How Does the Stock Market Work?

Quick Answer

The stock market allows investors to buy and sell shares of publicly traded companies. If the value of a company increases, shareholders can profit. But if the value declines, shareholders could lose money.

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The stock market is the system investors can use to buy shares of publicly traded companies. If the value of a company grows, anyone who owns shares (or stock) in it stands to profit. The opposite is also true: If the value declines, shareholders could end up losing money.

While risky, stock investing can be a powerful way to grow your assets and increase your wealth over time. Still, just 58% of Americans report owning stock, according to a recent Gallup poll.

Let's unpack how the stock market works in simple terms. Understanding it can empower you to make decisions to help you reach your financial goals.

What Is the Stock Market?

Just like the housing market, the stock market involves buyers, sellers and prices that go up and down. It's an abstract term that refers to the way investors can buy into public companies that are listed on stock exchanges. A private company "goes public" through an initial public offering (IPO). That signals that it will begin offering stock shares to the public.

Going public allows companies to raise capital to fund business operations and ultimately grow. By doing so, they're giving up slices of equity: Buying into a public company gives shareholders a partial ownership stake. If the company's value goes up, that's good news for shareholders because they could turn a profit.

Stock prices are volatile by nature and constantly in flux. Lots of factors influence stock prices: Economic conditions, political events, company earnings and industry shake-ups can all move the market up and down. If you sell stock for more than you paid for it, you'll net a profit if your gains outweigh your tax liability. If stock prices are dropping, you might decide to sell and cut your losses.

What Are Stock Exchanges?

Stock exchanges are marketplaces that allow you to buy and sell stocks. The New York Stock Exchange (NYSE) and the Nasdaq are the two dominant stock exchanges in the U.S. Every exchange has its own requirements that companies must meet to list their stock. The NYSE, for example, requires a minimum share price of $4 for an initial listing. In addition, the market value of a company's publicly held shares must be at least $40 million, though some listings require $100 million.

How Do You Buy and Sell Stocks?

There are several ways to begin investing in the stock market. You can choose which type of account you'll use for investing and whether to invest in individual company stocks or mutual funds and exchange-traded funds (ETFs), which group entities into a single fund.

  • Contribute to a retirement account. If you have an employer-sponsored 401(k), you may be able to buy and sell individual stock shares. In addition, 401(k)s typically allow participants to invest in other assets like bonds, mutual funds and more. Some individual retirement accounts (IRAs) also allow for individual stock purchases, though most are made up of funds.
  • Open a brokerage account. A brokerage account lets you invest in all kinds of securities, including individual stocks. The brokerage firm simply executes your stock orders on your behalf. Bonds, mutual funds and ETFs are usually on the table as well. Brokerage accounts have no contribution limits, and investors can access their money whenever they need it (tax consequences aside). Some brokers allow investors to buy fractional stock shares based on how much money they want to spend. For example, if you want to invest $50 in a stock that's trading at $100 per share, you'll get 0.50 shares.
  • Partner with a robo-advisor. Robo-advisors use algorithms to invest in the stock market for you. You'll likely fill out an online questionnaire regarding your income, assets, risk tolerance, investment timeline, financial goals and more. The platform then automatically makes investments on your behalf, usually in funds that hold a variety of assets. However, you probably won't be able to select your investments or buy individual stocks.

One word about day trading. While popular, it's an extremely risky investment approach that can lead to significant losses. Day traders actively buy and sell securities within the same day. The goal is to cash in on daily price movements in the stock market. Research from the University of California suggests that only 1% of day traders are able to predictably make a profit after fees. Many use leveraged capital, which only dials up the risk. This involves borrowing money from a broker to purchase more stocks. It could amplify an investor's losses if things don't go as planned.

How Are Stock Sales Taxed?

If you sell stocks for more than you paid, you can expect to be taxed on those gains. The same goes for dividends you may have earned. These are regular payments certain companies make to shareholders to distribute some of its profits. The amount you're taxed on stock sales depends on how long you held the stock, your income and your tax filing status.

If you keep the stock for less than a year, you'll encounter short-term capital gains. This is taxed as ordinary income. Long-term capital gains tax is more favorable, which is why holding stocks for a year or more can make financial sense.

Investors who sell stock for less than they paid might be able to report the loss on their tax return. This could reduce their overall tax liability.

Risks of Stock Investing

For the past century, the stock market has produced an average annual return of around 10%. But the truth is that investment returns are never a sure thing—and individual stock picking is especially risky. Who can say for sure which stocks will do well and which won't? Trying to time the market to buy and sell at the exact right moment is virtually impossible.

There are safer ways to get involved in the stock market. Mutual funds and ETFs allow investors to use a single purchase to invest in a pool of securities. Instead of buying individual stocks, you can buy into a wide range of holdings. This provides built-in diversification. Diversifying your investments is a way to mitigate risk. If all your money is in one stock, industry or sector, an unexpected market dip could tank your portfolio.

How Does the Stock Market Affect Your Finances?

Even if you don't see yourself being a very active investor, it's still important to understand the stock market. It's one part of an overarching financial system that affects everyday Americans. Fluctuations can impact everything from your job stability to your retirement accounts. When companies generate capital by selling stock, it fuels growth and expansion, which can create more jobs. As the market swings up and down, you'll likely notice your investment accounts reacting in kind.

The Bottom Line

The stock market is a primary way to invest in publicly held companies and can help you build wealth over time. It's risky by design, but diversifying your portfolio and leaning on investment vehicles like ETFs and mutual funds can help mitigate risk. In the end, the best investment strategy is one that's based on your retirement horizon, goals and risk appetite.

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