What is the stock market and how does investing in it work?
16 June 2021
Your pension is more than likely to be invested in ‘the stock market’. It’s something you’ve probably heard of and might even have seen in Hollywood blockbusters like The Wolf of Wall Street. But do you know what it’s all about? First of all, there are more than one of them. There are stock markets all over the world, with some of the bigger ones including America’s New York Stock Exchange and the UK’s London Stock Exchange. They are physical or digital places where investors can connect with others to buy and sell investments.
The first modern stock market – or exchange – appeared in the 17th century in Amsterdam. Physical trading floors, where you’d see traders frantically gesturing and yelling to each other used to be how exchanges functioned. But today, the face-to-face human trading floor is all but dead as exchanges have gone virtual and traders buy and sell stocks online.
How does a stock market work?
The concept of the stock market is fairly simple. It’s like any other market where you can buy and sell things. But instead of goods, you’re buying ‘stocks’. Stocks are typically shares in a company, so if you buy shares in Google, for example, you own a small part of that business and get to share in the company's success - or if you’re unlucky - its failure.
Your pension investments are generally used to buy stocks. If the price of the stock goes up, you make a profit when you sell it and your pension value would rise. If the price goes down, you make a loss, and your pension value could fall. It’s that simple.
How are stocks priced?
Stock prices on exchanges are governed by supply and demand. At any given time, there's a maximum price someone is willing to pay for a certain stock and a minimum price someone else is willing to sell shares of the stock for. Think of stock market trading like an auction, with some investors bidding for the stocks that other investors are willing to sell.
If there is a lot of demand for a stock, investors will buy shares quicker than sellers want to get rid of them, and the price will move higher. On the other hand, if more investors are selling a stock than buying, the market price will drop.
Demand for a company’s shares will depend on their individual performance. This can also be influenced by the general health of the economy. Other factors sometimes come into play too, such as certain industries performing well or particularly badly following a major event or news story, for example.
What’s a stock market index?
An index provides a benchmark – or standard – to allow investors to measure overall market performance and compare individual stock performance to the market as a whole. The FTSE 100 is considered the UK’s leading benchmark index and measures the performance of the biggest companies on the London Stock Exchange. Other examples include the S&P 500 and the Dow Jones Industrial average in the US.
Investing in the stock market
You can either invest directly in individual companies’ shares or through a fund which bundles together the shares of various companies. For many people, investing in a fund is a good way to start as the fund’s manager will pick the stocks they think will perform best and do the hard work for you. You can also invest in an index tracker fund which, as the name suggests, tracks the performance of all the companies’ shares in an index. Your pension will most likely be invested in the stock market using funds.
One thing to keep in mind however you invest in the stock market is that it’s for the long term - usually 5 to 10 years minimum - so you can get through any dips in performance. It’s also important not to panic and withdraw all your money at the first sign of a downward trend. While never guaranteed, the stock market has always regained its value historically over the longer-term, and tends to outperform money held in savings accounts. So hold your nerve and your investment will more than likely recover.
Pensions are a long-term investment. The retirement benefit(s) you receive from your pension will depend on a number of factors including the value of your plan when you decide to take your benefit(s) which isn’t guaranteed and can go down as well as up. The value of your plan could fall below the amount(s) paid in.