How to Understand the Stock Market

Investing in the stock market is an exciting way to participate in the growth of the U.S. and world economies. As a stock market investor, you can enjoy the financial success of your favorite companies right along with them. While the intricacies of stock market investing can get complicated, the basic structure and function of stocks and the stock market is relatively straightforward.

Common Stock & Preferred Stock

The two main types of stock are common stock and preferred stock. Common stock is the most commonly traded and offers investors the greatest potential for price gains. If you buy a share of common stock, you own a portion of the company. When the company generates profits, more investors tend to buy shares, driving the price up. If you own a stock that increases in value from $50 per share to $60 per share, you've gained 20 percent on your investment.

Preferred stock is a different type of stock that has different characteristics than common stock. While a share of common stock may pay a small dividend, it is more appropriate for an investor seeking share price gains rather than income. Preferred stock is just the opposite, typically paying a much higher dividend but generating much smaller price movements. This can work both ways for investors: If the stock market goes down, common shares will fall more dramatically than preferred shares. However, the opposite is also true. When the market roars higher, common stock will typically generate much higher capital gains than preferred stock.

Buying and Selling Stock

The stock market is driven by supply and demand. If more investors demand to own stocks, the market rises. If there are more sellers than buyers, the market falls. Demand is created by a combination of factors, but the primary drivers are company profits and the state of the markets in general. While there isn't a perfect correlation, typically more profitable companies attract more buyers. Even when a company is doing well, however, investors can decide to sell due to rising interest rates, global unrest, declining prospects for the general economy and actions by government and monetary policy officials, such as the Federal Reserve Board.

Investment Considerations

While the short-term movements of the market are unpredictable, the long-term trend is typically up. The longer you hold your investment in the stock market, the more likely you are to make money, at least based on historical trends. Short-term fluctuations notwithstanding, the stock market as a whole has returned close to 10 percent per year since 1926. However, if you own an individual stock, your returns could vary considerably. Some stocks double in value rapidly, while others end up completely worthless. The value of your stock is ultimately tied to the fortunes of the company in which you invest. Just because the stock market as a whole rises doesn't mean the value of your stock will rise as well.