spread, and income taxes erode the returns of investors that buy and sell frequently. This is why many investors focus on buying stocks on a regular basis, then holding them for the long term.

For example, participating in your company's 401(k) retirement plan enables you to purchase stocks with every paycheck. You can ride out stock market volatility because you have many years between now and when you need the money in retirement.

Buying on a recurring schedule is called "dollar-cost averaging." This means that you buy the same dollar amount of shares on a regular basis, no matter what the market is doing. When the market is up, you buy fewer shares. But, when the market is down, you'll buy more for your money. Over time, this strategy helps you take advantage of short-term volatility to buy stocks when they are "on sale."

In this example, you buy $200 every pay period, for a total of $600 invested. The stock price fluctuates every pay period, so you buy a different number of shares each time. At the end of the third purchase, the $600 that you invested is worth $762.50. You now own 61 shares of stock with an average purchase price of $9.84 by taking advantage of the changes in the stock's price.

How to start investing

There are many ways to start investing, but there are three simple options that investors should consider:

Open a brokerage account with a traditional investment firm

Traditional investment firms like Schwab and TD Ameritrade offer brokerage accounts allow you to buy and sell stocks easily. You may be required to trade a minimum number of shares or to buy stocks in minimum blocks or whole shares.

Use a FinTech app to buy fractional shares

FinTech apps make it easy for investors to purchase stocks based on the amount they have to invest instead of an entire share of stock. Some FinTech apps allow purchases starting with just $1, which makes it easy for everyone to own stocks.

Purchase a mutual fund or ETF

Mutual funds and ETFs enable investors to buy shares in a variety of companies through one investment. Popular mutual fund companies include Vanguard and Fidelity. This diversification reduces risk and allows you to participate in the growth of numerous companies without having to research which stocks to pick.