What is the stock market, how does it work and how can I invest?

If your only knowledge of the stock market comes from watching the news and seeing where the FTSE 100 index ended the day, you may have just a vague idea of what it is and how it works.

Or perhaps you have invested in shares, either directly or via a fund or a pension, having done so without really understanding what stock markets are for.

If you are in either category – and you will be very far from alone if you are – it’s a good idea to start from the beginning to understand what the stock market is, what it achieves and how it works. This solid foundation can help you go on to make your money grow.

We’ll also explain the role of the various professionals and organisations connected with the stock market – such as stockbrokers, the stock exchange itself and fund managers – and what terms such as “index fund” and “stock market bubble” actually mean.

Jump to:

• What is the stock market?
• How does the stock market work?
• Why does the stock market matter?
• How can I easily invest in the stock market?
• What are ‘index funds’?
• What is the role of stockbrokers, portfolio managers and investment bankers?
• How is the stock market regulated?
• What about stock market volatility and stock market bubbles?

What is the stock market?

Any market exists to bring together buyers and sellers. In the case of the stock market, the goods on offer are shares (or sometimes other financial assets, such as bonds).

“Share” is perhaps, like the stock market itself, a term that is more often heard than fully understood.

It is a certificate, real or electronic, that represents part-ownership of a business. Collectively, it is the shareholders who own a business, not the managers or directors.

Shareholders are the ultimate decision makers about what the business does and they have the right to all the profits that the company produces.

Your share certificate is proof of your right to a say in those decisions, and to the appropriate share of the profits (the company also maintains a central register of all shareholders).

If you want to buy shares, in most cases you will need to buy them on the stock market. The exceptions are private companies, whose shares are not traded on the stock market – sometimes people own shares in a family shop or other business, for example.

There is, however, one key difference between a stock market and a market that sells, let’s say, fruit and vegetables. This is that there are two circumstances in which an investor, private or professional, can buy shares in a particular company.

The first is when the company invites investment as a means to raise money from those investors. This takes place when the shares are first admitted to the stock exchange (the terms “stock exchange” and “stock market” are broadly synonymous).

In this case, the investor’s money goes to the company concerned, which issues shares to the investor in exchange. Here, the market is bringing together those who have capital (the investors) and those who need capital (the company). Hence the stock market is a particular example of what are called the “capital markets”.

The term given to the raising of money via the stock market is variously a “flotation”, “float”, “listing” or “IPO” (initial public offering).

The second circumstance relates to the trading of shares. Once the shares in a particular company have become available on the stock market, they can be traded there.

The difference between this type of trading and the initial raising of money just discussed is that one investor is selling to another – the company itself is not involved and does not receive the money raised by the sale of the shares; that money goes instead to the investor who is selling.

To distinguish between the two activities, the initial raising of money from investors by the company takes place on what is called the “primary market” and the subsequent trading of shares between one investor and another on the “secondary market”.

How does the stock market work?

A major regulated stock market, such as the London Stock Exchange, operates a well-developed system for the safe and efficient transfer of shares from one investor to another, which has evolved over the decades.

A number of professional functions come together to enable stocks to be traded securely, speedily and at low cost.

Stockbrokers act as middlemen: sellers know that buyers will come to brokers to find the shares they want and vice versa, so brokers put the two sides of the deal together.

Brokers also facilitate trading by quoting continuously a buying and a selling price for each stock. The price at which the broker will buy a particular stock will be lower than the price he will sell at, so that there is a profit margin. You can see these two prices, called “bid” and “offer” respectively in City jargon, on the websites and apps of popular investment shops and the London Stock Exchange.

Brokers use their experience, expertise and knowledge of the market at the time to gauge the right prices to quote for buying and selling. In times of market stress, brokers will widen the gap (or “spread”) between the buying and selling prices to ensure they are not caught out by sudden sharp movements in price.

Once a sale is agreed, a “settlements” team ensures that the stock is transferred to its new owner and the money paid by the buyer reaches the seller. The registrar of the company whose stock was sold is also informed so that the share register can be updated.

These days, almost all share trading is electronic, so your share “certificate” will take the form of an entry in your account with your stockbroker or online investment platform. When you sell a share, you normally have to wait a few days to receive the money.

Your account with your stockbroker can take the form of a tax-efficient “shelter” such as a stocks and shares Isa or self-invested private pension (Sipp), or it can be a “plain vanilla” account that offers no protection from tax.

Why does the stock market matter?

The stock market fulfils a number of roles beyond its central purpose of providing a means for businesses to raise money and for investors to buy and sell shares.

It maintains ethical and governance standards across the large part of the economy represented by listed companies, and imposes standards of disclosure that facilitate scrutiny from investors, policymakers, the media and others.

A stock market index – which represents an average of the prices of the shares quoted on the market, or a portion of them – provides a simple, easily understood measure of investors’ confidence in the local economy, and even a nation’s government and currency (we cover indexes in more detail below).

