How Does the Stock Market Work?

The stock market is where investing “magic” happens. And unlike other sources of wonder and amazement, how it works is not all that mysterious. Casting aside its perhaps intimidating shroud of numbers, charts, jargon, and acronyms, it’s essentially just a place where shares of publicly held companies are bought and sold.

So, what exactly are stocks?

Back to basics. Stocks are shares of ownership in a company. That means that even if you own just one share of a company’s stock, you count as a part-owner. So, you—and maybe millions of others—have a bit of a say in operations (if you rock the vote at a shareholders meeting or by proxy), as well as a vested interest in the company’s performance. There are a number of factors that can affect a stock’s price but in the most general sense, when the company does well in terms of revenues and profits, the value of your shares may go up. But if the company performs poorly, the share price may drop. 

Why would a company want to go public?

One simple reason is to try and generate more capital. Going public is a way for private companies to solicit investors and raise the money it needs to expand its business. There are different paths to taking a company public, but a common way is to launch an initial public offering (IPO), issuing shares to the public for the first time by listing on one of the world’s many stock exchanges, such as the New York Stock Exchange or Nasdaq in the U.S. or the Tokyo Stock Exchange in Japan. These exchanges are generally and collectively referred to as the stock market. And that’s where interested investors can then buy a stake in the now publicly traded business, and the company can get an influx of cash to (presumably) invest back into its business.

Sounds fair. Who sets the prices?

You do. Kind of. Before an IPO is issued, the company works with underwriters (read: investment banks) to figure out its own worth, as well as how many shares to sell, based on an analysis of its historic and projected revenues, profits, costs, and other relevant factors.

But after that initial fair value estimate, it’s the public who dictates where the stock price goes when it begins trading on the secondary market. If a company is popular with investors, the high demand can drive share prices up. If it’s more of an outcast and lacks public demand, its price may go down. And in the case of IPOs, extreme unpopularity could even convince the company to delay going public.

Beyond the IPO stage and throughout a stock’s life, the public continues to determine prices through supply and demand: Buyers say how much they’re willing to pay for a share, sellers say how much they’ll take, and they mix and mingle until they find a perfect price match—all of which occurs on the stock market.

Is the stock market an actual IRL marketplace?

Once upon a time, yes. You’ve probably seen some movies that show a big group of harried businessmen (yes, mainly men) waving papers in the air, shouting into phones, and anxiously watching the big board from the stock exchange floor. Such scenes are a glimpse of the literal stock market of yesteryear.

Of course, some physical exchanges are still around and buzzing with activity (like ringing the opening bell!). But actual marketplace transactions are conducted mainly electronically these days. And though we’ve lost much of the hustle and bustle of in-person bids and sells, technological advancements around trading have helped make investing more affordable and easier to access for everyday investors.

Why should an investor consider investing in the stock market?

Because long-term investing can be a great way to grow your money, and the stock market offers some of the best opportunities available to the average person.

But isn’t the stock market risky?

Yes, those potential returns come with risks including the loss of your principal investment.  Generally investing in the stock market is like a game of risk versus reward. The larger your appetite for risk, the higher your potential reward and the higher potential for loss. 

But avoiding the stock market can be risky, too. For example, inflation risk. Saving is where any good financial plan starts, but on its own, it may not be enough to reach all your financial goals. Even a defensive portfolio, laden with conservative investments, risks falling short of the growth rate you many need. That’s because inflation can rapidly eat away at your hard-earned cash, leaving you less purchasing power than you’d expect from the nominal value of your dollars. 

How do investors pick stocks?

While investing in the stock market may be a good idea for many, investing in individual stocks may not, especially for the novice investor. Smart stock picking requires in-depth research and plenty of dedication. And building a well-diversified portfolio out of single stocks can be like a full-time job. Instead, you could leave it to the professionals who have indeed made a career out of it.

Mutual funds and exchange-traded funds (ETFs) allow you to tap the expertise of professional portfolio managers and the investing hive mind. They are certainly worth considering, especially for many people who are new to investing. That’s in part because some fund choices can essentially give you exposure to hundreds of underlying investments in one fell swoop, potentially providing easy diversification. They also may help cut down on trading costs but be sure to always review a fund prospectus before investing. In particular, index-tracking mutual funds and ETFs tend to offer lower-than-average fees and a stake in a diversified portfolio of investments that seek to mirror the performance of a designated index.

However you choose to get into the stock market, the most important thing is that you educate yourself and get comfortable with the risks.   After all, stocks can be a key component in every investor’s portfolio.

Looking for an easy way to invest? Acorns portfolios can include a mix of exchange-traded funds with exposure to thousands of stock and bonds. Find out more.