What Is the Stock Market? And How Does It Work?

For lots of people, just the thought of investing in the stock market is enough to send them into a cold sweat. Maybe you’re one of them. We get it—there are only so many stressful news reports and horror stories about market crashes . . . and bubbles . . . and corrections . . . that a person can take!

Let’s face it—the stock market can feel pretty intimidating. But it doesn’t have to be that way. In fact, all you need is a little bit of knowledge and you’ll see how the stock market can be an amazing way to put your hard-earned dollars to work for you.

Here’s the truth: When you get a basic handle on how the stock market really works and how to handle the risks and rewards of investing, you can put yourself on the path to building wealth and leaving a legacy for your family. So, let’s get right down to it!

What Is the Stock Market?

In a nutshell, the stock market is where investors go to buy and sell stocks (or shares), which are basically small pieces of ownership in a company. The stock market is made up of many different stock exchanges where companies go to sell their stock and investors come together to trade stocks with each other.

What Are the Functions of a Stock Market?

The stock market might seem complex, but let’s keep it simple. The main role of the stock market is to provide a safe, regulated and organized place where anyone—of any background—can exchange shares of publicly traded companies. It’s a huge part of our nation’s free-market economy and offers people a chance to share in the success of top companies. Here’s how:

When you buy stock in a company, your money helps the company grow. You also become a shareholder, which comes with sweet perks. You now get a say in how the company is run, a portion of its profits (called dividends), and your shares can become more valuable as the company grows over time. Talk about a mutually beneficial relationship, right?

The stock market is meant to be fair and efficient. It encourages open negotiations and clear pricing. It also provides a way for investors to easily convert (or liquidate) their investments into cash if necessary and acts as an indicator of the economy’s overall health.

Got all that? Awesome. Now that we have a basic understanding, let’s dig into the nuts and bolts of it all.

How Does the Stock Market Work?

Let’s take a closer look at some of the key concepts that drive the stock market—stocks, stock exchanges and stock indexes—and how they work together to make the stock market tick.

Stocks

Like we mentioned earlier, if a company is just getting started or wants to expand, they can raise money without going into debt by offering to sell pieces of ownership in the company to the general public. Those pieces of ownership are called stocks (or shares of stock), and companies can list shares of their stock on stock exchanges where investors can buy them.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

If your shares of stock become more valuable over time, you can sell them for a profit. Those profits are known as capital gains, and those gains might be taxed a little differently than your ordinary income. It’s a good idea to talk to your tax professional about any taxes you might owe if you decide to sell your shares of stock.

Stock Exchanges

A stock exchange is basically a marketplace where investors meet to actually buy and sell stocks. You’ve probably heard of a few of those exchanges, like the New York Stock Exchange (NYSE) and the Nasdaq.

So, how does someone buy and sell stocks on a stock exchange? First, a seller submits the price they’re willing to sell their stocks for (selling price) while a buyer lets sellers know how much they’re willing to pay for it (asking price). If an asking price and selling price match, then boom—you have a deal and the sale is made! Most of these transactions are made through a broker or an online stock-trading platform. 

Stock Market Indexes

Financial experts use stock market indexes to keep a pulse on the overall health of the economy. An index is pretty much a measuring stick for tracking the progress of the stock market. Here are some notable indexes you’ve probably heard of before:

• S&P 500 Index: This is one of the most popular indexes out there and it tracks the stock performance of the largest 500 publicly traded companies. When people want to know how the stock market is doing, they’ll usually take a look at the S&P 500.
• Dow Jones Industrial Average (DJIA): Made up of stocks from 30 large companies from a wide range of industries, the Dow Jones is the oldest stock market index in the U.S.
• Nasdaq Composite Index: This index is used to measure the performance of the technology sector and it tracks stocks from roughly 3,000 companies listed on the NASDAQ exchange.

Here's a fun fact to keep in mind as you invest: The historical average annual rate of return for the stock market according to the S&P 500 is 10–12%.¹

That’s why it’s so important to have a long-term view when it comes to investing. Because even though the stock market might be way up one year or way down the next, your money will most likely grow over the long term if you diversify your investment portfolio, invest consistently, and don’t pull your money out at the first sign of trouble.

What Is Stock Market Volatility?

And speak of the devil . . . here’s that “trouble” now. When thinking about stock market volatility, picture the market as an unpredictable roller coaster.

Sometimes, a seemingly tiny event can send stock prices skyrocketing or plummeting. This can make investors freak out, which creates even more panic and can spiral the market into an even bigger mess. Yikes!

At this point, people who have a lot of money invested in riskier stocks can feel the heat. But by sticking to a reliable, long-term investment plan (stay tuned, we’ve got one coming your way), you can reduce risks and keep your cool, even when the market’s on fire.

How Stock Markets Are Regulated

The United States stock market is regulated by the Securities and Exchange Commission (SEC). They’re basically the watchdogs of the U.S. stock market who oversee all market activity to keep things on the straight and narrow.

Remember, the function of a stock market is to give anyone a chance to build wealth and find success in a fair and regulated environment. The SEC’s job is to make sure that’s always the case, so they’re pretty strict about their rules.

