Investing > How the Stock Market Works

How the Stock Market Works

This guide outlines the key aspects that make the stock market work, giving you an edge in the world of stock trading.

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Investing in the stock market is an effective way to build wealth if you do it right. I’m sure you’ve heard of the extreme rises and dips of the stock market. Both the crashes and the record-breaking highs that have occurred throughout stock market history have taught us lessons.

It’s a fact that investing is risky. The good news is that you can trim down the risk and come out ahead when you plan the steps you’ll take in advance. But first, realize that knowledge is key.

The more you absorb what you learn and apply it to your investment strategies, the higher your bank account is likely to be. What’s more, you’ll experience fewer failures and more wins overall.

The Benefits of Investing in the Stock Market

There are plenty of advantages to investing in the stock market. Here are a few top reasons to jump in:

1. You can earn money annually based on the average growth rate.

Each year, you’ll make money on top of your investment. That’s just how the market works most of the time.

Certain years you’ll earn more than other years, but the bottom line is you want your money to regularly earn dividends on top of your initial investment. This builds up.

For example, if you invested $10,000 at the rate of 8% annual return, after 10 years, you would have $21,590. And if you decided to contribute an additional $1,200 each year for that time frame, you would have $40,364. That’s one ideal scenario. Of course, the more you contribute each year, the more you can earn on your investment.

If you invest $10,000 every year for 10 years, based on the 8% return rate, your earnings would grow to $178,045 at the end of that time frame. Now, after 30 years, you would have $1,324,086.

2. Stock investment may pose a bit of risk, but it’s not as risky as you may have thought.

It’s a fact that stocks have gone up in prices; therefore the rewards are higher too. This means there’s still money to be made. They’ve risen more than they’ve dipped the other way when you look at the annual return rates.

Economies continue to grow nationally and globally. Because of this historically enduring climb, performance is unlikely to dive year after year.

3. Compounding interest over time is greater than the non-compounding interest.

The example given earlier about investing $10,000 each year over a period of 30 years to earn $1,324,086 illustrates compounding interest. Start with the initial $10,000 investment, make a monthly contribution of $1,000 for 50 years and you’ll earn significantly more.

At the rate of 8%, you’ll have $7,354,258.00. Interest has compounded, in other words, the principle which is your investment and the interest earned in a given year is added together. The new total is invested back into the stock market and now you have more money that earns interest.

Putting money into a savings account won’t compound as rapidly as the stock market, nor earn as much. In addition, the value of a dollar decreases with the inflation rate.

4. You may earn dividends on your shares of stock.

Although it’s not mandatory, a public company can pay dividends to shareholders who purchase preferred shares. (More on this later in this guide.) Dividends are special perks that shareholders get in the form of stock or cash.

Remember, as stated, not every company does this, but the ones who do, usually pay their shareholders quarterly.

5. Shareholders may have rights to capitals gains and voting.

Public companies make money off of stocks, which are assets. When a company sells an asset, the difference between what they paid for it and what they sell it for is called a capital gain.

Shareholders get a percentage of earnings from capital gains. There are exclusions such as proprietary items. Examples of these are assets of patents, copyrights, and inventions.

It’s important to understand capital gains because, like every shareholder, you’re taxed on the stocks you sell. If you sell stocks in the short-term, it’s taxed at a higher rate.

The longer you hold on to the stock before you sell, like for a year or more, the lower the rate of the capital gains tax you’ll have to pay.

Defining the Stock Market

First, let’s describe what the stock market does. The stock market is the vehicle where public companies trade their shares freely.

A stock exchange is a marketplace platform where investors (buyers) and traders (sellers) exchange shares of stock also known as equity securities. It’s a hub, a community place where investors, traders, and stockbrokers are connected. Anyone can purchase stock and make trades with the assistance of a stockbroker and brokerage account.

Picture of a display showing stock values
Stock market is the place where companies can trade their shares.

Today, this can be accomplished electronically. Individuals who want to purchase and trade stock with little assistance can do this online. They must have a brokerage account which becomes the middle vehicle to execute the trades.

The New York City Stock Exchange (NYSE) in the United States of America is recognized all over the world. It is also referred to as “Wall Street” due to its physical location on Wall Street.

