What Is The Stock Market And How Does It Work?

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An easy-to-understand explanation of the stock market, individual stock exchanges like the New York Stock Exchange, and stock indices like the Dow Jones Industrial Average and S&P 500.

 

 

I was first introduced to the stock market in 3rd grade. We had to choose several stocks and follow them for a while to see if we would have made any money. It was the era of Crystal Pepsi, so, of course Pepsi was one of my choices. I didn’t make any money. (Big surprise!)

 

My knowledge of the stock market pretty much stayed about the same for the next 22 years. To me, the world of finance was confusing and intimidating, so I avoided it at all cost. Like the proverbial ostrich with its head in the sand, I preferred not to even try.

 

Then I decided to finish my business degree. What do you know, Finance is a required course for any undergraduate business degree! It was time to face my fears. I did it, and now you all are reaping the benefits.

 

Like me, a lot of people find the world of finance and stock markets very confusing, and for good reason. They don’t even use real words. The world of finance is a veritable alphabet soup: NASDAQ, ETF, NYSE, S&P 500, etc. Stick with me here and I will try to sort things out for you so you have a better understanding of how it all works and what all those acronyms are.

 

What Is Stock?

Just in case anyone isn’t clear, a stock is a small piece of ownership in a company. Let’s say you have a company that is worth $100. You need cash, so you want to sell part of the ownership of your company (called “going public”). You break up the ownership into 100 shares of stock each worth $1. I buy a share for $1 and am now a 1% owner in your company.

 

Why would I buy it? Because you are a smart, hard worker and I know you will grow the company. Next year when the company is worth $200, my share will be worth $2 and I will have doubled my investment. I won’t get any money, though, unless I sell my stock or you pay dividends, which is a little bit of the company’s profits that gets distributed to the owners, or shareholders.

 

The “Stock Market”

Think of the stock market like the church. People refer to the Universal Church, which is the compilation of a bunch of local churches and believers. The “stock market” is a compilation of hundreds of individual local stock exchanges. Two major exchanges that you have most likely heard of are the New York Stock Exchange (NYSE), which has been around since 1792 and is the biggest in the world, and the National Association of Securities Dealers Automated Quotation System (NASDAQ) which is the second largest globally. There are hundreds more exchanges in the US and abroad, like the Boston Stock Exchange, National Stock Exchange, London Stock Exchange Group and Japan Exchange Group.

 

So,

Stock Market = Universal Church

NYSE, NASDAQ, etc. = City Bible Church, Gresham Foursquare, Felida Baptist, etc.

 

Stock Indices

If you listen to the news you probably hear them talk about the S&P 500, and it sounds like a roller coaster, always plunging, climbing and dipping. It isn’t a roller coaster, it’s a stock index.

 

What Is A Stock Index?

A stock index is pretty much just a list of stocks, a sample of the market meant to represent the whole. It works just like a poll in which pollsters talk to a small number of people to generalize how the overall population feels about something. There are three major indices in the US, all of which are more accurate than the political pollsters of the last election.

 

Dow Jones Industrial Average (DJIA)

The first index was created way back in 1896 by Mr. Charles Dow. He is no longer around, but his stock index sure is. The DJIA contains 30 of the largest and most influential companies in the US. Because it has been around so long, it is the most recognized in the world and often what people are referring to when they say, “the market.” The stocks included in the DJIA are very stable and include all areas of the economy except transportation and utility.

 

Standard & Poor’s 500 Index (S&P 500)

The S&P 500 consists of 500 companies. Because it contains a much larger sample that covers all areas of the economy, it has taken the place of the DJIA as the benchmark that represents the entire US stock market. It is quite steady, with only 25-50 changes a year, and accounts for 70% of the US market.

 

NASDAQ Composite Index

The NASDAQ Composite isn’t just a sample, it contains every single one of the over 3,000 companies traded on NASDAQ. It is much more volatile than the other indices because of the nature of the companies traded on NASDAQ. They are mostly technology and internet-based, with some financial, consumer, bio-tech and industrial as well.

 

 

Ok, now for your test. Can you explain the difference between the stock market, a specific exchange, and a stock index? Let me know in the comments if you still have questions or if you think I missed something. Have a good day and thanks for reading!

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