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How The Stock Market Works: Everything you need to know (in 5 min)

How does the stock market work? I'll show you everything you need to know in this simple, easy to follow 5 minute breakdown of how the stock market works.

We’ve all heard of the stock market. But how does it work?

Isn’t it risky?

Can’t we lose a lot of money? There was the dot-com crash. Then the 2008 financial crisis.

And aren’t stocks just for rich people anyway?

I grew up thinking all of this myself.

After learning a bit about the stock market, I realized it’s not nearly as scary or risky as I thought.

I also realized that everyone can, and should, get started by investing in the stock market. You can do it with as little as $50.

How the Stock Market Works Table of Contents:

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The History of The Stock Market

While countries had systems that operated similar to a stock market dating back to the 1100s, the first authentic stock markets appeared in the 1400s and 1500s.

The industry typically recognizes Antwerp, Belgium as the first world stock market system.

Oddly, the first stock markets didn’t have stocks.

The setup of the earliest system modeled today’s stock market. However, the original stock markets focused on government, business, and personal debt rather than shares of individual companies.

The first publicly traded company formed out of necessity. During the 1600s, exploration to East India provided access to a variety of unique goods.

However, transporting the goods back from East India was risky. Storms, sea pirates, and poor navigation often resulted in the loss of products.

To mitigate the risk of loss, ship owners would look for investors to help cover their costs. These investors didn’t want to lose money either.

The investors began paying and earning dividends on proceeds on groups of voyages, rather than just a single trip.

Investing a little into multiple excursions instead of one meant that ship owners could get the funds they needed to transport goods, and investors could still turn a profit even if one or two shipments disappeared.

The East India companies changed the way companies conducted business and paved the way for modern-day stock markets.

The first modern stock exchange opened in London in 1773. The New York Stock Exchange opened in 1792.

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Who Is Behind The Stock Market

The New York Stock Exchange is owned by the Intercontinental Exchange, but it’s regulated by the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission.

Both organizations watch to ensure that the markets operate correctly but neither of them has complete authority of the stock market.

A group of self-regulatory organizations operated by brokerage firms helps ensure that all interests are represented equally.

Each exchange has regulatory groups that check for insider trading and market manipulation.

The stock market itself is composed of individual companies offering public shares of their business.

The New York Stock Exchange currently hosts 2,800 companies and trades more than 1.46 billion shares each day.

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How The Stock Market Is Regulated

The United States uses two government agencies to oversee activity in the stock market.

The Securities and Exchange Commission (SEC). is responsible for protecting investors, facilitating capital formation, and maintaining a fair and orderly security market.

In addition, they monitor corporate takeovers and approve company registration statements.

Whenever a company goes public, it is required to meet public reporting requirements.

These include filing a registration statement with the SEC. The SEC must then approve a company’s registration statement before they are allowed to sell stock on the market.

There is a list of requirements companies must meet to fulfill regulatory compliance with the SEC. These requirements enable the SEC to monitor the market accurately.

The Commodity Futures Trading Commission regulates futures, swaps, and other investment options. The primary responsibilities include promoting integrity and resiliency in the derivative markets.

They work to protect investors against abusive trade practices, fraud, and market manipulation.

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How Stocks Work

When you purchase “stock” in a company, that means you’re buying a slice of ownership in that business.

Companies use stocks to raise money for expansion, create products, and fund other business expenses.

When a company first appears in the stock market, they’ll offer shares to their company via an initial public offering (IPO). After the IPO, shares trade publicly on a daily basis.

Buyers and sellers will exchange shares at the current market price.

Most investors will purchase and sell their stocks through a broker. To purchase stocks online, you’ll need to open a brokerage account.

From there, you can submit buy and sell orders with the funds that you have available.

The stock is a way for the average consumer to build wealth by purchasing small pieces of a company. For most stockholders, you are purchasing a portion of their profits.

