What is the Stock Market and How Does It Work?

The stock market is a collection of global exchanges where shares of public companies are bought, sold and issued. Here’s everything you need to know.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

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The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’ve probably heard of the stock market before. But whether you’re brand new to investing or fairly experienced with trading, the stock market can still be confusing.

Let’s break down what the stock market is, how it works and how you can use it to build wealth over time.

What is the stock market?

Put simply, the stock market is a collection of global exchanges and markets where shares of public companies are bought, sold and issued.

Before we break down how it works any further, let’s define a few must-know concepts regarding the stock market.

What is a stock?

A stock is a small piece of a company that can be bought and sold on the stock market. Owning a stock entitles the buyer to a share of the company’s profits and assets, proportionate to the size of the stock they own. Units of stock are referred to as ‘shares’.

Stock market vs. stock exchange

You may have heard of the London Stock Exchange (LSE), the New York Stock Exchange (NYSE) or the Tokyo Stock Exchange (TSE). These are stock exchanges within the global stock market, and most major economies have a stock exchange.

The key differences between the stock market and a stock exchange are the following:

  • The stock market is a term for all types of stock trading, whereas a stock exchange is a body that facilitates trading.
  • The stock market is made up of over-the-counter (OTC), electronic and stock exchange trading.
  • The stock market refers to the process and facilitation for buyers and sellers of stock to trade, while a stock exchange is a body that works to make a profit.
  • Both stock markets and stock exchanges are crucial for the global economy ‒ by generating money, they affect economic activities.

What is a stock index?

A stock market index displays how investors believe an economy is performing. An index gathers data from a range of firms across sectors. That compiled data draws conclusions that help investors compare current prices with past prices to gauge market performance.

Indexes differ in size, with some tracking thousands of stocks and others just a small number.

Each index serves a distinctive purpose, sometimes across different sectors. Major stock indexes include the FTSE 100, the S&P 500, the Dow Jones, the Nasdaq and the Russell 2000.

What is the UK stock market?

There are two parts of trading that are informally known as the ‘UK stock market’.

One part is the London Stock Exchange (LSE). It is among the globe’s oldest exchanges and is largely made up of two markets:

  • The Main Market contains more than 1,000 of the world’s largest companies.
  • The Alternative Investment Market (AIM) is home to smaller, less-developed companies.

The second part of what is known as the UK stock market is its indices. These indices include the FTSE 100 Index and FTSE 250 Index.

The FTSE 100 is an index comprised of the top 100 companies in terms of their market cap on the LSE Main Market. Companies in the FTSE 100 include Shell, ITV and Barclays.

The FTSE 250 is comprised of the 101st to the 350th largest companies listed on the London Stock Exchange. Companies in the FTSE 250 include Greggs, easyJet and Aston Martin.

How does the stock market work?

In many ways, the stock market is very similar to an auction house, where buyers and sellers decide on prices and make trades. There are two ways this happens:

1. The primary market

The primary market is where companies list newly issued stocks. This kind of stock is called an initial public offering (IPO).

Public companies – or those companies that are planning to go public – use the stock market to list their shares. Investors then use the market to purchase those shares, giving the company money, which is typically spent on business growth.

2. The secondary market

The stock market allows investors to sell their stocks to other investors, known as the secondary market. It’s likely what most people think of when they think of the stock market.

In this case, the market tracks the performance of a stock and lists prices depending on the stock’s supply and demand, political or economic events around the world and the performance of the company itself.

If a buyer wants a stock that is owned by another investor, the buyer will bid for that stock – this offer tends to be less than the asking price. Once a buyer and seller agree a price, the trade can take place.

RELATED: Is the Stock Market Going to Crash?

How are prices determined on the stock market?

Stock market prices are generally determined by supply and demand. If there is high demand for a stock, the stock price will likely increase as investors buy up shares. The reverse is also true – if many investors want to sell a stock at the same time, the price will likely drop.

The stock market works in much the same way as other economic markets. When a buyer and seller negotiate a price and a stock is sold, that price becomes the current market price.

Why is the stock market so volatile?

It’s well known that the stock market can be volatile, and many elements contribute to its level of volatility.

National and regional economic factors – such as tax and interest rate policies – can influence changes in the market. For instance, if a bank lists short-term interest rates for overnight borrowing, this can dramatically affect the stock market.

Changes in inflation can also contribute to stock market trends and volatility, as can political uncertainty – such as the 2020 US election – and other global events.

Volatility is expected in the stock market, so don’t panic if you experience this. At The Motley Fool, we recommend buying and holding shares for at least five years to negate inevitable short-term volatility. The stock market is a game best played over a long period of time.

RELATED: Foolish Investing: Taking the Long-Term Approach

What happens when you buy shares?

The buying and selling process is usually carried out through a brokerage account, which is simply an entity licensed to trade stocks on a stock exchange. Usually, a broker is fully online and carries out transactions electronically, although it’s possible the broker could be an actual person whom you tell what to buy and sell.

When you buy a share of a corporation, you’re really purchasing a piece of that company. Usually, it means you own a proportion of that company’s assets and profits, appropriate to how many shares you own.

How can you invest in the stock market?

A great way to start investing in the stock market is to place funds in an online investment account that you can then use to invest. That could be a brokerage account, a robo-advisor, or a stocks and shares ISA account. Check out our top picks for each to determine which is the best investment vehicle for you.

For most, investing in the stock market means selecting one of two types of investment:

1. Investing in mutual funds or exchange-traded funds

Funds allow you to buy small pieces of different stocks in one transaction. Investing in a fund also means you own small pieces of the companies. To build a diverse portfolio, you can put several funds together. Mutual funds are sometimes known as equity mutual funds.

2. Investing in individual stocks

If you want to invest in a specific company, you can purchase one share or several shares as a way to become accustomed to stock trading. Building a diversified portfolio from a selection of individual stocks is doable, but it requires a lot of research and investment.

The advantage of mutual funds is that they are characteristically diversified, which reduces your investment risk. For most investors – especially those investing their retirement savings – a portfolio comprised largely of mutual funds is the best option.

On the other hand, mutual funds are less likely to see dramatic rises, whereas some individual stocks may do. The benefit of individual stocks is that a careful choice can bring vast profits, but it’s unlikely that an individual stock will make you a millionaire.

At The Motley Fool, we recommend that you buy and hold up to 25 different types of stocks, as this can be a great option to build wealth. Let the stock market work for you by holding your stocks for at least five years.