How the stock market works

Whether you're planning for a child's education costs, a first home or your eventual retirement, a smart investment strategy can help ensure you'll be ready for future expenses. When those needs are several years down the road, adding stocks to your investments can be a sound way to reach your long-term goals.

If you're new to the world of stock investing, there can be a lot to cover. By learning how the stock market works, you can more confidently navigate this investment option and make better decisions with your money. Let's take a deep dive into stocks and the stock market by covering:

• What is a stock?
  
  • How stocks can make money
  • Risks involved in stock ownership
  • Basic stock categories to know

• How the stock market works
  
  • Understanding primary & secondary markets
  • What to know about stock market exchanges
  • How supply and demand affect share pricing

• How to invest in the stock market
  
  • Types of stock investments
  • Brokerage vs. retirement accounts

• Should you add stocks to your investment plan?

The term "stock" refers to a tradable security that gives you an ownership stake in a company. Businesses divide ownership into small units, or shares, and sell them to the public at varying market valuations as a way to raise capital. Those additional funds can help the company grow by hiring more staff, buying equipment or building new factories.

Most publicly traded companies' stocks are divided into millions, if not billions, of shares. However small your slice of the pie, you technically become one of the business's owners when you purchase stock. For example, if you own 5,000 shares of a company with 5 million total shares, you potentially have a claim to 0.1% of the company's net assets and profits.

Investing in stocks, also called "equities," involves buying shares with the goal of building wealth. When you buy stocks, you're hoping to make money in a couple of ways:

• Receiving a portion of the company's profits in the form of a dividend (though not all companies pay dividends)
• Having your shares appreciate—that is, selling them for a higher price than you paid for them

In general, a good investment is one where the expected return is better than alternatives and you find the risk level acceptable. To measure the return on stocks, you add the dividend yield—the dividend payment as a percentage of the share price—to the percent of appreciation.

For instance, suppose you buy a share of a company for $100 a share. A year later, the company provides a dividend yield of 2%, and its stock price has grown by 6% (meaning it now trades at $106). The total annual return on the stock is 8%—the 2% dividend yield plus the 6% appreciation.

Over its long history, the stock market as a whole has averaged a yearly return of roughly 10%. That means stocks have regularly outperformed most other asset classes, including bonds and real estate.

Whether stocks represent an acceptable risk depends on your personal circumstances. Even though the stock market has a historical average return of 10%, there have been many times when prices fell year over year. There are no guarantees a company will pay dividends or that shares will ever grow in value. Those aspects are often based on the company's performance, so there is a "systemic risk" that even a healthy company will feel the impact of changing economic conditions.

Also, some businesses may fail no matter what's happening with the greater economy. Perhaps the company developed a product or service that never took hold or decided to invest in unprofitable markets. There is a risk that you could simply be backing the wrong horse.

With those risks in mind, stocks tend to be a better fit if you have a long-term investment horizon. When you're building assets for a retirement that's decades away, a temporary dip in your portfolio's value may not throw you off track. You have time for the market to pick up again and potentially regain lost ground. Another way to mediate risk is to diversify your stock investments across a variety of companies and industries. Ideally, stocks that end up providing you with healthy returns would offset any that underperform.

Companies can designate their shares as common or preferred. Both give ownership rights to shareholders, but there are some key differences to note:

• Common stock typically comes with voting rights, giving shareholders a say in who sits on the company's board of directors. Most people invest in this kind of stock, where dividends aren't guaranteed and share prices can fluctuate with the market. If your main focus is growth potential, common stock may be the better choice.

• Preferred stock may not offer voting privileges but gives shareholders priority in receiving dividends and asset claims if the business faces liquidation. Preferred stock involves calculated, discounted share prices and fixed dividend yields, making it a better fit for investors who value stability or income.

Investors have another way of classifying stocks based on a company's performance compared to other companies in the same industry or overall market: Growth vs. value stocks.

• Growth stocks describe shares of a company with an above-average pace of rising revenues and earnings. Buyers pluck up growth stocks based on their potential to keep increasing in price over time. If the company continues to do well, the shares may rapidly appreciate and provide big returns if they're sold at a peak price.

• Value stocks signify that a company has attractive fundamental qualities—decent sales, earnings and dividends—but nevertheless has share prices that are much lower than expected. These buyers are usually aiming to take advantage of a mature company's stock at a bargain, anticipating its value will climb or pay off over time.

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Now that you better understand stocks and their potential benefits and risks, let's discuss the system where they're bought, sold and traded: the stock market.

Just like everyday goods and services you buy, sell and trade in your life, equities can be obtained through a primary market or a secondary one.

The primary market involves buying shares when they first become available. A company that has just "gone public," for example, will issue shares as part of its initial public offering, or IPO. Similar to buying directly from the manufacturer, you buy shares at a price set by the issuing company.