NYSE is also known by other slight name variations such as “the stock exchange,” “the exchange,” “the market.” Although trading on the floor of the New York Stock Exchange is active, today, a majority of trades connected to it are executed online.

The Open Outcry in the Trading Pit

The trading pit is where traders the open market auction floor where traders bid on-the-spot and up-to-the-minute. In that way, it differs from trade negotiations between two parties or those trades completed electronically. Traders voice their interests and signal with their hands to get the brokers’ attention to buy and sell a particular stock.

Trading day stock market hours for the NYSE are on weekdays starting at 9:30 a.m. and closing at 4:00 p.m. Eastern Standard Time (EST).

A Brief History of the Stock Exchange

Europe began trading equity on a small scale back in 1602 when the Dutch East India Company began trading company shares in Amsterdam. Soon after, the art of trading spread to the Port of London and other places.

In the 1700s and 1800s, share trading gained popularity. The Philadelphia Stock Exchange was founded in America in 1790. A few decades later in 1801, the London Stock Exchange opened its doors for trading under that name, although, it had previously traded back in 1698, it was not officially known by that name back then.

Located at 11 Wall Street in New York is the New York Stock Exchange (NYSE). It was founded in 1792, and now, it is the world’s largest marketplace.

Today, stock exchanges are located all over the world. Many of them are connected electronically which enhances the efficiency of the trading system.

Bulletin boards that are over-the-counter (OTCBB) are around as well. These exchanges are not as closely regulated as other more stable stock exchanges. For example, larger more reputable stock exchanges such as NYSE and others, ensure that a company meets certain requirements before it can be listed on its stock exchange.

Many agencies try to protect investors by enforcing policies and regulations for the industry. These are called self-regulatory organizations (SROs). The NYSE is one such agency, but also:

Those listed above represent just a handful of SROs. There are many more organizations the self-regulate in various countries all over the world.

Considerations Before Listing on the Stock Exchange

Companies listed on the stock exchange receive many benefits. Even so, there are things to factor in before taking that step:

  • Associated costs – Listing fees and regulatory compliance, and reporting costs are ongoing.
  • Regulations – In addition to the monetary costs associated with adhering to regulations, companies may be required to make structural changes and this could slow down business efficiency. The SEC regulates SROs, and they, in turn, regulate the companies that are listed.
  • Economic indicators – They may sometimes forecast a less than positive outcome. In August 2019, an inverted yield curve where the short-term Treasury bonds paid more than long-term ones.
Yield Curve Steepening Accelerates Chart
Traders need to learn how to use indicators to get crucial info on stocks.

Companies Benefit by Issuing Shares

The acceleration of advancements in technology and science creates a challenge for firms to remain competitive. Raising capital for new business operations and growth expansion are the two main reasons companies issue shares.

Start-up technology businesses, in particular, are issuing shares to raise the capital they need to function. Initially, they may have relied on other financial resources to back a loan for operating capital. Issuing company stock is a faster way of raising the money they need for their growing businesses.

After they experience success on a larger scale, issuing shares may be a way to continue to meet customer demands and fund new products. According to an article, Pinterest, Uber, and Lyft’s initial public offerings (IPOs) took place in 2019.

The trend to go public is on the rise for technology companies and other industry sectors. Companies that issue shares present more investment opportunities. Researching new firms who enter the stock market helps investors make wise stock purchasing decisions.

How a Company Sells Shares on the Stock Market

In general, how a company begins to sell on the open market is that divides ownership into shares which are collectively called stock or equity. That company then has the right to go public and sell its shares on the stock market.

Anyone who owns stock/shares is considered a shareholder and therefore owns stock in the company. The value of the shares an investor owns is based on how many shares are outstanding.

Outstanding Shares Relates to Investor’s Shares of Stock

When investors own stock, they own a piece of the total amount of outstanding shares or shares outstanding on the open market. How the stock market works is that it won’t include a company’s treasury stock. Every other amount of stock held by investors comprises the number of outstanding shares.

