Stock markets were created in the Middle Ages in Europe as venues where businesses could sell ownership stakes in exchange for capital to fund expansion. In turn, stock markets also served as physical locations where investors could trade shares with the goal of buying a claim on a company’s earnings to make a profit.
In the United States, the first stock exchange opened in 1790 in Philadelphia and two years later the predecessor to the New York Stock Exchange (NYSE) was established. For centuries trading was done in person by brokers. Although trading now is electronic, the stock market today functions in much the same way as 500 years ago.
Understanding the stock market
The stock market is the term for all the trading activity among stock exchanges; the stock exchange is the platform on which the stocks trade. Stock exchanges are securities marketplaces where stockbrokers and traders buy or sell securities. These securities can include stocks, derivatives, bonds, or pooled investments such as mutual funds, hedge funds, and exchange-traded funds (ETFs).
What is a stock?
A stock, or equity, is a security that represents an ownership stake in a corporation. Companies first issue their shares in an initial public offering (IPO). In an IPO, a company divides itself into a certain number of shares and sells some of them to the public. Investors who buy a company’s shares own a portion of the company.
How does the stock market work?
The stock market is a place where buyers and sellers meet to trade securities—most often, equity shares of public companies. The funds a company raises from selling stock allow it to expand.
Stock exchanges work as primary and secondary markets, with companies raising initial funds via IPOs in a primary market and stocks thereafter trading on the secondary market.
Once a company lists publicly, investors can then buy and sell the shares among themselves. Buyers often endeavor to buy a stock at a low price and sell it at a higher price for a profit later. When they own company shares, they are anticipating that the value of the stock will rise or that they will receive dividend payments, or both.
Companies must meet certain standards to be listed on an exchange. For instance, the NYSE requires that corporations have 1.1 million publicly traded shares with a market value of at least $100 million, and a minimum listing price of $4 per share, to qualify. If a company falls below the standard, they’re at risk of being delisted from the exchange.
Stock exchanges are often ranked by their market capitalization, which is the sum of the valuations of all listed companies. Market cap is simply the number of total shares of a company multiplied by their current market price. The New York Stock Exchange is the world’s largest, with a market cap larger than the Nasdaq, Tokyo Stock Exchange, and London Stock Exchanges combined. The world’s 10 largest stock exchanges in order of descending market cap as of June 2022 are:
- New York Stock Exchange (NYSE)
- Shanghai Stock Exchange
- Japan Stock Exchange
- Shenzhen Stock Exchange
- Hong Kong Stock Exchange
- National Stock Exchange, India
- Toronto Stock Exchange
- Frankfurt Stock Exchange
How are share prices set?
Stock prices are determined by the forces of supply and demand. The market reflects investors’ confidence in the economy and expectations of future corporate profits. Buyers bid on a stock at a certain price and sellers indicate the price at which they’re willing to sell. When the prices match, a market maker or some other matching service completes the trade. If demand for a stock exceeds the number of shares available, prices go up, and when more investors are looking to sell, prices fall.
Participants in the stock market
Many people and institutions participate in the stock market. They include:
- Investors. Individuals and financial institutions that invest in publicly listed companies. Retail investors are small, individual investors who invest directly in the stock market. Institutional investors such as banks, pension funds, asset managers, or other financial institutions make investments on behalf of other people.
- Traders. People who buy and sell securities with the goal of profiting from investment strategies that exploit short-term price fluctuations.
- Market makers. Large financial institutions that buy and sell securities to keep the market liquid. When investors want to sell, market makers will buy; when investors want to buy, they will have shares in reserve to sell. They set prices that reflect the supply and demand of the market. Some market makers include Credit Suisse Securities, Deutsche Bank Securities, and Goldman Sachs.
- Stock brokers. Financial professionals who buy and sell stocks on behalf of their investor clients.
- Broker-dealers. These individuals handle trades between buyers and sellers and may offer securities from their own inventory to sell to customers. They trade on their own behalf.
Why is the stock market important?
The stock market fulfills two important functions for companies and investors. It helps companies fund their businesses without having to issue debt, and it gives investors a regulated way to invest in and share in the profits of public companies.
A stock exchange also provides valuable research and pricing information for investors. It publishes company announcements and financial reports which can be accessed by the public.
