How Does The Stock Market Works?

Maybe we always wondered, why do we have to hear what the stock market is doing every night? When the market’s booming, we’re made to believe the economy is booming. And in America, the stock market has been mostly booming for almost 40 years. As the stock market goes, so goes the wealth and the health of the American economy.

But if you add up all the goods and services bought and sold in the US, the actual economy, that number isn’t growing as quickly as it used to. Wages have hardly budged in decades and the average American family’s net worth still hasn’t recovered from the Great Recession. So what exactly is the stock market measuring?

To understand what stock markets are measuring, it helps to imagine a very simple business like a lemonade stand. In this analogy let’s name her Jill. When Jill tried to get a loan, the bank said it was too risky, and the rich investors weren’t buying it.

But Jill has another option. She can go public, giving anyone who wants to, the chance to invest in her business through something called an initial public offering or IPO. Investors pay a certain amount, say a dollar, to own a small part or share of Jill’s business.

Jill sells a bunch of shares and growing her lemonade empire! Jill can put that money towards opening new lemonade stands, which means more profits. Jill can put some of those profits towards developing new products. She can also give some of that money back to her investors. These are called dividends.

She doesn’t have to do this, but it does help get people excited about her company and more likely to buy her stock, like Sam. He was sick on IPO day, but he thinks he knows this lemonade stand thing is gonna be huge.

So he offers to buy some shares from one of the original investors for twice what she paid for them. He’s thinking if Jill keeps this up, he can sell these shares for even more later on.

That’s the stock market. It’s people buying and selling tiny pieces of companies, based on how much they think those pieces will be worth in the future. Except in real life, it’s happening thousands of times a second, all over the world.

There are stock markets everywhere, but the New York Stock Exchange is the big kahuna. It’s been around since 1792 when 24 stockbrokers put on their finest short pants and top hats and got together under a buttonwood tree on Wall Street in New York City.

Today, it’s where shares in big traditional companies like IBM and GE are traded. The NASDAQ is the cooler younger brother. It was born in 1971 and doesn’t have a physical location. All the trading happens electronically. That’s where you find tech companies like Apple and Facebook.

So, in America, if you want to know how the stock market is doing, you want to know how both these exchanges are doing. That’s where indexes come in. They take a whole bunch of share prices and transform them into one clean number. The S&P 500 tracks 500 of the largest companies on both exchanges.