Investor Share Percentage: 5%
Investor’s Quantity of Shares Owned: 50,000
Company’s Outstanding Shares: 1,000,000
Here’s the formula:
Investor – Investor’s Quantity of Shares Owned / Company’s Outstanding Shares = Investor Share Percentage
50,000 / 1,000,000 = .05 which is 5%

Holding excess of millions of outstanding shares is common for a public company because, at any time, it can issue more shares to meet its investment needs. For example, a company might want to raise money so investors can purchase stock.

But a company can also buy back some of its own stock to reduce the number of shares available on the open market. This type of program is called a share repurchase.

Outstanding shares are what a new investor wants to be aware of because it affects the number of shares available for purchase including the per-share price.

It’s easy to find out the number of outstanding shares for a public company. By law, public companies who trade stock are required to report it on the quarterly filings of the Securities and Exchange Commission (SEC) EDGAR company filings search tool.

Use the EDGAR tool to search for a company by name. Click the desired document index number under the Central Index Key (CIK) column. A list of documents will appear.

Look under the “Filings” column located on the left for the type of filing and locate the line with the most recent “10-Q” filing because it represents the quarterly filing for the company. It will be easy to find because the most recent filings are closest to the top of the list. Select “Interactive Data” on the same line.

After the document displays, look at the first column on the left titled “Document and Entity Information – shares.” In the last line before the next section, it reads “Entity Common Stock, Shares Outstanding.”

Beside it, you’ll see the figure to the right on the same line which represents the outstanding shares. Detailed company search instructions are provided on the SEC website.

On stock exchange sites, look for a company you’re interested in researching more about. Check for an “SEC filings” tab that you can click to view the 10-Q quarterly reports for the outstanding shares.

On a main stock exchange page though, you’ll notice a company’s daily volume of shares traded on a particular day. The outstanding shares figure is must larger than that. The information is on the company’s 10-Q quarterly report.

So, you can usually tell by the sheer difference in outstanding shares in the SEC filings and the drastically smaller volume listed on a stock exchange site. The important thing to understand is that “daily volume” and “outstanding shares” are not the same.

Note that you’ll also be able to find the average volume of shares traded on a company’s website. Click on the investor relations link typically found on the homepage.

Keep in mind, a company’s stock information posted on its website may be outdated or date-specific, that is, unless its website has a real-time feed. For more accurate data about stocks, it’s best to rely on the SEC filings and stock exchange websites that link to that data.

Two Types of Stock Carry Unique Benefits

As an investor, you’ll want to learn as much as possible about the type of stock you’re buying because each kind has particular benefits. Buy the right stock to meeting your investment goals.

Common Stock

Equities are the same as common stock, and large volume trading occurs with common stock. Since it trades more, the value of common stock is higher than the preferred shares.

The benefit of common shares is voting rights. Shareholders of common shares hold annual general meetings (AGM) where they have the right to vote on who sits on the board of directors and which auditors are appointed.

There may be stipulations on the voting rights of those who hold common shares. A company can assign shares differently to indicate the level of voting privileges. For instance, Class A shares may have 20 votes per share, Class B just one vote, Class C, no voting rights, while others may be given a dual-class structure.

A dual-class structure is a stock where the founders, executives, and possibly family members can purchase a small quantity of stock yet have a higher percentage of voting rights. Although the total value or equity of dual-class shares may be smaller in a company that offers them, shareholders of dual-class shares hold the majority of voting power over any other class of shares the company offers.

The popularity of dual-class structures continues to grow. Large conglomerates, growing tech companies, and family-owned businesses tend to prefer dual-class structures. Public organizations whose founders want to seek investors, yet remain in control of the direction of the company are favoring dual-class stocks.

Dual-class stocks are not without controversy. The Council of Institutional Investors (CII) reports that the Class B structure of “one vote per share” is what 90% of companies on the market go by and the CII favors this structure.

Preferred Stock

Preferred stock refers to shares in which dividends are issued. In most cases, voting rights are not given, but capital gains are distributed if the public company’s assets are liquidated.

In the case of a liquidation event, if the capital gains check you receive is less than what you paid for your preferred stock, you’ve lost on that investment. It could also work the other way if the capital gains check you receive is larger than your investment. If that’s the case, as we stated previously in how capital gains works, those earnings are taxable.

The Advantages of Watching for IPOs

When a company decides to publically sell its shares, it makes an initial public offering (IPO). This lets the public know that they can purchase stock.

