- Different types of stock markets are available, although all trade shares from public companies.
- Common and preferred types of stock offer different benefits and disadvantages.
- Before investing, it’s important to consider the potential risks and benefits of different investment strategies.
A recent Gallup survey found that less than a third of Americans between ages 18 and 29 owned shares of stock, meaning a vast majority of millennials are potentially missing out on capital gains.
If you’re new to investing, one of the first things to master is this: How does the stock market work? How do investors make money? The following guide will help those who would like the knowledge and confidence needed to buy stock.
What Is the Stock Market?
The stock market is a public marketplace that allows customers to buy and sell shares of companies. According to Nasdaq, one of the primary stock markets in the United States, the term “stock market” is incorrect because it implies that there is only one such marketplace. There are actually numerous stock markets both in the United States and around the globe. The two most popular markets in the United States are the New York Stock Exchange (NYSE) and the Nasdaq.
How Does the Stock Market Work?
Publicly traded companies make up these exchanges. Daily stock trading — a fancy term for “buying and selling at an agreed upon price” — impacts the share prices for each one of these public companies. Because there are there can be thousands of companies listed on these markets, experts commonly look at “indexes,” which are averages of stock prices on the market.
These indexes provide investors with a glimpse of the performance of the market. Three of the most common indexes are the:
- Dow Jones Industrial Average
- S&P 500
- Nasdaq Composite
The Dow Jones Industrial Average (DJIA) tracks 30 of the largest publicly owned companies listed on the NYSE and Nasdaq. The Dow calculates its price by taking the prices of the 30 component stocks and then dividing them by the Dow Divisor, a figure that accounts for structural changes within a company (such as if they begin offering another class of stock).
The S&P 500 tracks the 500 largest publicly traded companies in the United States and weights them based on market capitalization. Market capitalization refers to how much a company is worth. You can calculate market cap by multiplying the price per share times the total number of shares outstanding. The Nasdaq Composite is another weighted market-cap index that tracks all 3,300 common equities on the Nasdaq exchange.
As we’ll detail below, investors can purchase single stocks from various companies on these exchanges. Or, instead of figuring out which individual stocks they should invest in, investors could instead purchase an index funds. Index funds are designed explicitly to match the performance of the various financial market indexes.
What Types of Companies Are Listed on Stock Markets?
Every company in the United States is either “private” (held in private ownership) or “public” (portions of the company can be owned by individuals or entities in the general public). Regardless of whether they’re public or private, companies can sell a fraction of the company by releasing shares of stock. Offering stock allows companies to raise money to meet its business goals.
Only public companies are listed on stock markets. Companies must first meet the listing requirements for the market in which they wish to sell stock. For instance, the Nasdaq requires companies to have at least 1.25 million publicly traded shares, not including those held by the executive board. The minimum bid price, the price a buyer would be willing to pay, must be at least $4 per share.
If companies can meet these and other requirements, they may be allowed to proceed with the initial public offering, also known as an “IPO”. The initial public offering lets investors buy and own stock in newly issued stock in a company that is opening its ownership to the public for the first time. Company shares that have already been purchased can still be bought and sold many times over.
Types of Stocks
Not every share of stock is the same. The two most prevalently owned types of stocks are common stock and preferred stock.
As the name indicates, common stock is the most popular type of stock available and is key to understanding “How does the stock market work?” Common stock is what provides investors with fractional ownership in a company and yields earnings if the company chooses to grant dividends. Common shareholders are also granted the rights to vote on important company matters including the directors that serve on their Board. Typically, the number of votes that an investor has is a 1:1 ratio with the number of shares that they own.
Owners of common stock are the last to be paid in the event things turn badly for the company, behind lenders and preferred stockholders (more on preferred stock below). As such, common stock is typically one of the riskiest positions to take. However, over time and if the company’s prospects and prosperity grow, the value of company stock also grows. Owning common stock tends to yield the highest rates of return and is one of the best ways to increase net worth.
Preferred stock also provides investors with ownership in a company. In contrast to common stock, preferred stock provides investors with fixed dividends whereas a company has no obligation to pay dividends to owners of common stock. And, if a company were ever to dissolve, preferred stockholders are given priority to receive payouts before common stockholders. For this privilege, however, shareholders are generally not given voting rights if they own preferred stock.
