Stock markets – A beginner’s guide

Investing in stock can be a great way to increase your wealth, but it is not without its pitfalls. In this article, we set out to explain, in plain English, just what the stock market is, how it works, and more importantly, how to make it work for you.

We will cover the basics of stock, stock markets, stock exchanges and stock indexes. If you have ever thought about investing in shares but did not know where to start, this article will give you a complete grounding in all aspects of the stock markets.

Just what is stock and the stock market?

A stock market is just exactly how it sounds, a market in which the product being traded is stock.

Stocks are often referred to as equities or publicly traded companies. These stocks become available for purchase when a firm decides to make shares in the company available to private investors. Effectively what you buy when you purchase stock is part ownership of the issuing company.

Once a company has decided to go public and sell shares in their company then they are listed on the stock market. The stock markets then expedite the sale and purchase of these stocks.

Three main market segments will trade in stocks.
  • Individual Investors
  • Companies
  • Institutional Investors
It is between investors that most trading occurs. For instance, if you decide you are going to buy Acme Widget shares, it is unlikely that you are buying shares directly from Acme Widgets, but rather an investor who is selling their own stock in the company.

There are also different categories of stocks to consider, it is impossible to cover them all in an article with this scope, but some major ones are listed below.
  1. Common Stock – As the name suggests, this is the most common stock that people invest in. Buying common stock gives you partial ownership of the company whose shares you bought. Common stock carries the risk of losing all your investment should the company fail.
  2. Preferred Stock – The big difference between common and preferential stock, is that preferential stock owners have a preference over common stockholders to recoup some of their investment should the company fail.
  3. Domestic and International Stock – This is simply a categorization that differentiates stocks by their location.
While these are some major types of stocks there are many other types including Large-cap, Mid-cap, and Small-cap Stocks, growth stocks, dividend stocks, and IPO stocks to name a few.

What is a Stock Exchange?

Whereas the stock market is the process of buying and selling stocks, a stock exchange is an actual place where the buying and selling take place. This intermediary is where the connection between buyers and sellers is made.

The buying and selling in stock exchanges are done through ‘Market Makers’ (which we cover in more detail a little later in the article). The largest stock exchange is the New York Stock Exchange (NYSE), other large stock exchanges include: -
  • London Stock Exchange
  • Shanghai Stock Exchange
  • Frankfurt Stock Exchange
  • Tokyo Stock Exchange

How is the price of a stock calculated?

It is as simple as market forces, or supply and demand. The more popular a stock is for whatever reason the higher the price will be. At any point, the market determines what value stock has based purely on the maximum price people are willing to pay for it.

If a stock is in demand, then there are more investors buying stocks than selling. At this point the shares that are being sold demand a higher price. Of course, the opposite is also true. If demand for a certain stock drops, then there are more sellers than buyers and the price will drop to reflect this fact.

This mechanism is what allows vast amounts of money to be made, and lost, in the stock market.

The role of Market Makers

Market makers are the middlemen between buyers and sellers. Market makers are individuals who effectively act as a buffer so there is always a market to buy and sell whatever shares are being traded.

The reason that Market Makers are used as a mechanism for trading stock, is it ensures that when you want to sell 20,000 shares in a particular firm, you don’t have to wait until someone is willing to buy this exact number of shares. A Market maker will buy the shares from you straight away.

How do you buy stock?

All stock transactions must take place through a broker. A broker is an individual, or more likely a company, that is licensed to trade in stocks. Traditional, brick and mortar, brokers are one type, but online brokers are becoming the norm. These include companies like Interactive Brokers, E-Trade, TD Ameritrade, and SoFi Active Investing to name a few.

Once you have selected and opened an account with a broker, the actual process of buying shares is extremely simple. You simply tell your broker what shares you want to buy and the amount you want (or input the details online.) The details of this transaction are then passed to the exchange, where a Market Maker will sell you the shares at the going price.

What is a Stock Index?

When you hear on the news that the ‘Market is up,’ or the ‘Market is down,’ what is being referred to is a stock index. These are effectively markers for how the stock markets are performing overall.

There are many of these indexes, some common ones are listed below.
  • Dow Jones Industrial Average
  • S&P 500
  • FTSE 100 Index
  • Nasdaq 100
Although they use different criteria to obtain their figures, all stock indexes perform the same function – To give a snapshot of the overall performance of the stock market.

Indexes are important for getting an overall feel of how the market is behaving, but it is important to understand that they do not reflect on how individual stocks are faring.

In Summary

The stock market is fundamentally a simple, market-driven, mechanism to trade shares in publicly listed companies. It is easy for anyone to set up an account with a broker and be trading shares within minutes. Of course, that is the easy bit. The difficult bit is to know what shares to buy.

If you are just getting started in the buying and selling of shares and are unsure of where to start, why not have a look at our top five shares to look out for in 2021 to give you a head start.