The existence of this means for ordinary people to invest their money in shares prompts wider interest in investing, finance and the economy and offers them a way to build wealth and achieve financial independence without the risk and obstacles involved in starting a business of their own.

How can I easily invest in the stock market?

The term “stockbroker” can conjure up images of public school males in bowler hats who spend their days looking after the finances of customers from the same background, making the stock market seem remote and alien to others. That stereotype once contained a good deal of truth, but it belongs firmly to the past, and investing in shares is now open to all.

The internet is partly to thank for this revolution. It is now as easy to open a stockbroking account as to, for example, sign up to a new energy supplier.

Admittedly, opening that account is only half the story, because you then need to choose what to invest your money in. But here, too, much simpler answers have become available in recent years.

When it comes to your actual choice of what to invest in, the simplest solution is a “tracker fund” or “index fund”, covered in the next section.

Other simple means to invest in the stock market do exist.

One is to use the investment service that many banks offer their current account customers. Here, you will be offered a small, simple range of investment funds to choose from, with help to identify the one right for you.

Similar services are available from special online investment platforms that offer a small number of portfolios designed to cater to people with various needs and levels of acceptance of investment risk, along with guidance to help you choose the best option. Such services are often called “robo advisers”, as the guidance is delivered by algorithms.

Another alternative is to join a workplace pension – something that will normally happen automatically when you start at a company, unless you actively opt out.

The organisation that runs the pension on behalf of your employer is also likely to offer you a simplified range of investment options. If you express no preference it will invest your pension contributions in a “default” fund.

What are ‘index funds’?

If you are investing without the help of a workplace pension, “robo adviser” or similar, an index fund offers the most straightforward way to put money into the stock market.

Its advantages are that it offers built-in diversification – a vital consideration in any investment strategy, because it means less risk and low cost.

Index funds, also called trackers, tracker funds or passive funds, make no attempt to invest in winning stocks or avoid losing ones. Instead, they simply spread your money over a range of stocks found in a particular stock market index.

Let’s say you’d like to invest in the biggest British companies. There are many funds that track the FTSE 100; you can put money into them via your chosen investment platform and you will pay a very small annual fee for the fund, although the platform will charge its own separate fee.

If you’d prefer a fund managed by a human stock picker, try this list of The Telegraph’s 25 favourite funds.

Alternatively, for advice on investing in British shares read our guide to the best way to invest in British stocks (for the highest returns).

What is the role of stockbrokers, portfolio managers and investment bankers?

Stockbrokers, as we said earlier, are investors’ gateways to the stock market: if you want to buy or sell individual shares, you will need to do so via a stockbroker.

These days stockbrokers largely take the form of online platforms, such as Hargreaves Lansdown and Interactive Investor, although the more traditional type based on personal contact does still exist.

Fund managers provide an alternative means to invest in the stock market if you want exposure to the market, but don’t want to choose individual shares yourself.

A fund, whether it’s a tracker or run by a professional stock picker, gives you access to a diversified basket of shares in one go. Fund managers buy and sell shares for their funds via stockbrokers.

Investment bankers are involved in the first of the stock market’s functions mentioned above, namely the initial raising of money from investors when a company sells shares to the public for the first time, and makes its shares available on the stock exchange.

Investment bankers guide the company through the process and advise it on the price at which it should offer its shares.

How is the stock market regulated?

The world’s major stock markets are, on the whole, tightly regulated, often by financial watchdogs that have been delegated the powers by governments.

In Britain, the London Stock Exchange comes under the supervision of the Financial Conduct Authority (FCA), which itself seeks to ensure that regulated businesses conform to the Financial Services & Markets Act.

In practice this regulatory framework, in conjunction with the exchange’s long history and its famous motto of “Dictum meum pactum” (my word is my bond), ensures that ordinary people who invest in the market can expect to be dealt with fairly and efficiently.

Numerous avenues for fraud and bad practice exist within the financial world, but at least you should be safe if you stick to dealing with regulated entities such as stockbrokers, fund managers and the stock exchange.

What about stock market volatility and stock market bubbles?

Volatility – the way share prices go up and down, sometimes seemingly for no good reason – can be unnerving for new investors, who may picture themselves putting money into the market one day, only for share prices to fall severely the next.

Volatility is an unfortunate fact of life for stock market investors, but they can take comfort from the fact that, despite the ups and downs, the lesson of history is that those who keep their money in stocks for the long term (five years or more) tend to make good returns.

A more active way to deal with volatility, or even turn it to your advantage, is to invest on a monthly basis – something that most stockbrokers can do on your behalf in a process akin to setting up a standing order on your bank account.

If you invest, say, £50 a month, when share prices fall you will automatically get more shares for your money. When prices rise you will get fewer. Not only can this technique benefit you financially, but it may also help you worry less about volatility.

The time to be really wary of investing in the stock market is when there is a bubble. This is when, instead of being volatile, share prices simply go up, sometimes at an ever-increasing rate.

If a share price chart looks like that, think twice about buying shares – or start a regular investment plan, so that during any later fall you will automatically buy shares at lower prices.