Regulating the stock market
Stock exchanges in the U.S. are primarily self-regulated. In fact, some exchanges, such as the NYSE, are self-regulatory organizations (SROs), which create and maintain their own industry standards. SROs are privately owned; however, they are still subject to some regulation by government agencies. The government can also mandate broader policies. This self-regulation and broader oversight is meant to protect investors from fraud and ensure transparency in company listings and transactions.
The Security and Exchange Commission (SEC) also has oversight of the U.S. stock market. The watchdog organization was established as part of President Franklin D. Roosevelt’s New Deal economic recovery program. It ensures that companies follow financial reporting laws so that investors are protected. It also enforces securities laws, issues stock market regulations, and works with the Department of Justice on criminal proceedings.
The SEC gives investors access to financial reporting and SEC registration statements through its Electronic Data Gathering, Analysis, and Retrieval (or EDGAR) service.
Potential benefits and risks of investing in the stock market
Investing in the stock market comes with potential benefits and risks. For an investor looking to invest in the stock market, learning how to research the fundamentals of company’ stocks is a key to being an informed investor.
Potential benefits of investing in the stock market
The stock market has been shown to provide higher returns than other types of investments over the past decades. The average annual return of the stock market from 2002-2021, adjusted for inflation, is about 7%. The market goes through bull and bear phases, and investors who look at the long-term financial benefits of investing in the stock market are better prepared to weather short-term drops in the market.
Besides making money when a stock price rises, investors can also receive income from the dividends that many companies pay out. Additionally, investor funds are liquid—meaning they can quickly convert stocks they own into cash and without penalty.
Risks of investing in the stock market
There is always risk in investing in the stock market. Stocks rise and fall, and investors risk losing money when they buy shares. Those who have a very low appetite for risk or who are focused on short-term gains and losses may want to avoid fluctuations in their portfolio’s value.
Research has shown that investors who pick individual stocks usually don’t beat those who invest in an index fund like the S&P 500 that tracks the overall market. Those who chase returns in individual stocks rather than putting at least some of their investment in an S&P 500 index fund tend to take on more risk of losses.
How do you invest in the stock market?
Investors can enter the stock market in many ways, depending on how hands-on they want to be. An investor could open an online brokerage account and make their own trades. Or they could hire a financial advisor or money manager who can introduce them to portfolio strategies and complete the buy and sell orders for them.
Some investors use so-called robo-advisors, which are low-cost computer-driven investment management services provided by many brokerages that invest money based on the investor’s stated goals. An investor can also choose to put money into a 401(k) or other retirement savings plan and focus on the long-term aspects of investing.
Many investors use a combination of these strategies.
Alternatives to investing in the stock market
There are ways to invest without using public stock markets.
- Cryptocurrency. Crypto is a digital asset that does not trade directly through the stock market, but on a blockchain technology-supported currency exchange. Investors will need to open an account with a crypto exchange, have a so-called digital wallet and fund it with fiat currency to invest in crypto. Crypto appeals to some investors because its performance isn’t directly tied to the wider economy, and exchanges that trade crypto can offer zero-cost services. On the other hand, crypto is not as regulated as financial securities.
- Real estate. Investors can buy investment properties and collect rent; invest in commercial real estate, or in REITs—real estate investment trusts—that own or finance real estate. Like the stock market, the real estate market fluctuates, but the longer-term nature of real estate investment can make short-term fluctuations easier to stomach, and investors can sell when the market for homes seems to be going up.
- Venture capital, angel investing, and other start-up investing. Early-stage companies often seek startup money to fund their ventures. Most startups are owned by their founders, who give up equity in exchange for labor and funds. Venture capital funds raise substantial amounts of money to back startups. But accredited individual investors can also invest in startups. They can buy shares at a fixed cost in a priced equity round, or buy convertible securities, an investment that ultimately converts into equity. Individual investors can also invest via crowdfunding sites, although the SEC puts crowdfunding limits on investors by annual income and net worth.
The bottom line
The stock market performs important functions for companies and investors. It gives companies a way to fund their businesses, and gives investors a regulated way to invest in and share profits of public companies.
The SEC and other regulators work to ensure that companies and investors follow financial regulations and that individuals are protected and have transparent access to companies’ financial reports. But investing in the stock market comes with risk, and the investors best equipped to invest in the markets understand both the risks and the statistical long-term rewards.
The SEC and other regulators work to ensure that companies and investors follow financial regulations and that individuals are protected. Investing in the stock market comes with risk and only the best equipped can avoid them and understand long-term rewards.