If an investor bought a stake in the company when it was held privately and wanted to sell their shares, now that the company made an IPO on the stock exchange, that investor can profit by selling their shares on the open market.

New and experienced investors also want to look for IPOs to determine if it’s worthwhile to make the investment and purchase their stock. In the early trading stages of an IPO, the company’s share prices will go up and down as stock’s value is measured and analyzed. This might take a couple of months to settle.

Price/Earnings (PE) Ratio and Analysis Types

To determine the value of stocks, a popular tool to use is the “multiple” or more commonly known as the Price-to-Earnings (PE) Ratio also referred to as the “multiple” standard measurement. There are many types of other metrics available, but the P/E ratio is one pricing tool that many investors, analysts, brokers, and business owners tend to trust for measuring stocks. In addition, the fundamental analysis and technical analysis are two ways stocks are processed to determine share values.

The Price-to-Earnings (PE) Ratio Formula

Current Stock Price / Earnings Per Share (EPS) = P/E Ratio

Remember, all pricing tools give estimates. Because of this fact, there are always risks involved with any investment computing tool. The P/E Ratio formula allows you to plug in the known information to get as close to as possible to accurate stock value.

To figure long-term valuations can use a Price-to-Earnings (PE) Ratio that takes past earnings into consideration. It’s important to realize that when a source unrelated to a public company, such as a finance newspaper, it may calculate a P/E ratio in different ways.

Outside Source’s Trailing P/E Formula

Trailing P/E reflects the twelve months in the latest fiscal year. Sources such as newspapers may use it to calculate a company’s P/E ratio.

Current Stock Price / Latest Fiscal Year’s Reported EPS = Trailing P/E

Another way to calculate a company’s P/E Ratio is by using a forecasted formula. This seems logical because investors buy shares counting on the value to increase. To minimize risk, lean on the more conservative side when considering buying shares based on estimations.

Current Stock Price / Upcoming Year’s Forecasted EPS = Forward P/E Ratio

Here’s a formula for calculating the Current P/E ratio:

Current Stock Price / Past Six Months Total Earnings Reported by the Company PLUS Upcoming Six Months Forecasted Earnings = Current P/E Ratio

As a new investor, you’ll see a variety of P/E ratios from different sources. It’s essential to know how they derived their figures. Note too that since analysts use different estimating tools, you’ll likely see varied P/E ratios.

Fundamental Analysis of Stocks

Investors gather information from the financial statements of a company to conduct a fundamental analysis of its stock. They mainly factor in:

  • Future growth
  • Earnings
  • Revenues

Recommendations based on the results of fundamental analysis are:

  • Sell if the stock is overvalued. This is the case if the stock’s perceived value is lower than its price on the market.
  • But if the stock is undervalued. The stock’s value is thought to be higher than its price on the market.

Technical Analysis for Stocks

Investors look at a company’s past performance data and make predictions based on their findings. They review prior movements in:

  • Volume
  • Price

Select the Correct Technical Analysis Approach That Matches Your Investment Goals

Investors trading short-term for quick gains may want to try a top-down approach. In a top-down technical analysis, you’ll first research the economy as a whole and then drill down from there.

You would follow this sequence:

  1. Analyze economies by looking at industries positioned for growth.
  2. Research sectors within those industries.
  3. Find specific public companies that fit the industry.

Long-term investors such as those saving for retirement may want to go the bottom-up route:

  1. Analyze company stocks that are ready to grow.
  2. Validate the sector growth potential.
  3. Verify the industry’s growth.

The keys to wise bottom-up investment decisions are:

Understand that a good entry point (the time to purchase stock) is when a stock is bottoming out. The stock is at its lowest or near the lowest price.

By contrast:

A good exit point for the stock you own stock and is when your stock is priced high or at its highest. When you sell, you get the most ROI. That makes sense for short-term investing. For long-term investing, you’ll want to hold on to your stock and enjoy the continuous compounding interest as it grows each year.

Take into account downtrends as they present opportunities to purchase undervalued stocks.

Traders may use a top-down, bottom-up, or combination of the two technical analysis approaches. There’s no one rule that traders follow universally. They find buying and selling patterns by making use of trendlines, charts, and algorithms that automatically compute statistical data.

