How Do Stocks Work (Investing Basics)

How do stocks work? Investing in stocks via the stock market may seem intimidating. I mean, who hasn’t seen a movie where investment brokers are fervently yelling on the New York Stock Exchange to buy and sell stocks for their clients. 

Honestly, this scared me from buying stocks for many years. I naively thought I needed to hire someone to go to the “stock market” and buy them for me. I thought it costed a fortune to buy public companies on Wall Street. Ultimately, I settled for mutual funds with a financial advisor.

I honestly didn’t know how stocks worked in 2003 when I started investing. Today, we have the internet. We can arm ourselves with knowledge and learn more about trading stocks.

Stocks (aka securities) are sold through trading platforms or online brokerages where you can make real-time trades for zero to low commission fees. Anyone can open an account and buy or sell shares if the price is right for them.

Because of this, every investor must understand the basics of how stocks work. Investors need to understand the fundamentals of stocks to make the best decisions for their portfolios. So, keep reading to learn more about how stocks work.

What is a stock?

Let’s start by defining a stock. Investopedia defines a stock as a “security that represents the ownership of a fraction of a corporation. In other words, a stock represents a piece of a company that investors can own. 

Stocks are the foundation of an investor’s portfolio. They are sold on the stock exchange (i.e., the stock market) via brokerages and private sales. 

Groups of stocks are put together and sold as a type of security that follows and tracks a particular index or sector are called exchange-traded funds also known as ETFs.

An individual unit of a stock is called a “share. An investor’s ownership is defined by the number of shares that they own. Investors do not own the company. Instead, they own shares of the company. However, owning stock does come with benefits. 

How do stocks work

Ok, now that we have a basic understanding of what stocks are, let’s get into it: how do stocks work?

Where are stocks sold?

Stocks are listed for sale on stock exchanges. There are more than 60 large in the world. Here are the top nine:

• NYSE (New York Stock Exchange)
• NASDAQ (National Association of Securities Dealers Automated Quotations)
• London Stock Exchange Group
• Euronext
• Toronto Stock Exchange
• Bombay Stock Exchange
• Tokyo Stock Exchange
• Shanghai Stock Exchange
• Hong Kong Stock Exchange

The NYSE is the largest public stock marketplace in the United States, followed by the NASDAQ. All companies that want to be publicly traded are usually added to one of these two exchanges. 

OTC Pink is not considered a major marketplace for trading. It is a decentralized market without the same regulation and disclosure requirements as companies listed on the major public exchanges. Although companies on the OTC Pink are required to be registered with the SEC, they are not required to disclose their financial statements. These stocks are considered the most speculative of all stocks and may include delinquent and dark companies. Investors should use extreme caution when trading in this market.

Tip: Don’t confuse the Nasdaq Composite Index with the Nasdaq Stock Exchange. The Nasdaq Stock Exchange is where stocks are listed for sale, and the Nasdaq Composite Index represents the entire Nasdaq stock market in terms of value.  

How are stocks priced?

The initial price of a stock is determined at its IPO (Initial Public Offering). Companies set the initial price based on the supply, demand, and the company’s performance.

Over time, the market sets the market value or price of the company. When there are more sellers than buyers, prices generally go down. And when there are more buyers than sellers prices generally go up. You can also hat if the company performs well and there is high demand (lots of buyers, few sellers), the price tends to be high. If there is low demand (few buyers, lots of sellers) and the company’s performance is poor, the price tends to be low. 

Supply and demand are influenced by the company’s performance and fundamentals (cash flow statement, balance sheet, income statement). Investors want to know the return on assets, revenue, and debt over several years to determine its strength and growth potential.

When shares are undervalued, the shares are selling for less than they are worth. Conversely, when shares are overvalued, the shares are selling for more than they are worth. 

How are stocks sold?

Stocks are bought and sold as “trades” through stock exchanges. They’re traded through brokerages that have access to the stock exchanges. 

Most of us will work through an online brokerage that sells and buys shares for us electronically, like my favorites TD Ameritrade or Charles Schwab. You may also use a financial advisor to make trades for you.

When you buy stock, you buy it in the form of a preferred stock or a common stock. Common stocks are associated with voting rights, and preferred stocks are associated with financial advantages like dividends. 

How do people make money with stocks?

When you buy shares of Company X, you own part of the company and receive dividends (a portion of the profits) when they are declared by Company X’s board. 

If Company X does well, your investment will grow in value over time. Conversely, if Company X does poorly or goes bankrupt, your investment will suffer losses and possibly go to zero. 

The riskier the investment is for a particular company, the more likely it is that your shares will lose value quickly – but you can also see greater gains if it turns out to be successful! 

When you invest your money in stocks, you are taking a risk. Not only can the price go up or down, but you could also lose your entire investment overnight! Only you can determine the risks you are willing to take when investing. However, it’s essential to understand that when the stock price is going up and down, the shareholder isn’t actually making or losing money. The up and down price simply represents the value of the stock. The stock becomes more and less valuable to investors on a daily, weekly, yearly basis. There may be times when the value of your stock doesn’t change at all. 

Note: The only time the shareholder makes or loses money is when they sell the stock. If the stock is sold for more than it was bought for, the investor makes a profit. If it is sold for less, the investor loses money. Shareholders who own stock make money when they sell their shares of a stock through their brokerage account.

Why do companies sell stock?

Corporations sell stocks to raise money for their business. Sometimes the money raised, aka capital, is needed to pay debts, and sometimes it’s used to reinvest back into the company for growth. 

Is a share the same as a stock?

No. There is a difference between a share and a stock. Although the two terms are sometimes used interchangeably, they’re pretty different things. An individual unit of a stock is called a “share.”

Benefits of owning stock

As a shareholder that owns stock, you have the right to vote in shareholder meetings, receive dividends, and sell your shares if you desire. In addition, you’re entitled to a portion of the company’s profits. When you buy stock, you’re investing in companies. As the company grows and becomes more profitable, so will your stock. 

Final Thoughts

If you’ve been looking for a way to reach your financial goals and make some money with your investments, then maybe stocks are the answer. Of course, this article isn’t investment advice. There is risk involved in owning any individual company’s stock because it can go down as well as up. However, if you invest wisely and buy shares of companies with solid reputations that show growth potential, you may find yourself making some extra money in 5-10 years. 

Don’t hesitate to refer back to this article if you find your questioning, “How do stocks work?” It can take time and experience to gain a clear understanding of stocks and the stock market. But know that we are market makers too and we do play a role in the stock market. We have the power to own stock and build investment portfolios.

Have you ever invested in stocks? What are your thoughts on this type of security? Let me know!