Financial Planning

How Does the Stock Market Work?

By understanding how the stock market works, you can make better investment decisions. An easy way to understand the stock market is to know why it exists, who it serves, and how it works.

How Does the Stock Market Work?

Why should you learn about the stock market? Because having a better understanding of the stock market and how it works can help you make better investment decisions. Fortunately, learning about the stock market can be a simple process, and with a little explanation, you can begin to understand the basic concepts of the stock market. The stock market is perhaps the most visible symbol of capitalism in America today. Millions and millions of dollars' worth of securities trade in the stock market every day. Pensions, institutions, corporations and individual investors all vie with each other to get their trades filled at the best prices possible. But how does it all work?

The stock market dates back to the Revolutionary era when merchants started trading securities under a buttonwood tree on Wall Street. This exchange slowly grew in size and complexity over many decades until it became the worldwide bastion of commerce that it is today. But while the technology that drives the markets has changed dramatically since its inception, the fundamental principles that the market operate upon have remained largely unchanged. The stock market still basically functions as a place where buyers and sellers converge to exchange money for securities in an orderly fashion.

The persons who make an orderly market in stocks are known as market makers, and they are the ones who actually facilitate the trades that happen on a daily basis. Orders are filled on a first-come, first-serve basis, and as with any other type of good, there is a wholesale price, known as the bid price, and the ask price, which is the retail price for the stock or bond. Some buyers and sellers are willing to buy or sell their shares at whatever the current bid or ask price is. They must therefore place a “market” order, which will execute at whatever the current price is when it is their turn for their order to be filled. The market maker gets to keep the difference between the bid and ask prices as compensation for providing a market.

Protective Life Insurance Company does not recommend or endorse any particular investment option, and does not provide investment advice. Neither Protective Life nor its representatives offer legal or tax advice. Purchasers should consult their financial advisor, attorney or tax advisor as needed regarding their individual situation.

Why do we need the stock market?

Companies can begin public trading by hosting an Initial Public Offering (IPO) that will be issued at a set price. The company gets to keep the money that is raised from the offering, and the IPO stock price is partly determined by dividing the estimated worth of the company by the number of shares being offered. Once the company's stock begins trading on the exchange, its price will be determined by the laws of supply and demand. If the company performs well, then its share price will probably increase over time. But there are many different forces that determine the price of stocks and bonds that trade in the markets, and no one person or group fully understands all of them. Many financial analysts and portfolio managers try to predict how the markets will behave, but no one can always do so with 100% accuracy.

Let's say you have a company and needed money to expand. Typically you'd have only two ways to raise money to expand the business. You could take out a loan, but that accrues interest. Another option could be to find investors who would give you money in exchange for a share of the ownership in your company. Why would anyone want to give money to someone else's business? Because if they think you have a good idea and that your business may be profitable, they're expecting to see a return on their investment.

But where do you find investors? And where do investors go to shop for companies in which to buy shares?

This is where the stock market comes in.

Where do you find investors?

Investors can be found just about anywhere: online, in a newspaper, or by asking family and friends. But what if your business isn't doing as well as you anticipated? Not only would this make it difficult for you to find investors, but make it harder for current investors to sell their shares of stock. The truth is at any time, some or even all of your investors may decide to sell their shares of stock. But to do this, they would need to find a buyer. And for a company that isn't performing well, this can be a big problem.

Enter the stock exchange “supermarket"

The New York Stock Exchange (NYSE), for example, solves this problem by giving investors a convenient, one-stop place to buy and sell shares of stock. The NYSE can be thought of as a “supermarket” where everyone who wants to buy and sell shares of NYSE-listed stocks can go. In the United States there are also other stock exchanges such as the National Association of Securities Dealers Automated Quotations (NASDAQ).

Today's stock exchanges make buying and selling easy and don't require traveling to meet a seller under a buttonwood tree on Wall Street in New York. Either you can contact a stockbroker or you can submit your trades online (typically for a fee). If these exchanges didn't exist, buying and selling stock would be much more complicated. Just think about having to place ads for buyers, waiting, and then negotiating on a price every time you wanted to sell stock. With the stock exchanges, you can buy and sell shares instantly.

And while nothing can be completely guaranteed in the stock market, investors who diversify their holdings in the markets and hold them for the long term tend to have a better chance of making money than those who buy and sell random securities in the short term hoping to “strike it rich”. However, there are also many experienced traders who make a great deal of money doing just that. There is no one “right” way to trade securities, but careful consideration of investment choices should always be applied.

Getting more information

Sure, the stock market can be intimidating. But a little information and research can go a long way to help ease your fears. If you have questions regarding investing in the stock market, be sure to work with a qualified, licensed investment professional.

For more information on money management, visit our learning center.

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Stock Market

The stock market can be intimidating for beginning investors wanting to get started. This article explains the fundamentals of how a stock market works. For more information, visit our learning center.

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All Learning Center articles are general summaries that can be used when considering your financial future at various life stages. The information presented is for educational purposes and is meant to supplement other information specific to your situation. It is not intended as investment advice and does not necessarily represent the opinion of Protective Life or its subsidiaries.

Learning Center articles may describe services and financial products not offered by Protective Life or its subsidiaries. Descriptions of financial products contained in Learning Center articles are not intended to represent those offered by Protective Life or its subsidiaries.

Neither Protective Life nor its representatives offer legal or tax advice. We encourage you to consult with your financial adviser and legal or tax adviser regarding your individual situations before making investment, social security, retirement planning, and tax‐related decisions. For information about Protective Life and its products and services, visit www.protective.coma>.

Companies and organizations linked from Learning Center articles have no affiliation with Protective Life or its subsidiaries.

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