Financially reviewed by Patrick Flood, CFA.
For beginners who lack investing experience, “the stock market” can seem like a big, complex, intimidating entity, especially after seeing scary headlines about market crashes. But it doesn’t have to be this way. Here we’ll explain what the stock market is, how it works, and how to invest in it.
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In a hurry? Here are the highlights:
- A stock is an instrument by which investors can have fractional ownership in a company, providing claim to that company’s future earnings.
- Publicly traded companies are listed on a stock exchange. Exchanges provide a framework for trading; they enforce and ensure liquidity, price transparency, etc. to facilitate a fair environment where transactions can take place.
- The stock market is simply the marketplace where buyers and sellers come together to trade investments. The stock market is comprised of the collective exchanges.
- Investors must access the stock market via a broker.
- Most investors hope to achieve positive returns through buying and holding investments over a long period of time. Returns occur through capital gains and dividends.
- Investing is now cheaper and easier than ever before for DIY retail investors.
What Is a Stock?
A stock is just an instrument by which investors can own a piece of a publicly traded company, sold as shares. Companies “go public” by being listed on a stock exchange via what’s called an initial public offering (IPO). The share price is the price per share of stock. Shareholders are hoping this value goes up over time. The totality of outstanding shares is called the company’s market capitalization, or market cap for short, which represents the company’s total value as dictated by the market’s opinion on that company’s future earnings potential.
Owners of shares of a company’s stock (or “equity”) have a claim to – and are betting on – that company’s future earnings. For example, if you own shares of Apple stock (or even a fraction of one share), you are considered an Apple shareholder. Specifically, if there are 100,000 outstanding shares of a company’s stock and you own 10,000 of them, you have a 10% ownership stake in the company.
What Is a Stock Exchange?
In this mutually beneficial relationship, it’s important to note that in buying shares of a company, you are buying from an existing shareholder on the other side of that transaction who wants to sell, not from the company itself. Stock exchanges are the framework that allow these transactions to happen, where a stock is listed.
On the company’s side, they have an incentive to be listed on an exchange to be able to offer shares of their stock for sale, providing access to traders. This provides the company with financial capital for expansion. The exchanges are responsible for enforcing and ensuring liquidity, price transparency, etc. to facilitate a fair environment where these transactions can take place. The exchanges also maintain company news, announcements, market-level performance data (via indices like the S&P 500 index), and more.
Notable stock exchanges in the U.S. include the New York Stock Exchange (NYSE) and the NASDAQ. Elsewhere in the world exist the London Stock Exchange, the Hong Kong Stock Exchange, and more. Stock exchanges have strict regulations and standards to protect investors. Collectively, these exchanges comprise “the stock market.” While some use the terms “stock exchange” and “stock market” interchangeably, technically the latter is composed of the former.
What Is the Stock Market?
As the name suggests, the stock market can be thought of as a marketplace, where people can gather to buy and sell things, in this case investments. Those investments can be stocks (individual companies), ETFs (exchange-traded funds; baskets of stocks), mutual funds, currencies, bonds, etc.
Investors – even beginners – don’t need any sort of training, qualifications, or certification to “enter” this marketplace, though it’s probably a good idea to have some idea of what you’re doing before going in blind, so it’s good that you’re here reading this post. The stock market is open to everyone. Like a store, it has opening and closing hours, and days where it’s closed. Typically, the stock market is open Monday through Friday, 9:30am to 4:30pm Eastern time, and it is closed on major holidays.
Whereas previously you had to pick up the phone and call a professional, licensed advisor to buy or sell stocks, it’s now easier and cheaper than ever before to access the stock market with an online broker or mobile investing app. Nowadays, these brokers usually have zero fees and zero trade commissions, so you can invest for free.
Colloquially, when people talk about the behavior of “the market,” they’re referring to stocks in aggregate, measured by a popular index like the famous S&P 500 or the Dow Jones Industrial Average. These indexes are viewed as representative samples of the market as a whole. Most investors are betting that the stock market will go up over the long term, and thus are happy when headlines talk about “the market” moving upward.
Beginners are typically scared of the market by assuming it requires extensive education or experience to be “good” at investing, and further erroneously assuming that investing in the stock market is a complex process. On the flip side, beginners can also unfortunately be swayed by sensationalized articles, newsletters, videos, and blog posts from people selling subscriptions to their “hot tips” services, only to later be disappointed when these “hot tip” investments either lose money or underperform the market.
In reality, when approached with a sensible level of caution and a little bit of knowledge, investing in the stock market can be an extremely efficient, effective method of building wealth. It is considered the best way to reliably beat inflation over time.
Now that you understand what the stock market is, let’s look at how the stock market works.
How the Stock Market Works
Again, “the stock market” as a whole is comprised of the collection of exchanges, which list the publicly traded companies in which you can invest by buying shares. The stock market serves as the safe, secure, regulated marketplace where buyers and sellers come together to trade investments.
As millions of investors are bidding for (buying) or offering (selling) shares of a stock, these trades set and affect the movement of the share price. In aggregate, as interest and trade volume increases, that price becomes more “stable” in a sense, and the bid-ask spread – the difference in price between average bid and average offer/ask – decreases in size. Don’t worry, you won’t have to analyze or execute any of this with most modern brokers; it’s just what’s going on behind the scenes when your order is placed.
