Investing in the stock market can appear complicated, and first-time investors are frequently unsure how to proceed. Don’t worry, everyone starts out in the same place. The most important step for a beginner investor is to understand how the stock market works so that you can better manage your investments. This page will teach you everything you need to know about the stock market, from its definition to how it works and the benefits and drawbacks of investing.
Key Points
*The stock market is a marketplace where you can buy, sell and trade stocks at any time during the business day
*The stock market operates in the same way as an auction house, with investors negotiating on the price of shares by bidding
*The price of a stock on the stock market is set according to supply and demand
What is the stock market?
The stock market is a marketplace where people buy and sell stock in companies based on how much they believe they will be worth in the future. There are stock exchanges all over the world, with some of the largest being America’s New York Stock Exchange and the United Kingdom’s London Stock Exchange. Each share of stock you purchase represents a share of the company from which you purchased it.
The value of large indexes within each stock market is the best way to observe the performance of each stock market. The S&P 500 in the United States, the FTSE100 in the United Kingdom, and the Nikkei Index in Japan are all examples of indexes.
The news headlines frequently state that the stock markets have moved up or down, which usually means that the stock market indexes have moved. This movement refers to the value gained or lost by the index as a whole, and investors who engage in stock market transactions seek profits through stock price movement.
Where is the stock market?
The world’s two largest exchange markets are located in the United States: the New York Stock Exchange, which was founded in 1792 on Wall Street, and Nasdaq, which was founded in 1971 to deal with technology companies such as Apple and Facebook.
How the stock market works
The stock market works in the same way that an auction house does, with buyers and sellers negotiating prices and making trades. Companies that intend to go public list their shares on the stock market, and investors purchase those shares, generating money for the company, which is typically used to grow the business. An initial public offering is a type of stock offering (IPO).
Investors can buy and sell their stocks to other investors, and the stock market will track the performance of each stock and set prices based on supply and demand.
Buyers offer a bid or the highest amount they are willing to pay for another investor’s stock. These bids are typically less than the asking price. A buyer and seller must agree on the amount they are willing to pay or sell for a trade to take place.
The stock market operates electronically and online, with prices frequently calculated automatically, as opposed to traditional marketplaces where bids must be made in person.
What is the stock exchange?
Stock exchanges are secondary markets, which means that existing shareholders trade with potential buyers. When you buy a share, you are not purchasing it from the company that listed the share; rather, you are purchasing it from an existing shareholder. This transaction is similar to selling your shares; you are not selling to the company, but to another investor.
What are stock market indexes?
Because tracking every single stock is difficult, indexes such as the S&P 500 and FTSE 100 represent sections of the stock market and make observing them a little easier.
The FTSE 100, for example, is the share index of the top 100 companies listed on the London Stock Exchange. These 100 companies represent the overall performance of the industry.
How are share prices set?
When a company first lists its stock on the stock market, it goes through a process known as an initial public offering (IPO). The company will set a date to open its shares to the public once the pricing details and IPO are finalized.
Once investors purchase shares, the market monitors their performance and sets prices based on the supply and demand of investors willing to buy or sell each share. Share prices in the stock market are frequently determined through an auction process in which buyers and sellers place bids on shares.
How volatile is the stock market?
The stock market is inherently volatile, and many factors influence its volatility. Regional and national economic factors, such as tax and interest rate policies, may influence market behaviour. For example, if a bank establishes short-term interest rates for overnight borrowing, this can have a significant impact on the stock market.
Other factors, such as changes in inflation trends, could have an impact on long-term stock market trends and volatility. For example, a massive weather event affecting a major oil-producing region may cause oil prices to skyrocket. This rise may also cause the prices of oil-related stocks to rise.
Political uncertainty is another factor that contributes to stock market volatility. The US election in November 2020 had an immediate impact on global stock markets, and trade deals between major powers can also move stock markets up or down.
Finally, a global event can cause the stock market to swing dramatically. The graph below depicts how the coronavirus pandemic affected stock markets around the world.
What are the risks of investing in the stock market?
The greatest risk of investing in the stock market is that you could lose your entire investment if the price of the stock you own falls to zero, such as if the company in which you own stock goes bankrupt.
A market crash occurs when the value of the stock market falls by less than 10%. A bad market crash could even trigger a recession. There have been several infamous stock market crashes throughout history, including the 1929 Wall Street crash, also known as ‘Black Tuesday,’ and the 2008 financial crisis that followed the US housing bubble.
A bear market occurs when the value of a stock market falls by 20% from its peak. Bear markets can happen in any asset class and can wipe out years of gains.
You risk losing money if you buy and sell stocks. Some people consider day trading to be risky because it is impossible to guarantee a profit. In contrast to short-term trading, long-term investing in the stock market may be more profitable, but you must be aware of the risks of market crashes.
Why should I invest in the stock market?
The potential for substantial returns is the primary reason for investing in the stock market. There are usually no other types of investments that perform better in terms of long-term performance. However, because of the volatility and risk associated with investing in the stock market, you’ll need to consider how much you’re willing to invest, as you can’t rule out the possibility of losing your money.
Pros and cons of investing in the stock market
| Pros | Cons |
|---|---|
| The value of shares in the stock market can grow with the economy. | The market is volatile, which can be very risky for your investments. |
| Making the right trades at the right time can give you high returns on your investments. | There’s a risk of losing all the value of your investment if, for example, the company you’ve invested in goes bankrupt. |
| It’s easy to buy and sell shares because you can do everything online. | The prices of shares can fluctuate, which makes it hard to earn gains on short-term investments. |
| It allows you to stay ahead of inflation if you plan on investing over the long-term. | You’ll need to invest a lot of time researching companies and the performance of shares in the stock market. |
What are the other types of financial markets?
There are several other types of financial markets, including the following:
Bond market: Bond markets allow businesses to acquire large sums of money to finance large projects or investments. In a bond market, investors buy bonds from a company that wants to borrow a lump sum, and the company agrees to repay the bonds with interest over a set period of time.
The commodities market is where businesses buy and sell natural resources like oil, corn, and gold. Because prices are volatile, a company can buy resources and lock in a fixed price. If the price of those commodities rises, they stand to profit handsomely in what is known as a future commodities market.
Market for derivatives: Derivatives are complex products that derive their value from underlying assets. Futures contracts in the commodities market are an example of derivatives.
Opening a savings account vs investing in the stock market
As you are now aware, there are numerous risks associated with investing in the stock market. If you want to invest in something where the risks are low and the returns are guaranteed, you should consider opening a savings account.
