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How does the stock market work? – Benzinga

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The U.S. stock market is now collectively worth $30 trillion. It holds the accumulated retirement wealth of multiple generations, the hopeful investments of individual investors, and the portfolios of massive institutional powerhouses. The majority of Americans are invested in the stock market in some way, although participation in the stock market is still down since the lead-up to the 2008 Great Recession when 62 percent of Americans were invested.

About 40 percent of the stock market is owned by household investors who buy shares of individual companies. To own stock in a company is to own a piece of it, a share. Unsurprisingly, buying and selling shares of individual companies is more common for investors with more disposable income.

Many other investors are not active investors, instead of participating in the stock market in a more passive or even peripheral way by owning mutual funds or exchange traded funds (ETFs) that tend to be the preferred investment vehicle for 401(k)s and IRAs. Mutual funds create an extra layer wherein the fund buys stocks individual stocks and the investor buys shares in the fund.

What is the stock market?

A market is a place to buy and sell and the stock market is no different, except that the quantities changing hands are sometimes massive and that shares in companies and funds are primarily what’s being exchanged. Going back to their origins, stock markets were physical buildings where stock trading took place, complete with frenzied running to place orders amid a scattered confetti of “ticker tape” and deafening crowds of screaming traders. Most trades are done electronically now, allowing for a more efficient market despite its growth over the years.

We commonly refer to the stock market as though there’s only one, but there are many stock markets that make up the overall U.S. stock market, sometimes called exchanges. Many of these exchanges have become household names themselves, such as the Nasdaq Exchange (NASDAQ) or the New York Stock Exchange (NYSE), with its 2,400 traded companies representing about two-thirds of the total U.S. stock market by value.

Stock shares, ownership, and initial public offerings (IPOs)

Companies can be either public or private and both types can have shares — but a public company has its shares publicly traded, usually on a stock market exchange.

Public companies that aren’t listed with an exchange are still traded, but they are traded either as OTCBB (over the counter) if they don’t meet the listing requirements of NASDAQ or the NYSE, or they might trade as “Pink Sheets”, named after the pink slips of paper on which the stocks used to trade. Pink sheet stocks are usually comprised of companies that are too small to be listed on a national exchange or don’t wish to make their accounting public.

A publicly traded company issues its first shares during an Initial Public Offering (IPO). The revenue from these shares is usually used for growth plans and other expenses. Growth in the number of shares after the IPO is often due to stock splits, which are a tool companies use to lower the per-share price without reducing the value of investors’ holdings. If you had invested $5,000 in Apple at its IPO, you’d have over $2 million today and you’d have over 50 shares for every one share you bought at the IPO, the latter due to stock splits.

A share in a company is ownership in the company. However, owning a handful of shares doesn’t earn a seat at the boardroom table. Apple, for example, has nearly a billion shares after beginning an aggressive buy-back program that reduced the number of outstanding shares.

Ownership may come with other benefits, though. Many companies pay a dividend on their shares. When the company does well and decides to fund its dividend, investors are paid a dividend for each share, allowing investors to benefit from any growth in the value of the stock as well as earn a bit extra for their ownership. These dividends can be taken as cash or they can be reinvested. Most references to historical stock market performance include income from dividends as well as stock value appreciation.

What is an index?

Stock market indices are just groupings of stocks that share common traits or that meet the criteria to be included in the index. Indices can be based in part on market capitalization, which is the total value of all outstanding shares. Indices can vary in company type ranging from a broad spectrum, like the S&P 500, to indices heavily weighted in a certain segment, such as the NASDAQ Composite Index, which has a strong representation of tech stocks.

The larger indices serve as a bellwether for the overall stock market, often driving investor sentiment up or down with each change in the index’s value. Most often, it’s the Dow Industrial Index, made up of the 30 largest and most influential companies, and the S&P 500 that make headlines on the nightly news, demonstrating how an index can come to represent the broad market.

What is a broker?

If you want to buy a share of stock or sell a share of a publicly traded company, you’ll need a broker to help you complete the transaction. Stock brokers are individuals or firms that execute buy or sell orders at your request. In exchange for executing your trades, the broker collects a commission or a fee.

Brokers can be either discount brokers or full-service brokers, with each type catering to a different type of trading. A discount broker executes trades inexpensively, typically charging between $5 to $15 per trade, but usually doesn’t provide personalized guidance for its least-expensive trading services. Full-service brokers offer a more comprehensive variety of services, often including investment advice. The higher level of service provided by a full-service broker usually means higher fees.

