How does the stock market work?

The reality is that investing in the stock market carries risk, but when approached in a disciplined manner, it is one of the most efficient ways to build up one's net worth. While the value of one's home typically accounts for most of the net worth of the average individual, most of the affluent and very rich generally have the majority of their wealth invested in stocks. In order to understand the mechanics of the stock market, let's begin by delving into the definition of a stock and its different types.

What are stocks and shares?

Of the two, "stocks" is the more general, generic term. It is often used to describe a slice of ownership of one or more companies. In contrast, in common parlance, "shares" has a more specific meaning: It often refers to the ownership of a particular company.

Typically a single stock or share will only be worth a very, very small percentage of a business (we're talking much smaller than 1%), but if you own even one, you'll own part of that company. You can also invest in funds and indexes, which we explain in more detail later.

You can buy shares in most of the world's biggest businesses, including Apple, Amazon and some British companies like Vodafone and Tesco. In fact, the stock market is pretty much exclusively populated by big businesses, as that's one of the requirements that a company must meet before entering the market (known as 'going public' or 'floating').

But why would a company go public in the first place? Well, while it does invite some extra pressures like having to answer to shareholders and being subject to a constant expectation of short-term growth, there is one major benefit: money.

Assuming investors actually buy the stocks, going public gives a company a huge injection of cash which can then be used to fund future growth.

What is the stock market?

The stock market is where investors connect to buy and sell investments — most commonly, stocks, which are shares of ownership in a public company. You’ll usually buy stocks online through the stock market, which anyone can access with a brokerage account, robot-advisor or employee retirement plan.

The stock market works through a network of exchanges — you may have heard of the New York Stock Exchange or the Nasdaq. Companies list shares of their stock on an exchange through a process called an Initial Public Offering, or IPO. Investors purchase those shares, which allows the company to raise money to grow its business. Investors can then buy and sell these stocks among themselves, and the exchange tracks the supply and demand of each listed stock

That supply and demand help determine the price for each security or the levels at which stock market participants — investors and traders — are willing to buy or sell. Buyers offer a “bid,” or the highest amount they’re willing to pay, which is usually lower than the amount sellers “ask” for in exchange. This difference is called the bid-ask spread. For a trade to occur, a buyer needs to increase his price or a seller needs to decrease hers. This all may sound complicated, but computer algorithms generally do most of price-setting calculations.

While we'd never recommend that you get involved in the stock market without doing some research first, you certainly don't need to understand every little thing about the way it works to start investing. But don't just take it from us – take it from the most successful investor of all time, Warren Buffett:

“If calculus or algebra were required to be a great investor, I'd have to go back to delivering newspapers.” — Warren Buffett

Why should you invest in the stock market?

Long-term, investing can make more money than saving: If you're fortunate enough to have any spare cash lying around, you should usually look to put it into a savings account or an ISA. These accounts are good for increasing the value of your savings in the short or medium term but, over longer periods, investing in the stock market usually provides greater returns.

Over long periods, indices always go up: Over the course of several years, stock market indexes always increase in value. And this isn't just true of indices tracking the biggest companies in a given region (like the FTSE 100) – regardless of what the index covers, these are usually a pretty sure bet for making a return on your investment.

As you might have picked up by now, the key to increasing your chances of success in the stock market is to play the long game. Naturally, then, it only makes sense that the earlier you start investing, the more your money could grow.