One of the easiest ways to get started using technical analysis is to track two moving averages of say for 15 and 30 days. When they intersect at the lowest price, that could indicate a possible entry point for buying.

Setting Share Prices

Auctions are how stock prices are set. When a buyer wants to buy, the buyer will bid on an offer made by the seller. An offer is also called the asking price or simply “ask.” When a buyer accepts the ask, the trade is complete.

Putting Buyers and Sellers Together

To increase the likelihood of buyers being matched with sellers, professional traders referred to as market makers are employed by a few stock markets.

Market Makers want to encourage a two-sided market where there is “a bid and an ask.” A spread is a middle ground between the two prices:

Offer (Ask) – Bid = Spread

A narrow spread is a sign of good quality stock because it has:

  • More shares on both the bidding (buyer) side and the offering (seller) side
  • Higher stock liquidity
  • Good depth
  • Short-term profit potential in high volatility price situations

Bid (Highest Bid) – Offer (Lowest Ask) = Bid-ask (Bid-Offer Spread)

A trade happens when a seller accepts a bid or the buyer accepts the asking price. If there are more sellers than buyers, the sellers might want to reduce the price of the stock and accept the offers. On the other hand, if buyers exceed sellers, the buyers might be willing to pay more to secure the stock since it is in demand.

Market Capitalization Stock Classification

A popular way of describing stock is by market capitalization. The formula is:

Outstanding Shares Market Value x A Single Share’s Market Price = Market Capitalization Stock Classification

The variety of cap types have shown certain benefits in performance.

Company TypeValueBenefit
Large-cap$200 billion or moreRecession tough
Mid-cap$2 billion and $10 billionGrowth potential
Small-capLess than $2 billionHistorically outperformed large-caps immediately after a recession.

Sector Stock Classification

Company classification can be determined by sector by using the Global Industry Classification Standard (GICS). Established in 1999 by Standard & Poor’s (S&P) and Morgan Stanley Capital International (MSCI), the GICS classifies equities listed on the stock market around the world.

The sector classification of the companies gives you an overview of the whole market’s performance.

The Real Estate sector added recently to the list in 2016, shows the progressive nature of GICS. It’s willing to adjust to meet the changes in the economy and recognize real estate as a growing sector separate from Financials.

Regarding investing, if you’re more conservative, look for stocks with prices that tend to be stable, low volatility and pay high dividends.

Look at sectors in:

  • Healthcare
  • Utilities
  • Consumer staples

Those investors who are more zealous, you should go for sectors that show more volatility:

Consider these sectors:

  • Energy
  • Information technology
  • Financials

Stock Market Indexes or Indices

Indexes, also called indices, track how groups of stocks fluctuate in price and the effects it has on the economy. Two of the most well-known indexes are the S&P 500 and Dow Jones Industrial Average (DJIA). You’ll hear them referred to as just the stock market.

With only 30 companies, the DJIA is much smaller compared to the S&P 500. Nonetheless, both are broad sectors. But there are all kinds of indexes available and some cater to a particular industry or sector.

Indexes are groups of stocks, so they are not separated and traded like individual stocks. Trades are made by way of exchange-traded funds (ETFs) or on the futures markets.

Investors can trade indices indirectly via futures markets, or via exchange-traded funds (ETFs), which trade like stocks on stock exchanges.

Market Indexes

Investors can measure stock with two different types of market indexes.

Market-cap Weighted Index

This type of index measures capitalization-weighted (market-cap weighted). It takes into account the total outstanding shares’ market value. This figure changes daily since all it needs is for one stock to change its price within the index.

Price-weighted Indexes

Other indexes such as the DJIA, NASDAQ Composite, and the S&P 500 are price-weighted.

The formula is:

Sum of stock prices for every member /(divided by) number of members = price-weighted index

A variety of other indexes in different countries also use market indexes as well.

Getting Started is Simple

To begin:

  • Open a brokerage account
  • Deposit a small amount, say between $500 and $1000 to start with.
  • Determine your investment goals.
  • Research the market.
  • Go for it.

Investing sooner rather than later is the best way to experience how the stock market works. Start today.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on TheTokenist.io. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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