The stock market has become a popular past-time in recent years. Or at least that was the case until 2022, when a correction sent once-thriving share prices into the gutter.

Yet, despite the vast number of investors in the world, there seems to be a large number of newcomers that don’t entirely understand what the stock market is. So, let’s pull back the curtain from the world of investing and explore what stocks are, how they work, and how I can use them to build long-term wealth.

What are stocks?

Before diving into explaining what the stock market is, it’s important to understand exactly what stocks are.

For those who don’t know, stocks, also knowns as shares or equities, represent a tiny piece of a business. Investors who buy and hold shares are actually purchasing a small part of a larger enterprise. And as an owner of a business, that entitles the investor to a slice of the profits.

This is where the value of shares is derived from. If a company is thriving and profits rise, then the size of the claim on earnings becomes larger, making each share more valuable. However, the opposite is also true. If profit suffers, so does share value, and the stock price will tumble as a result.

I should note that stock price and stock value are rarely the same. And it’s this misalignment which creates lucrative buying opportunities which value investors are constantly looking for.

With that said, what is the stock market?

What is the stock market?

The idea behind investing is to buy some shares at a certain price with the aim of selling them again in the future at a higher price. The stock market is what makes these transactions possible and operates through numerous exchanges around the world.

Arguably the most prominent exchange is the New York Stock Exchange. But there are others like Nasdaq and the London Stock Exchange.

When a company decides to go public, its shares are listed on its local exchange. This is usually the country of operations, but there are some exceptions. For example, for many years, Chinese companies aimed to be listed in New York to gain easier access to international investors as well as benefit from a bit of prestige.

Regardless, it’s through these exchanges that investors can access the stock market to try and build wealth. Having said that, there is also something called the Over-The-Counter (OTC) market. The OTC market enables investors to buy directly through a network of brokers rather than an exchange. It’s often home to stocks that are too small to be listed on one of the main exchanges.

Primary and secondary markets

The stock market is like a coin with two sides called the primary and secondary markets. So what are these?

• Primary Market – This is where shares are offered to the investing public for the first time through a process called an Initial Public Offering (IPO). Whenever shares are purchased in an IPO, the money goes to the company so that it can reinvest the capital into its business. After all, the whole point of going public is to raise money.
• Secondary Market – This is where shares are traded between investors through intermediary financial institutions called stockbrokers. The role of the broker is to match buyers and sellers together, charging a small fee for its services. When investors buy stocks on the secondary market, the money goes to the previous owner of the shares, not the underlying business.

What are the rewards and risks of investing in stocks?

Like most things in life, investing in the stock market is not a risk-free endeavour. As stated earlier, stock prices can go up as well as down. And unless an investor is using all sorts of crazy derivatives, a share price going down usually means a lot of money being lost.

Understanding the risk

Stocks are notoriously volatile, especially the micro and small caps. That’s because, in the short-term, stock prices are driven by mood and momentum. And these factors can swing in either direction relatively quickly.

For example, it’s not uncommon to see a stock trade at a very expensive price if it’s delivering explosive growth to shareholders. However, as soon as that growth starts to unexpectedly slow, the share price can quickly plummet. This is exactly what happened to many technology stocks in early 2022.

The investors who bought shares in even the most amazing high-quality companies at the peak are probably feeling quite unhappy. The point is that even the best company can turn out to be a poor investment. Having said that, over the long term, if the company is able to fix whatever problem caused the sell-off, then chances are that the stock price will eventually recover. But there is never a guarantee.

Realising the potential rewards

This level of risk is what gives many novice investors the impression that the stock market is just a casino. In the short term, that certainly seems to be the case. But in the long term, stock prices always eventually reflect the value of the underlying business. Therefore the best way to succeed, in my opinion, is to only invest in strong businesses and hold onto them.

For example, investors who were able to spot the long-term value of Apple back in 1980, invested just £1,000 and held onto those shares until today would have approximately £1.34m today. That’s the power of long-term investing when executed correctly. Of course, that’s obviously easier said than done.

How do I place an order to buy or sell shares in the stock market?

In the past, buying and selling shares used to be quite a palaver. Today, with technological innovation coming from fintech stocks, the process has become far easier, more accessible, and cheaper.

To get started buying and selling stocks, an investor first needs a brokerage account which grants access to an investment platform. There are plenty to choose from. But it’s important to carefully examine the fees these platforms charge. For UK investors, it’s also worth exploring the option of a Stocks and Shares ISA, which is a tax-efficient account. The Roth IRA is the closest equivalent in the United States.

Through the trading account, an investor can place an order to buy or sell a particular stock. The order is passed onto a broker who finds an investor to fulfil the buy or sell order from the stock market and then facilitates the transaction.

Don’t forget when an investor is buying shares outside of an IPO, they’re buying from another investor who is selling those shares, and vice versa.

There are different types of orders that can be placed. But the three most common are: 

• Market orders – allow the investor to buy or sell the share at the best current price in the stock market. 
• Limit orders – allow the investor to buy or sell once a stock hits a specified price. But there is no guarantee of order fulfilment since the stock may never reach the specified price.
• Stop orders – allow the investor to close their trade at a given price. This is typically used by traders to lock up profits or prevent losses.

Final thoughts on what is the stock market

Investing in the stock market can be quite a daunting process, especially for beginners. But used correctly, it’s arguably one of the best wealth-generating instruments available to almost everyone today.

That’s we’ve written a guide to help new investors get started on their investment journey.

How to start investing in stocks today

Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.