Dylan Lewis: You may have heard that investing in stocks can be a great way to create wealth
over time. And that's certainly true, but how does the stock market work?
I'm Dylan Lewis from the Motley Fool, and in this FAQ, we're going to answer that question and talk
about how you can get into the market.
Stocks, otherwise known as equities or equity
securities, represent ownership interests in companies. The stocks that are publicly
traded are available because those companies decided to list their shares and make them
available to public investors. Now, stock markets facilitate the sale and purchase of
these stocks between individual investors, institutional investors, and companies.
There are two components of stock markets: the primary market and the secondary market.
First, the primary market. Stocks first become publicly traded through a process known as
an initial public offering, or IPO. This involves a company selling shares or pieces of itself
to investors in order to raise capital and listing their shares on a stock exchange.
This initial sale comprises the primary market. After that, you have the secondary market.
That's after the IPO takes place, virtually all subsequent stock trades take place between investors.
That is, the company is not involved. Stock exchanges such as the New York Stock Exchange
or the NASDAQ facilitate buying and selling of stocks between investors.
The vast majority of stock trades take place on the secondary markets between investors.
That means that, for example, if you wanted to buy shares of Microsoft and hit the buy button
through your broker's website, you are buying shares that another investor has decided to
sell, not shares from Microsoft itself. Just to take a second to piece it altogether,
let's break down these symbols. NASDAQ is the exchange that shares of Microsoft are
listed on. MSFT is the ticker symbol for the company Microsoft. These abbreviations are
identifiers that help avoid confusion and uniquely identify a specific exchange and stock.
OK, so, if investors are constantly buying
and selling shares on the secondary market, how are stock prices determined?
Well, the price of a stock is largely governed by the basic economic principles of supply and demand,
plain and simple. At any given time, there's a maximum price someone's willing to pay for
a certain stock and a minimum price someone is willing to sell shares of that stock for.
Think of the stock market as an auction, with some investors bidding for the stocks and
other investors that are willing to sell. If there's a lot of demand for a stock,
investors will buy shares quicker than sellers want to get rid of them, and the price will move
higher to reflect that. On the other hand, if more investors are selling a stock than
buying, the market price will drop. Now, you might be thinking yourself,
"What if people don't want to sell their shares? How can you buy them?" In order to ensure
that there's always a liquid marketplace for stocks on an exchange, individuals known as
market makers act as intermediaries between buyers and sellers. Market makers buy and
hold shares and continually list quotes to buy and sell those shares. The highest offer
to buy shares listed from the market maker at any given time is known as the bid,
and the lowest offered selling price is known as the ask. The difference between those two
is called the spread. The main reason for using market makers as a system, as opposed
to simply letting investors buy and sell shares directly between one another, is to ensure
that there's always a buyer to match with every seller and vice versa. If you want to
sell a stock, you don't need to wait until a buyer wants your exact number of shares;
a market maker will buy them right away. Now, if you want to buy a stock, you'll have
to do it through a broker -- basically, someone that is licensed to trade stocks on an exchange.
A broker may be an actual person who will tell you what to buy and sell, but in today's
day and age, it's probably an online broker that processes each transaction electronically.
When you buy a stock, here's a simplified version of how it works. You tell your broker
what stock you want to buy and how many shares you want. Your broker relays that order to
the exchange. A market maker sells you the shares at the current market price.
Then, those shares are delivered to your account. You've probably heard statements such as
"the market is up" or "the stock beat the market." Often, when discussing the stock market, people
generalize "the stock market" to a stock index. Stock indices such as the S&P 500 or the
Dow Jones Industrial Average are a representation of the performance of a large group of stocks,
but not the entire exchange, and are often used as a benchmark to compare the performance
of individual stocks to an entire portfolio. For example, the S&P 500 index tracks the
performance of 500 of the largest publicly traded companies in the United States.
Indexes are a convenient way to discuss an approximation of what is happening in the stock market,
but they do not fully represent the entire stock market.
The beauty of a stock market index like the S&P 500 is that they aren't just a measure
of how stocks are doing; they can also be a way for folks that are new to investing
to easily put their money to work. Thanks to Jack Bogle and Vanguard, the average investor
can buy a fund that tracks an index like the S&P 500 and pay a tiny fee to do so, making
it easy and cheap to start investing. For folks that are looking to get into the market
for the first time, we recommend doing exactly that. Look for an ETF or a mutual fund that
tracks the S&P 500, and boom, you are immediately a part owner in 500 of the largest publicly
traded companies in the United States. If you're looking for some more guidance,
we have a free investing starter kit over at fool.com/start. It walks you through all
things money and investing and it has a five-stock sampler to get you started.
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