Buyers obviously hope to buy the stock for the lowest price. Sellers hope to sell the stock for the highest price. Consistent with the laws of supply and demand, when there are more buyers of a stock than sellers, the share price will increase. Conversely, when there are more sellers of a stock than buyers, the price will decrease.
For the sake of simplicity in this post, we’re referring solely to investors who desire to “buy and hold” investments to achieve a positive return over the long term (20+ years), usually in the context of saving for retirement. Investors achieve positive returns via capital gains and dividends. Capital gains refer to the price appreciation of their investments upon selling for profit, while dividends are simply a return of value from companies to shareholders in the form of distributions of periodic cash payments. For example, if you buy $100 worth of shares of an index fund and you sell after they increase in value to $150, you have realized $50 in capital gains for a 50% return.
The stock market – and most indices – is ordered by market capitalization, the size of the company according to the total value of its outstanding shares. The top 10 companies make up over 20% of the total stock market by weight. The market is segmented by asset type, geography, cap size, and sector.
- Asset types include stocks, bonds, metals, cash, etc.
- Geographies refer to where in the world the assets reside. There are geography groupings like Developed Markets, Emerging Markets, etc.
- Cap sizes include large-caps, mid-caps, and small-caps, coinciding with large companies, medium-sized companies, and small companies.
- Sectors are standardized by the Global Industry Classification Standard (GICS) and include these 11:
There are also hundreds of various indexes that track various collections of stocks, e.g. the famous S&P 500, NASDAQ Composite, Russell 1000, etc. Funds exist to track these indexes to get broad, diversified exposure to the stock market. These broad indices are seen as representative proxies for “the market” as a whole. Analysts follow and discuss specific sectors, cap sizes, geographies, and indexes. Similarly, investors may desire to only invest in specific narrow subsets of the market, e.g. small-cap U.S. energy stocks.
There are other financial markets like commodities (water, oil, coffee, soybeans, etc.), which are primarily traded with futures, derivatives like options contracts, cryptocurrency, foreign currency exchange, and more. Those are beyond the scope of this post.
Now that you know how the stock market works, let’s look at how to invest in the stock market.
How to Invest in the Stock Market for Beginners
Investing in the stock market is easier than you might think. You can obviously join a full-service broker who provides professional advice or pay a fee-based financial advisor, but I’m always trying to fight for lowering the physical, mental, and financial barriers to investing for beginner DIY retail investors. Modern brokers have made it cheaper and easier to invest than ever before, even for beginners with zero knowledge and low capital.
- Choose a stock broker. Investors must use a broker to access the stock market. I’d suggest M1 Finance. Through the brokerage, investors are able to buy and sell investments as described above. Most brokers also have modern, user-friendly mobile apps.
- Choose an account type. If you’re investing for retirement, you’ll want a tax-advantaged account like a Traditional IRA or Roth IRA. With a Roth IRA, for example, your investment growth and subsequent withdrawals after age 60 are tax-free. If you have a shorter time horizon like 5-10 years, a simple taxable brokerage account is what you want. Most brokers offer these 3 types of accounts, but some offer specialty accounts like SEP IRA, Trust, Joint, 529, etc. Figure out what account type you need and select a broker that offers that account. Your employer may also separately offer a 401(k) retirement plan. You can simultaneously have a 401(k), IRA, and taxable account.
- Determine your risk tolerance. If you have a high tolerance for risk, are investing for the long term, and won’t care if your portfolio value drops over the short term, you may want to be “aggressive” with a portfolio of 100% stocks. If you have a low risk tolerance, however, you’ll likely want to diversify with multiple asset types like bonds, gold, etc. I delved into risk tolerance in detail here. Risk tolerance and time horizon (how long you’ll be investing to reach your financial goal) will inform your subsequent asset allocation.
- Fund your account. Connect your bank and fund your account, preferably setting up regular deposits to get your portfolio growing as quickly as possible.
- Choose your investments. Without going into too much detail, the best strategy – especially for beginners – seems to be passively investing in broad, low-cost index funds to maximize diversification, as opposed to picking individual stocks, which tends to underperform the market over long periods for the vast majority of investors, even professionals. I went into detail on index investing here. You can invest in an index fund via what’s called an ETF (exchange-traded fund), which is just a basket of stocks that tracks an index. For example, here is a list of popular S&P 500 index funds. Choose asset types based on your target asset allocation. Don’t feel like putting in any effort choosing investments? You may be interested in a ready-to-go “lazy portfolio.”
- Place the order(s). Simply find the stocks or ETFs via their ticker symbol, the abbreviation used to identify the asset, e.g. AMZN for Amazon, and place the order online through your broker.
- Sit back and relax! While it may be tempting to tinker, don’t try to time the market and don’t let your emotions drive investing decisions. Doing so is usually more harmful than helpful. Pick a strategy and stick to it. Jack Bogle, founder of Vanguard and considered the “father of index investing,” advised investors to “stay the course.” If you have multiple asset types, you’ll probably want to rebalance your portfolio at least once per year, as your allocations may stray from their target. Thankfully, M1 Finance offers dynamic rebalancing as well as one-click manual rebalancing.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.