Anyone who holds the shares after that may decide to sell them to another investor—a secondary transaction. If the share's price has increased on the market, the seller pockets the difference; if it's dropped, they take a loss. This secondary market makes up the vast majority of stock dealings.

Most secondary market activity takes place through stock exchanges. These exchanges serve two main roles: They provide a platform through which trades are officially made, and they maintain certain rules that buyers and sellers have to follow to ensure fairness and transparency.

The world's two largest exchanges, the New York Stock Exchange (NYSE) and Nasdaq, facilitate the services for most stock trades, though there are some smaller U.S. exchanges and several international ones. With the major exchanges, companies must be "listed" and meet the minimum requirements of the exchange to participate, and trading is handled by brokers and dealers. Companies that don't meet exchange requirements may make their stock available via over-the-counter (OTC) trading where buyers and sellers work more directly.

As with other goods, the price of a company's stock comes down to supply and demand. The supply aspect is relatively straightforward. The fewer shares available, the more each share is likely going to be worth. In fact, some companies occasionally "split" their stock—offering two shares for each existing share—to bring the price of each share down.

Conversely, the higher the demand for a company's stock, the higher its share price. Demand can increase if investors expect the overall economy to be strong, thus bolstering the company's sales. Or, buyers may be hopeful about a company's new product or market expansion. The stock market is a forward-looking mechanism—demand is based not just on current profits, but on the expectation for future profit.

There are any number of ways to invest in the stock market, but becoming a shareholder doesn't have to be all that complicated. Here's a brief overview of how to buy stocks and how to choose the type of account that best meets your needs.

The most straightforward way to participate in the stock market is to buy shares of an individual stock. A few corporations sell their shares directly to the public, although you generally have to purchase them through a broker. Brokers could take the form of:

• Online brokerage firms
• Banks with brokerage services
• Stockbrokers or financial advisors

If you're looking to place trades online, creating an account usually only takes a matter of minutes. Once you're set up, research the stocks you want to buy—many trading platforms have their own research tools—and figure out how much you want to purchase. What if you don't have enough money to buy a full share of a specific company's stock? Many brokers allow you to buy partial, or "fractional," shares that cost less. However, buying a fractional share typically only makes sense if the platform offers fee-free trades, since it's harder to recover transaction charges.

Purchasing individual stocks isn't the only way to invest. You can also buy shares of a mutual fund, which is a basket of individual stocks. Investing through a fund doesn't provide the growth potential of owning an individual stock, especially for investors trying to get in on the next Microsoft or Apple. But it doesn't carry the same amount of investment risk, either. Therefore, fund investing may be a good choice for those who want to strike a balance between returns and risk-management through a more diversified portfolio.

You can buy mutual funds through a broker, much like you would an individual stock. Or you can purchase shares directly through the fund company's website.

When buying a stock or mutual fund through a standard brokerage account, your money is subject to the normal tax treatment. That means you invest post-tax dollars and then pay tax on any investment returns—whether they're dividends or capital gains from selling shares for more than the purchase price.

However, you can also purchase stocks through a tax-advantaged retirement account, if doing so aligns with your overall investment strategy. For example, you can buy individual stocks and mutual funds—among other securities—within an IRA. Depending on your income and IRA type, you could deduct all or part of your contributions from your income taxes, up to an annual limit. You then pay ordinary income tax on any withdrawals you make after age 59½.

You receive similar benefits when you contribute to an employer-sponsored retirement plan, such as a 401(k). Workplace plans often have higher contribution limits and, in many cases, matching funds from your employer. However, most 401(k)-style plans only allow you to invest in a limited number of mutual funds that the company has pre-selected.

Given their tax benefits, investing through a retirement account can be a great choice if you don't plan on accessing your funds until you leave the workforce. Because you face a steep 10% penalty on most withdrawals before you reach 59½, however, they may not be as well-suited to younger investors who may need to sell shares or access their money earlier.

Over long periods of time, stocks in general have delivered returns that have significantly outpaced inflation. That makes them a potentially smart choice if you're trying to build assets that you won't need to access for several years. Because of the inherent volatility of the market, however, stocks may not be your best option if you have a shorter investment horizon. They're not an asset you want tapped for your emergency fund, for example, where you may need quick access to your money at any time.

To further minimize your investment risk, be sure to diversify your exposure to different companies and different sectors. Mutual funds are a relatively easy way to spread out your holdings, but you want to allocate your assets across funds to maximize exposure across industries.

Getting started in the world of stocks requires a comprehensive look at all the advantages and disadvantages. Your local Thrivent financial advisor can help you determine what role equities should play in your financial plan and help make sure you manage risk appropriately.