Explain It to Me Like I'm 5: Here's How the Stock Market Works

If you're clueless about stocks, here's what you need to know.

Once you've built up a solid emergency fund, you may be ready to start investing your money in stocks. You can do so by opening a brokerage account, and you can also buy stocks in a retirement plan. Though 401(k) plans generally don't allow you to hold stocks individually, you can hand-pick stocks in an IRA account.

But what exactly is the stock market and how does it work? If that's something you're wondering about, don't feel embarrassed. You're better off getting an explainer and knowing what you're getting into, especially since stocks can be a risky investment. Here's what you need to know.

What is a stock?

Not every company trades publicly. But companies that do trade publicly issue stock that you can buy shares of. When you own a share of stock, you own a piece of the company in question.

How does the stock market work?

The stock market refers to the broad mix of stocks that's available for investors to buy and sell, and the different exchanges where stock shares are traded. You wouldn't be able to go "visit the stock market," but you can visit the New York Stock Exchange, for example, which is located on Wall Street.

When you read about stock news, you'll often see things like "Wall Street did this'' or "Wall Street did that." To be clear, this is just another way of referring to the actions taken by stock market investors as a whole.

You should also know that the stock market consists of a number of indexes that are used as benchmarks to measure its general performance. Once popular index is the S&P 500, which consists of the 500 largest publicly traded stocks on the market.

Another popular index is the Dow Jones Industrial Average, which tracks 30 of the largest U.S. companies. There's also the Nasdaq, which consists largely of, but is not limited to, tech stocks.

Of these three indexes, the S&P 500 is most commonly used as a measure of the total stock market's performance, even though there are stocks available to be bought and sold that are not part of the S&P 500. So when you hear something like "the stock market fell today," that might really mean that the value of the S&P 500 index declined.

How do you make money by investing in stocks?

The price of any given stock can fluctuate from day to day. And stock prices can change based on factors such as news events or financial events that are specific to individual companies.

For example, stock prices might fall on a whole if an economic indicator points to a near-term recession. If a specific company releases earnings data and it's negative, that company's share price might decline, even if the broad stock market does not decline at that time.

To make money in the stock market, your goal should be to buy quality stocks and hold them long enough so that their share prices gain value over time. While it's possible to make money in stocks over a shorter period of time, because the market can be very volatile, a long-term approach is better.

As an example, let's say you buy 10 shares of a given company at $100 apiece, for a total investment of $1,000. If, over 20 years, the value of those shares rises to $500 apiece, you'll be sitting on a stock portfolio worth $5,000. If you sell those stocks at that point, you'll walk away with a $4,000 profit.

You should also know that some stocks pay dividends. When companies make money, they can choose to either reinvest it in the business or share it with stockholders. When they go the latter route, it results in dividend payments, which is basically extra income and another way to make money in the stock market.

How do you buy stocks?

Most people who buy stocks today do so in a retirement plan or brokerage account. Usually, this means opening an app or website, logging into your account, entering the company name or stock symbol (also known as a ticker) of the company you want to buy, and indicating how many shares you want.

Your brokerage account interface will let you know what price you'll be buying at (based on what prices look like at the time), and once you click the "buy" button (or whatever similar button your account uses), those shares will be added to your account. At that point, you'll have the option to hold your stocks or sell them.

You should also know that many brokerages allow you to buy shares on a fractional basis. This means that if a company's stock is trading for $100 a share but you only want to invest $50, you can buy half a share instead.

How do you know which stocks to buy?

Well, that's the tricky part. You never know when an otherwise strong company might falter in the future, leading to a lower share price. Your best bet, however, is to research different companies to get a sense of how they operate and what financial advantages they have. You may want to focus on companies that manage their cash flow well, have little debt (or debt that's under control), and have a lot of growth potential.

The good news is that publicly traded companies are required to disclose financial information on a regular basis. So you don't need to guess at how much cash reserves a given company has -- you can access that information and use it to help guide your decisions.

As a general rule, it's a good idea to buy and hold stocks across a range of market sectors. This means that rather than buying 20 different tech stocks, you should instead buy a few tech stocks, a few bank stocks, a few energy stocks, a few healthcare stocks, a few retail stocks, and a few auto stocks, just as an example.

The more diverse a stock portfolio you have, the more protection you might buy yourself against losses. That's because if one market sector takes a hit, your assets will be spread out across many others. A diversified portfolio could also be your ticket to helping your portfolio grow.

Finally, you should know that you can invest in the stock market without buying individual stocks. Instead, you can load up on exchange-traded funds, or ETFs, which are funds that trade publicly.

Some ETFs focus on a single market sector, while others, like S&P 500 ETFs, aim to track the performance of the broad market. Owning ETFs is a great way to diversify your portfolio without having to do the level of research required to buy stocks individually.

And there you have it. That's the stock market in a nutshell. Hopefully, you're now feeling more comfortable with the idea of buying stocks. And if not, ask questions. There's no such thing as too much financial education.