Bear vs. Bull Markets
If you’re reading or watching investment news, you’ll commonly hear terms such as “bull market” and “bear market.” Analysts use these terms to describe the stock market outlook broadly.
If the stock market is rising or has risen, then analysts will refer to it as a bull market. “Rising” means that the prices of shares have been increasing for some time as a sign of investors’ optimism in the state of business and the economy. During a bull market, investors can expect the values of their shares to rise, just as “a rising tide lifts all ships.”
If the stock market is or has been declining for a prolonged period, then analysts will refer to it as a bear market. During a bear market, values of shares decline or stagnate as a reflection of investors’ low or negative expectations for business and the economy, and many investors may sell shares to cut their losses, therefore contributing to the downward spiral.
With a better understanding of “How does the stock market work?”, you can take the time to understand the various types of investment strategies available. Typically, there are two broad investment strategies — active and passive.
Active Investment Strategy
As its name indicates, an active investment strategy is one that involves a much more hands-on approach. A specific individual researches the companies, establishes an investment criteria, oversees the brokerage account and is responsible for buying and selling stocks.
Because the average person does not have the technical knowledge, time, or resources available to manage a portfolio, funds are typically turned over to a financial advisor.
Some people believe that an active investment strategy is worthwhile because it can allow investors to take advantage of short-term price fluctuations or buying opportunities to beat the average market return. Other people argue that it’s practically impossible to beat the market, that active investing is costly due to transaction expenses, and that it makes much more sense to take a more passive approach.
Active traders risk not timing a trade properly, missing out on a potential ceiling or floor. Trading expenses for an active trader can be sky-high because of the multiple trades. So, not only do they have to outperform the market, but they must also make enough to cover their fees. Trading fees can range from $4 to $15 per trade.
Passive Investment Strategy
A passive investment strategy is one that is much more focused on the long-term. These investors take much more of a hands-off approach and don’t concern themselves with everyday fluctuations in the market. Instead, they believe that the market will grow over time, which is why many of these investors have a “buy and hold” mentality. If you’re in the market for the long haul, you’ll mitigate much of the risk associated with the market.
A passive investment strategy could also save investors money because they aren’t engaging in nearly as many transactions and don’t have active trading expenses.
Passive investing strategies don’t necessarily involve just buying and sitting on one particular stock, either. Instead, they are much more concerned about capturing the performance of the market as a whole. Passive investing strategies typically means investing in things such as mutual funds and exchange-traded funds (ETFs) that track a specific index (such as those mentioned above), and ready-made target portfolios that meet an investor’s goals.
Determining Which Strategy Is Right for You
For most millennials who are new to the stock market, a passive investment strategy might be the most accessible approach, especially for long-term savings. Actively managing a portfolio requires a lot of technical knowledge about the stock market. The bottom line is that even experienced stock market experts rarely outperform the market over long periods of time.
Having said that, there is no black-and-white answer when it comes to choosing an investment strategy. Evaluate your financial goals and perhaps consult with a wealth management or financial advisor to select a plan that best fits your expectations, whether you’re saving for retirement or for a down payment on a new home.
Robo-advisors are investment platforms that have caught the attention of millennials due to their ease of use.
As with human financial advisors, you indicate your financial goals and answer a questionnaire that allows the robo-advisor to determine your tolerance for risk. Then, you’ll be directed to a portfolio based on the robo-advisor’s investment policies that matches your financial goals.
The portfolios are managed by algorithms and can include both active and passive strategies, although you won’t be in charge of the day-to-day transactions. These platforms don’t allow you to choose individual stocks that you’d like to invest in, although some will enable you to specify companies that you would prefer not to invest in. The fees for using a robo-advisor are typically lower than or comparable to those associated with financial advisors because of automation and the lack of one-on-one support.
No matter how you invest, it’s critical that you consider your goals and strategy — and stick with them. It’s easy to get caught up in the latest hype when you turn on the TV. Don’t get sucked into the “latest and greatest” stocks, as speculation can often turn into bubbles that one day burst or go nowhere at all. You’re better off making sound, well-researched investments that align with your goals rather than listening to the noise on TV.
Ready to Get Involved in the Market?
Now that you have an answer to “how does the stock market work” and fundamental investment strategies, you might be ready to invest in stocks. Be sure to check out our guide to investing in stocks as well as our guide to the top 15 robo-advisors to help you get started.