How the stock market works

In short

I once watched a neighbor keep a shoebox of old stock certificates on a closet shelf, and he never quite knew what they were worth. You may feel a little like that about the stock market. A share is a small slice of ownership in a company, and you can buy or sell it through a brokerage account. Prices move all day because buyers and sellers keep disagreeing about what a company is worth. Fees, taxes, and your own choices are what you control, and headlines are not. If your job offers a retirement plan, learn how it invests before you touch anything else. Take your time.

The whole of it

What it is

A friend of mine once asked me where the stock market actually is, and I told her I had wondered the same thing for years. It is not a building, though there is a famous one in New York. It is a network of exchanges, which are organized marketplaces where shares change hands. The New York Stock Exchange and Nasdaq are the two best known in this country. Behind them sits a set of firms that connect you to those marketplaces.

If you are holding a share, you own a very small piece of a real business. That piece gives you a claim on the company's future profits. Some companies pay part of those profits to owners as dividends, which are regular cash payments. Others keep the money and put it back into the business. Either way, you are a part owner, and that is worth pausing over.

Companies first sell shares to the public in what is called an initial public offering. After that, shares trade between investors, and the company itself is not involved in each sale. When you buy from a stranger, the stranger gets your cash. The company does not.

How it works

If you are holding a phone with a brokerage app on it, you have probably wondered what happens when you tap the buy button. Your broker sends your order to a marketplace. There it meets an order from someone who wants to sell. Every trade needs two sides, so the price lands where a buyer and a seller agree. That is all a price is.

Prices move when opinions change. A company reports good news, more people want its shares, and the price rises. Bad news does the opposite. Sometimes prices move for reasons nobody can explain that same day. That can feel unfair. It is just how a crowd behaves.

A few kinds of orders are worth knowing. A market order says to buy now at whatever the price is. A limit order says to buy only if the price is at or below a number you pick. Limit orders give you more control, though your trade may not happen at all. Brokerages generally offer both kinds.

Many people do not buy single companies. They buy a fund, which pools money from many investors to hold a large basket of shares. An index fund is a fund built to follow a list of companies, such as a broad list of large American firms. It holds hundreds of companies at once, so one bad company does not sink the whole fund. It also tends to cost less to run than a fund where a manager picks and chooses. Fund costs are shown as an expense ratio, which is a yearly fee taken as a percentage of your money in the fund. Small percentages add up over the years.

Your money is also held in a particular way. A brokerage firm keeps your shares in your account. If that firm fails, a nonprofit called the Securities Investor Protection Corporation may help you get your assets back. It does not cover losses from falling prices. That distinction trips up a lot of good people.

The numbers, and where to find yours

Every investor faces a few numbers, and some of them are set by law and change from year to year. The yearly limit on what you can put into an IRA, which is an individual retirement account, is the current figure, which the official source publishes each year. Workplace plans such as a 401(k) have their own limit, which is the current figure, which the official source publishes each year. You can find both on the Internal Revenue Service website at irs.gov, where the agency posts its current figures.

Taxes matter here too. If you sell a share for more than you paid and you held it for one year or less, the gain is taxed like ordinary income. If you held it longer than a year, the rate is different, and the rate you pay depends on your income. The percentages are set by law, so look at the capital gains and losses guidance on irs.gov to see the current ones for your situation. Your brokerage will also send a Form 1099 B after a year in which you sold, listing what you sold and for how much.

To find your own fund costs, open the fund's page at your brokerage and look for the expense ratio. To find your plan's options, ask your employer for the plan summary. The Securities and Exchange Commission runs a site called Investor.gov that explains fees and how to check on a firm. It is free to read.

A worked example

Let me tell you about a woman named Maria, who is thirty and earns 52,000 dollars a year. Her employer matches 3 percent of her pay if she saves at least that much in the workplace plan. She had put off starting because the whole thing seemed like a language she did not speak.

Here is the arithmetic, with every input shown. Her salary is 52,000 dollars. Three percent of 52,000 is 52,000 times 0.03, which equals 1,560 dollars. So if Maria puts in 1,560 dollars over the year, her employer adds another 1,560 dollars. Together that is 3,120 dollars from one year of saving.

Now say Maria looks at an index fund with an expense ratio of 0.10 percent. On a balance of 3,120 dollars, the yearly fee is 3,120 times 0.001, which equals 3.12 dollars. Compare that with a fund charging 1.00 percent. The fee there is 3,120 times 0.01, which equals 31.20 dollars. The gap in the first year is 31.20 minus 3.12, or 28.08 dollars. That looks small. But the gap comes out of her balance every year and shrinks what her money can earn later.

Notice what Maria did not do. She did not guess which company would win. She did not watch prices by the hour. She compared costs and took the match her employer offered. The example only shows how the pieces fit, and it cannot say where any real balance will end up.

Where it goes wrong

I have made my own mistakes in this area, and I would rather you learn from mine. The first is treating a price drop as a personal insult. Prices fall, sometimes sharply, and people who sell in a panic can lock in a loss. The second is paying more in fees than you know. A cost of one percent sounds like nothing until you see it every year.

The third is putting too much of your money into one company, perhaps the one you work for. If that company stumbles, you could lose your paycheck and your savings on the same day. The fourth is ignoring taxes. Selling a share can trigger a tax bill, and the timing of a sale changes the rate, as the capital gains guidance at irs.gov explains.

A fifth mistake is trusting a tip that someone at a dinner party swears cannot fail. No tip cannot fail. The Investor.gov site warns about this kind of pitch. And the last mistake is quieter. Some people never start because they fear they will do it wrong. Waiting has a cost too.

Questions to answer before you leave this page

What do you want this money to do, and by when? If you will need it within a few years, how would a sudden drop in prices affect your plans? Does your employer offer a plan with a match, and do you know how much you would need to save to receive all of it? Have you looked up the expense ratio on every fund you own, and do you know what you pay each year in dollars? How much of your savings sits in a single company, and how would you feel if that company had a bad year? Do you know which account you are using, and what tax rules come with it? And what is one small step, such as reading your plan summary, that you could take this week?