How the stock market works: A beginner's guide to investing

Whether you're planning for your first home, a child's education costs 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 stocks, it can seem a little daunting. But by learning how the stock market works, you can more confidently navigate this investment option and make better decisions with your money.

The stock market is like a giant marketplace where investors buy and sell pieces of ownership in companies, known as stocks or equity securities. Public companies list their stock on exchanges like the New York Stock Exchange (NYSE) or Nasdaq, making it possible for everyday investors to trade them.

When you buy a stock, you're buying a small slice, or share, of that company. The money it generates by selling that ownership stake can help the business grow—for example, by allowing its leaders to hire more staff, buy equipment or build new factories.

If the company does well, the value of your shares may go up, allowing you to sell your shares for a profit. Some companies also pay their shareholders a dividend—a portion of the company's profits—typically every three months. These dividend payments provide passive income to investors. But if the company struggles, your shares can lose value. The stock market always has both opportunities and risks.

Just like everyday goods and services that you buy and sell, stocks can be obtained through a primary market or a secondary market.

• Primary stock market. The primary market involves buying shares when they first become available. A company that is "going public" will issue shares as part of its initial public offering (IPO) at a price set by the issuing company. Think of this as buying an item new from the store.
• Secondary stock market. Anyone who holds the shares after the first issue can sell them to another investor, making it a secondary market transaction. You can think of it as reselling—like when you buy a concert ticket directly from the venue, realize you can't go and then sell it to someone else so they can use it (or sell it again). If the price has increased since you purchased it, you pocket the difference; if it has dropped, you take a loss.

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.

The Securities and Exchange Commission (SEC) regulates stock exchanges to ensure they operate fairly and orderly. The SEC also requires publicly traded companies to regularly share financial statements with the public so investors can make informed decisions.

As with other goods, the price of a company's stock is tied to supply and demand. The supply aspect is relatively straightforward. Generally, the more shares that are available, the less each share is likely to be worth.

Conversely, the higher the demand for a company's stock, the higher its share price (market value per share). 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, for example. The stock market is a forward-looking mechanism—demand is based not just on current profits but on the expectation for future profit.

Stock prices are determined by how much investors are willing to pay and how much sellers are willing to accept. If more people want to buy a stock than sell it, the price goes up. And if more investors want to sell than buy, the price falls. This push and pull is influenced by many factors: a company's earnings and growth prospects as well as interest rates and investor feelings about the health of the economy. Traders often react to news, good or bad, that could affect a company's future performance.

Electronic trading platforms match buy and sell orders in real time, ensuring prices adjust constantly to reflect the latest market sentiment. While short-term price moves can be unpredictable, a stock's value over the long run tends to reflect the underlying strength and earnings of the business.

Not all stocks are the same. Each type has different benefits and exposure to risk. Knowing the main categories can help you choose investments that fit your goals.

Companies can designate their shares as common or preferred. Both give ownership rights to shareholders, but there are some key differences:
● 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 focus is growth potential, common stock may be the better choice.
● Preferred stock may not offer voting privileges, but it 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 chance of increasing its revenue and profitability (earnings growth). If the company does perform, shares may appreciate and provide significant 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 still 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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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, but you generally have to purchase them through a broker. These can be online brokerage firms or other financial service companies that offer brokerage services.

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.

You also can buy shares of a mutual fund, which is a basket of individual stocks. Investing through a fund doesn't necessarily provide the growth potential of owning an individual stock; however, it doesn't carry the same amount of investment risk, either.

Investing in equities involves buying shares with the goal of building wealth (capital appreciation). 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 per 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 plus the 6% appreciation.

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 grow in value.

One source of uncertainty is "systemic risk," which can cause even a healthy company to feel the impact of changing economic conditions. However, some businesses may fail no matter what's happening with the greater economy. For example, a company you invested in may develop a product or service that doesn't take hold.

Because of these risks, 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 mitigate risk is to diversify your stock investments across a variety of companies and industries. Ideally, stocks that end up providing you with healthy returns will offset any that underperform.

When you buy 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 also can 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, unless your plan has a self-directed brokerage option, most 401(k)-style plans only allow you to invest in a limited number of mutual funds that the company has pre-selected.

Given the 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 age 59½, however, they may not be as well-suited to younger investors who may need to sell shares or access their money earlier.