How the Stock Market Works | Investing

The stock market is the magic beans of retirement. It can take your $500 per month and turns it into a $1 million nest egg by retirement.

While to the untrained observer, such financial growth can genuinely look like magic, savvy investors know this magician’s secrets and how to make the most of how the stock market works behind the curtain.

Here’s a look at some Wall Street basics investors should understand:

The stock market is a marketplace for buying and selling investment securities. It comprises of various stock exchanges, like the New York Stock Exchange and Nasdaq.

“Individual stocks will trade on one of these exchanges, but not both,” says David Kass, clinical professor of finance at the University of Maryland. “Generally, the NYSE will list older, larger and more established companies, while Nasdaq will list younger, smaller and more high-technology companies.”

Outside the U.S., foreign company stocks trade on their own country’s exchanges, like the Tokyo Stock Exchange or Shanghai Stock Exchange. U.S. investors can buy stocks directly on a foreign exchange, but it’s generally easier to buy American depositary receipts, or ADRs, which represent shares of a foreign company issued by U.S. banks that trade on American exchanges.

Stocks that don’t meet the requirements for trading on a stock exchange are bought and sold on over-the-counter markets, where they trade directly through broker-dealers as opposed to an open exchange.

These markets and stock exchanges make up what’s called the secondary market, where investors buy and sell shares among themselves. Before investors can trade stocks in the secondary market, though, the shares must be made public.

A company’s stock becomes available on a stock exchange after its initial public offering, or IPO. If you buy company stock in an IPO, you’re buying on the primary market. When you turn around and sell your IPO shares, you do so on the secondary market.

The performance of this secondary market element of the stock market is tracked through various stock market indices, like the Dow Jones Industrial Average or the Nasdaq composite. When the media or financial experts talk about how the stock market is performing, they’re referring to one of the major stock market indices. And when they say, “Wall Street closed at record highs today,” they’re referring to the record-breaking highs of these indices.

You can think of the stock market as a busy auction house, says Christine Matthew, an advisor with Signature Estate & Investment Advisors. “Buyers want to buy stocks at low prices, and sellers want to sell at high prices,” she says. “The market helps them agree on a fair price.”

The difference between what buyers are willing to pay (the “bid”) and sellers are willing to accept (the “ask”) is called the bid-ask spread. A smaller bid-ask spread indicates a more liquid, or easily traded, security.

A stock’s price represents what the cumulative market of buyers and sellers consider its value to be. As with everything in the economy, it’s largely dictated by supply and demand. When there are more sellers trying to offload their stock than buyers interested in purchasing, the price falls. If prices on all or most stocks drop significantly and suddenly, a stock market crash occurs.

“A stock market crash is a large percentage decline in the overall market in a very short period of time,” Kass says. “For example, on Oct. 19, 1987, the Dow Jones Industrial Average dropped by 22.6% in one day. That was the largest one-day percentage decline in many decades.”

Although the stock market averages 9% to 10% annual returns, without adjusting for inflation, investors can’t forget that stocks are risky. “They could decline by as much as 30% or more in a single year,” Kass says.

Many things can affect stock market prices, from the technical to the emotional. For instance, “good or bad news about a company can impact prices, such as when a company reports its earnings or profitability,” Matthew says.

But events that are not directly tied to the company itself can also affect its stock price. “Factors such as interest rates, inflation or unemployment can influence prices up or down,” Matthew adds. Even political events and natural disasters can make the stock market swing up or down.

One of the main reasons for so much market volatility is that stock prices are in part dictated by investor sentiment. Changes in investor psychology can “swing like a pendulum between fear and greed,” Kass says. This will in turn alter how they invest.

The volatile nature of the stock market is one reason to keep a long-term perspective when investing. It’s best to ignore short-term price movements and not panic when the market declines, Kass says. But it’s equally important not to let yourself get too euphoric when the market rises.

Instead, aim for an air of disconnected objectivity to help keep your head, heart and stomach strong throughout any and all market turbulence.

A stock represents a share of ownership in a publicly traded company. If you own a share of Apple (ticker: AAPL), you have an ownership stake in Apple. This grants you the right to vote on Apple’s corporate policy and a claim to a portion of its profits.

Investors typically buy stock in a company in the hopes that the share price will increase over time, as noted in the “buy low, sell high” axiom. But share price appreciation isn’t the only way to make money in the stock market.

You can make money in stocks through capital appreciation when the price rises or by earning income from dividends.

The most recognized means of making money in the stock market is by selling stock for more than you bought it. This is called capital appreciation. If you buy a share of Apple for $200 and sell it for $250, you’ve made $50 in capital gains. But to realize your gains, you have to sell your shares. So while you’ve made $50, you can no longer participate in any future growth or payments to shareholders that Apple may make.

Another way to make money in the stock market is through dividends. Dividends are payments companies make to their shareholders, usually on a quarterly basis. As long as you hold Apple stock, you are entitled to any dividends it pays.

You can take those dividends as a cash payment or reinvest them to buy more shares of Apple and increase your holding, which will earn you more dividends in the next round of payments since they’re paid on a per-share basis.

Many investors make money in the stock market simply by investing in companies that pay regular and increasing dividends.

Note that not all companies pay dividends, and even those that do have no obligation to continue. Like a company bonus, dividends are not guaranteed.

There are a few ways investors can buy stocks:

To buy stock through a broker, you’d need to open an account with an investment company. You can own stock in a non-retirement brokerage account or individual retirement account (IRA). Once you have your account, you place the trade through the firm’s website or mobile app.

“Shares can be bought and sold at the market price or for a price limit,” Kass says.

The market price is the prevailing price the stock is trading at currently. A market trade, then, is one that’s executed at the next available price.

A limit trade involves setting the price you’re willing to buy or sell at. Your trade won’t be executed unless that limit is met or exceeded. So a limit order to buy at $100 per share would only go through if the stock price drops to $100 or below. And a limit order to sell at $100 only occurs if the stock price rises to $100 or more.

Robo advisors are an alternative to larger brokers but often have a much smaller selection of stocks. Some robo advisors, like Stash, let you buy fractional shares of the companies they offer. So if you can’t shell out over $1,200 for a full share of Netflix Inc. (NFLX), you can buy $5 worth and grow your position over time.

If you’re just starting to invest or are investing with little money, the best way to buy stocks may not be by investing individually but rather to buy in bulk through an ETF or mutual fund. Funds pool hundreds or thousands of stocks into a single investible entity. Investors who buy shares in a fund get a proportional share of all the stocks in the fund.

Technically, if you buy Apple through a fund, you don’t own Apple directly; you own a share in a fund that owns Apple. But if you buy Apple through a fund, you also get a share in a fund that owns many other companies, making you far more diversified than if you owned just Apple. Plus, most funds trade for less than the price of one share of Apple.

Regardless of how or where you invest, remember that stock prices are volatile.

“Investors should have a long time horizon of many years,” Kass says. “For most investors I recommend a low cost S&P 500 index fund, such as that offered by Vanguard.”