Over the years, I have been asked by young people and old people alike, “What is the stock market? And how does it work?” What most who ask me this question don’t realize is that, truly, they are asking an incredibly complex question. So, today, we are going to break the stock market down into as simple of a definition as possible and then attempt to explain how it works.
As a most basic definition, the stock market is any place where two or more individuals come together to exchange ownership in a public company, or companies, by trading “shares” in that company. A share represents one unit of voting power within that company, and the person who holds it can attend shareholder meetings and vote on policy for the company. It also usually entitles the holder to receiving a portion of the company’s earnings, which are called “dividends”, but this is not always the case.
Of course, there are legalities involved in exchanging shares in a public company. As a result, each country has a governing body that determines how and where the trading of these shares can take place. In America, this ruling body is the Securities and Exchange Commission (SEC). The SEC only allows certain groups called “broker-dealers” to facilitate the trading of these shares. Examples of broker-dealers include Schwab, Fidelity, Ameritrade, and others.
The second most common question that I get is “What is a stock index and how does it work?” The answer to this question is a little more complicated. Basically, there are different sectors for stocks. For example, there are energy stocks, industrial stocks, retail stocks, large-cap stocks, small-cap stocks, and there are many other “dividers” that we call sectors.
An index attempts to take a couple of stocks from each sector and use those as a representation of how the entire sector is performing at any one period. For example, the Dow Jones Industrial Average (DJIA), which is one of the largest US stock market indices, takes the 30 largest companies within the US and allows people to view their performance as an indicator for how the US economy is doing as a whole, since the 30 largest companies’ performance should be fairly representative of total US outlook.
The third most common question, then, is “why is the stock market (usually meaning the US stock market) performing so poorly or so well?” This question’s answer is directly linked to the performance of the companies that make up the stock market. If each company that makes up the stock market is increasing sales, generating greater revenue each year, and actively innovating, then the US stock market will undoubtedly increase in price. On the other hand, if US companies are not (on average) performing well year after year, it is likely that the price of the US stock market (which is usually measure by the S&P 500 Index) will decrease.
Of course, there are a wide variety of international factors that can affect domestic stock market performance as well (such as wars, natural disasters, poor international economic news, etc.), but these only do so by affecting the projected performance of US companies as they are affected by this news.
We hope that this explanation of the stock market has served to improve your understanding of how the market works, as well as given you some insights into what the surrounding terminology means!