While you may be able to vote on issues or attend shareholder conference calls, purchasing stock in a company doesn’t entitle you to traditional assets or decision-making power.

There are two ways to make a return from stocks:

  1. The stock price could go up. Once the stock price goes up, you can sell the stock for a profit. For example: If you purchased 100 shares of a stock at $100 each, your initial investment would be $10,000. If the stock goes up to $120 per share, you could sell your stock for $12,000 for a profit of $2,000.
  2. Dividends. Some stocks offer dividends. Instead of using all the profit to grow the company, a portion of profits are paid out to shareholders as dividends. Companies typically send these payments out quarterly. Not all stocks offer dividends.

While lots of factors impact a stock price, it’s mostly a reflection of the growth prospects of a given company. If investors expect plenty of growth, that’ll be baked into the price.

If they don’t, the stock will be worth much less. And for prices to change, the company needs to surpass or under-deliver on those expectations.

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How Stock Exchanges Work

A stock exchange is a marketplace for buying and selling stocks and securities.

The New York Stock Exchange is the largest in the world, listing more than 80 percent of the S&P 500 and 90 percent of the Dow Jones Industrial Average.

Stock exchanges, like the NYSE, operate on an auction basis and stocks are actively traded on the stock exchange floor. If you want to sell a stock, your stockbroker implements a sell order.

The transaction is completed when one of the dealers on the floor finds a buyer with which to trade.

Much of the activity on the “trading floor” is electronic, with a computer acting as a dealer to match up buyers and sellers.

The stock exchange keeps track of the supply and demand for each stock available.

This supply and demand, along with other factors, help determine a base price for each stock and identifies buy and sell levels among investors and traders.

The buyer’s bid is typically lower than the asking price sellers request for shares. This difference is called the bid-ask spread.

For a successful trade, both buyer and seller compromise by lowering the asking price or increasing the offer.

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The Best Way to Start Participating in The Stock Market

We’re in the golden age of investing. It’s never been easier or cheaper to invest in the stock market.

Are you maxing out your retirement accounts?

You likely have a 401K at work. You also have the ability to contribute to an IRA account on your own. This is the first place that you want to start investing in the stock market.

First, you won’t need these funds for decades.The stock market is a very safe place to put your money in with those kind of time horizons.

Second, you’ll save a ton of money on taxes. Depending on the retirement account, you’ll either get to invest pre-tax dollars or not pay taxes on post-tax dollars. Either way, you’ll be earning more.

If you’ve been maxing out your retirement accounts and want to invest more, get a normal brokerage account.

Do you want simple or ultra simple?

The vast majority of folks should invest in the stock market in one of two ways:

  1. The ultra simple method: target date funds. You pick a fund based on when you expect to retire, the fund does everything else. This is as simple as it can possibly get. If you hate the thought of spending time worrying about investments, go with this option.
  2. If you’re willing to put a little effort it, get 2-3 basic index funds. Index funds match the market instead of investing into a single asset. It’s like getting a small piece of the entire stock market instead of a piece of one company. Index funds are much safer. Get US index fund, a bond index fund, and possibly an international stock fund. For putting in a little extra work, you’ll get fees that are slightly lower than a target date fund. It’s still pretty simple though.

Both options require little time, have low fees, have relatively low risk, and will get you decent returns over the long-run.

If you’re worried about your personal finances, you can improve them without even leaving your couch. Check out my Ultimate Guide to Personal Finance for tips you can implement TODAY.

Set up an automatic investment

Automating your investments monthly is the most reliable path to building wealth.

No matter where you’re today, start investing on a monthly basis.

Even if it’s $50/month, get started.  Set up an automated trigger as soon as you get paid.

That way, it doesn’t feel like you had the money in the first place. And you’ll be much more consistent with your investments instead of letting money site in your account until you finally get around to it.

Then slowly increase the $50/month over time. Or increase it as you get raises.

Before you know it, you’ll be one of those fancy people that has a massive stock portfolio that earns money while you sleep.

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