Before the advent of discount brokers, stock trading was largely a pursuit for more affluent investors who could afford a full-service broker. The internet can be credited with changing that paradigm, making stock trading easily accessible to anyone with an internet connection and a desire to invest.

For more information about the best online brokers, check out Best Online Brokerages on Benzinga.

Bids and asks

As you begin to learn about stock market investing, you’ll encounter the terms “bid” and “ask”.

The bid is the price a buyer is willing to pay for a stock, while the ask is the price at which a seller is willing to sell. If you wanted to buy a stock at $10, you can place the order with your broker to buy a fixed number of shares at that price. However, if nobody is willing to sell for that price, the trade won’t be executed. There is also the option to buy or sell at “market” price, which usually results in a faster transaction.

In smaller markets, like OTC trading, a market maker helps to facilitate trades by buying shares offered for sale and then posting those shares for sale again. This is particularly useful  when the spread between the bid and ask is wide and a stock is thinly traded, meaning there aren’t many buyers or sellers.

Trade dates vs. settlement dates

Stocks and exchange traded funds (ETFs) are subject to a settlement date after they are sold. Trade dates are relevant for tax purposes because they can lock in a taxable gain or loss for a given tax year. The trade date is the actual date of the trade. Settlement dates are a bit trickier.

A sale of a stock or ETF doesn’t settle until three days after the trade date. In most cases, this isn’t a big issue, but if you have a cash account and immediately reinvest the funds from the unsettled funds, you can’t sell that new stock until the old trade has “settled.” Violations of this SEC rule are called “free riding.”

Mutual fund trades and options settle in one business day.

What makes stock prices go up or down?

Stock prices can move up or down based on a number of reasons, but at the heart of it is a the age-old notion of supply and demand. The supply is simply the number of shares available at a given price and the demand is the number of shared wanted at a given prices. If there are more buyers than sellers, the price will go up — and vice versa.

If you look solely at the numbers, there can also be a disconnect between the price of stock and what its fundamental value suggests the stock is worth. Usually, this variance is due to investor sentiment in regard to that company.

Amazon’s stock trades at a price to earnings ratio that’s dramatically higher than either the S&P 500 or the Nasdaq, indicating that investors have high hopes for the future of the company. On the other side of the equation, many investors have become wealthy by searching for undervalued stocks, often trading below the price to earnings levels of similar stocks — but not always. Sometimes all it takes is successful execution on a new idea to propel a company’s earnings and stock price upward. Price to earnings ratios are just part of the story, as is price itself.

External influences, like economic or employment news, can also move markets up or down, creating opportunities on either side of the trade as investors buy or sell according to their own needs or strategies.

Historical stock market performance

Many investors have been successful in short-term trades but short-term trading often requires keeping a vigilant watch on prices, news, and trends. Some of the most successful investors have made their fortunes with long-term investing. The past 35 years have seen the Dow rise from 2,500 to 25,000 when adjusted for inflation. However, the 30 year period prior to that saw the Dow triple in value only to end the 30-year run virtually unchanged.

As the saying goes, timing is everything. Many investors and investment experts tout a 7% average annual return from stock market investments, looking at the broad market’s performance. Stock market performance measurements depend on the time frame, as demonstrated in the earlier examples of Dow performance, but over the long run, it’s clear the stock market’s direction has been upward.

Tax treatment of investment income

Income from stock investing can be particularly attractive because of the tax treatment of investment gains. For investments held longer than a year, gains are treated as long-term capital gains and taxed at a range of zero percent, 15 percent, or 20 percent, depending on your normal tax bracket. The capital gains rates are considerably lower than the respective normal tax brackets corresponding to each capital gains tax level between zero and 20 percent.

Investments held less than a year are subject to normal income tax rates and are treated as normal income. IRA and other retirement investments are taxed according to the rules for each type of retirement account.

Dividends can be taxed as normal income or can be treated similarly to long-term capital gains, provided the dividend meets a list of qualifying criteria including meeting holding period requirements.

For detailed tax information, check out Benzinga’s What are Capital Gains Taxes? 

Final thoughts

Once upon a time, stock market investing was risky business for all but the most disciplined of investors. While there are still ways to lose money, today’s investor has many more tools at is or her disposal to understand values and trends, making modern investing less of a gamble.

The availability of ETFs with low expense ratios offers to take the difficult decisions out of investing — at least for part of your account — allowing more freedom to experiment with the rest of your investment account.