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How Does the Stock Market Work?

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0:19 - What is a stock market?

0:41 - What is stock exchange?

3:34 - How do you buy stock?

3:50 - What is an index fund?

You may have heard that investing in stocks can be a great way to create wealth over time, and it's certainly true.

But how does the stock market work?

I’m Dylan Lewis from the Motley Fool and in this FAQ we’re going to answer that question and talk about how you can get into the market.

How does the Stock Market work?

Stocks, also known as equities or equity securities, represent ownership interests in companies. The stocks that are publicly traded are available because those companies decided to list their shares and make them available to public investors.

Stock markets facilitate the sale and purchase of these stocks between individual investors, institutional investors, and companies. There are two components of stock markets -- the primary market and the secondary market.

The primary market. Stocks first become publicly traded through a process known as an initial public offering, or IPO. This involves a company selling shares, or pieces of itself, to investors in order to raise capital and listing their shares on a stock exchange. This initial sale comprises the primary market.

The secondary market. After the IPO takes place, virtually all subsequent stock trades take place between investors -- that is, the company is not involved. Stock exchanges, such as the New York Stock Exchange (NYSE) or Nasdaq, facilitate the buying and selling of stocks between investors.

The vast majority of stock trades take place on secondary markets between investors. That means that, for example, if you want to buy shares of Microsoft (NASDAQ: MSFT) and hit the "buy" button through your broker's website, you are buying shares that another investor has decided to sell -- not shares from Microsoft itself.

And just to take a second to piece it all together -- let’s break down these symbols:

NASDAQ is the exchange that shares of Microsoft are listed on, and

MSFT is the ticker symbol for the company Microsoft

These abbreviations are identifiers that help avoid confusion and uniquely identify a specific exchange and stock.

How are prices determined on a stock market?

Okay, so if investors are constantly buying and selling shares on the secondary market… how are stock prices determined?

Well, the price of a stock is largely governed by the basic economic principles of supply and demand -- plain and simple. At any given time, there's a maximum price someone else is willing to pay for a certain stock and a minimum price someone else is willing to sell shares of the stock for.

Think of the stock market as an auction, with some investors bidding for the stocks that other investors are willing to sell.

If there is a lot of demand for a stock, investors will buy shares quicker than sellers want to get rid of them, and the price will move higher. On the other hand, if more investors are selling a stock than buying, the market price will drop.

Now you might be thinking to yourself -- what if people don’t want to sell shares… how can you buy them?

The market makers

In order to ensure that there's always a liquid marketplace for stocks on an exchange, individuals known as market makers act as intermediaries between buyers and sellers.

Market makers buy and hold shares and continually list quotes to buy and sell shares.

What happens when you buy a stock?

If you want to buy a stock, you’ll have to do it through a broker, or basically someone that is licensed to trade stocks on an exchange. A broker may be an actual person who you tell what to buy and sell, but in today’s day and age it’s probably an online broker that processes the entire transaction electronically.

Often, when discussing the stock market, people generalize "the market" to a stock index. Stock indexes, such as the S&P 500 or Dow Jones Industrial Average, are a representation of the performance of a large group of stocks (but often not an entire stock exchange) and are often used as a benchmark to compare the performance of individual stocks or an entire portfolio.

For example, the S&P 500 index tracks the performance of 500 of the largest publicly traded companies in the United States.

Indexes are a convenient way to discuss an approximation of what is happening in the market, but they do not fully represent the entire stock market.

Getting into “the market”

The beauty of a stock market index like the S&P 500 is that they aren’t just a measure of how stocks are doing, they can also be a way for folks that are new to investing to easily put their money to work.

For folks that are looking to get into the market for the first time, we recommend doing exactly that. Look for an ETF or mutual fund that tracks the S&P 500 and boom, you’re immediately a part owner in 500 of the largest publicly traded companies in the U.S.