If you end up in hot water over some shady stock market dealings, you could get hit with a trading suspension and other disciplinary actions that’ll really mess up your day. So, never try to hide anything from the SEC. They’re pretty good at finding this stuff out.
 

How to Invest in the Stock Market

So now that you have a basic understanding of what the stock market is and how it works, you’re probably wondering, Now what? Don’t worry, we’re not going to leave you hanging!

Here’s a game plan with some guidelines to help you start investing in the stock market in a responsible way.

1. When to Invest: Get Out of Debt and Have an Emergency Fund First

It’s a question we hear a lot around here: “When am I ready to invest?” We call it Baby Step 4, which means you’re out of debt (everything except the mortgage) and you have 3–6 months of expenses saved in an emergency fund.

Why wait? Because if you don’t have enough money set aside when an emergency strikes, you’ll be tempted to take money out of your 401(k) investments to repair your car or replace your air conditioner.

And not only could that move cost you hundreds of thousands of dollars (or more) in retirement savings down the line, but the taxes and early withdrawal penalties that come with raiding your 401(k) will make you wish the thought never crossed your mind.

So, first things first: Get out of debt, build up your emergency fund, and then start investing.

2. What to Invest In: Go With Mutual Funds Over Single Stocks

It might surprise you that in The National Study of Millionaires, no millionaire said single-stock investing helped them reach their net worth. That’s right, not a single one! They understand that betting your retirement future on a handful of company stocks is more like gambling at a casino in Vegas than actually investing. If the value of those single stocks you picked goes down, your retirement future goes down with it.

The good news is, single stocks are not the only way to invest in the stock market. It’s time to talk about our favorite way to invest in the stock market: mutual funds. Mutual funds pool money together from investors and use that money to buy stocks from dozens or even hundreds of different companies. Those stocks are handpicked by a team of experts who are trying to outperform the stock market.

So when you buy shares of a mutual fund, you’re instantly buying stocks from all those different companies too. That means with mutual funds you have the chance to invest in the stock market and enjoy the growth that comes with stocks while also diversifying your portfolio and lowering your risk at the same time. 

We recommend going a step further and adding an extra level of diversification by investing in four different types of mutual funds: growth and income, growth, aggressive growth, and international. That way, if one part of the economy tanks, your whole portfolio won’t go down with it.

3. Where to Invest: Tax-Advantaged Retirement Accounts

Those mutual funds have to be invested somewhere, and you don’t have to look far to find the best place to start investing through the stock market. It’s the 401(k), 403(b) or other workplace retirement plan you get through your employer. In fact, 8 out of 10 millionaires invested in their 401(k).

And most workplace plans offer an employer match, which means they’ll match your contributions up to a certain percentage of your salary, usually between 3–6%.² That’s free money, people!

What about investing outside of the workplace? Let us introduce you to your new best friend, the Roth IRA (which stands for Individual Retirement Account). With a Roth IRA, you could invest thousands of dollars in mutual funds per year with after-tax dollars (money that’s already been taxed) and then watch it grow tax-free. And that’s not even the best part. You also get to withdraw that money in retirement (or any time after age 59 1/2) without having to pay a penny in taxes on it!

4. How Much to Invest: Start With 15% of Your Income

Once you’re ready to invest, we recommend investing 15% of your gross income toward retirement. That means you’ll be saving enough for retirement to let your money grow over time while also leaving enough wiggle room in your budget to reach some other important financial goals, like saving for your kids’ college or paying off your house early.

Here’s the best way to allocate your 15% for investing:

• If you have a 401(k) with an employer match, start there and invest up to the match.
• Then open a Roth IRA and invest up to the annual contribution limit. Max it out!
• If you still haven’t hit 15%, go back to your 401(k) and invest the rest there.

But if you have a Roth 401(k) and you like the investment options that come with your plan, you could invest your entire 15% there. 

5. Going Above 15%: Brokerage Accounts and HSAs

If you’ve already maxed out your tax-advantaged retirement accounts or you’re ready to invest more than 15% of your income, you have a couple other options to keep investing for your future.

First, you could open up a taxable brokerage account and invest there. The main benefit with a taxable brokerage account is that you can take money out of the account at any time without having to worry about early withdrawal penalties.

But consider this a warning: You won’t enjoy the same tax advantages that you would through your retirement accounts. No tax-free withdrawals, no tax write-offs for contributions, and you’ll have to pay capital gains tax on any profits you maker.   

Another really great option is investing in mutual funds through a Health Savings Account (HSA). You can only contribute to an HSA if you have a qualified high-deductible health plan (HDHP). But if you do have one, you can invest money in an HSA and use it to pay for qualified medical expenses completely tax-free.

And once you turn age 65, you can use the money in your HSA for nonmedical expenses too (but you’ll still have to pay income tax on withdrawals for those expenses).

Work With a Financial Advisor

Trying to wrap your mind around the stock market is no easy task. But the good news is, you don’t have to navigate the stock market and investing on your own. With help from a financial advisor you can trust, you can get a better handle on the stock market and start investing for your future.

Don’t know where to find an advisor? Our SmartVestor program can connect you with up to five financial advisors who are ready to walk you through your options—and it’s free to get started!

Find your SmartVestor Pro today!

Ramsey Solutions is a paid, non-client promoter of participating pros.