How Does the Stock Market Work? Shares, Mutual Funds, Indexes, Oh My!

The stock market can seem a little intimidating, as well as a little risky. It's still a little scary to me; that's coming from someone whose dad made her listen to the audio version of Rich Dad, Poor Dad on the seven-hour drive back from college, so I would learn the ins and outs of investing. (Now, I wish I'd paid better attention.)

But just because the stock market seems like a scary, complicated black hole of money doesn't mean it actually is. In fact, it can serve you quite well.

You may be already using the stock market without even knowing it. If you have a 401(k), for instance, you probably have a choice of mutual funds in which to invest your money. Mutual funds are basically pooled money from many people that is invested in stocks, bonds, and short-term debt. If you do have a choice, you may select the default option, or, if you're like me, you ask your dad which one to pick. But after learning a little more about how the stock market works, you can choose yourself!

A stock is essentially a small piece of a company. So if you own stock in Amazon, for instance, you own a little piece of Amazon. That pretty much means you and Jeff Bezos are peers.

The stock market is really a misnomer. There are really lots of "markets" or stock exchanges. When people discuss how well the market is doing and the ups and downs on a given day, they're refering to the different markets and how well they are doing on the whole or on average. They may also be referring to specific indexes, about which we'll go into more detail later.

Stock exchanges are where buyers connect with sellers. You're probably familiar with the two biggest names in the U.S.: the New York Stock Exchange (NYSE) and Nasdaq.

Some stock trading happens in person. That's the case with the New York Stock Exchange. While much of the NYSE's stock trading is now done electronically, it remains one of the few places where floor trading sometimes occurs in person. You're probably familiar with the NYSE: It's that big, financial building on Wall Street that often has a famous person ringing its bell to single the opening and closing of the market for the day.

While the NYSE is a continues to be a prominent physical symbol of Wall Street and the Financial District, much of today's buying and selling is done electronically. Nasdaq bids are solely electronic, for instance.

A company sells shares to raise money. The price of individual shares is based on the estimated value of the company and sold through an initial public offering (IPO). The company keeps the money raised, which helps them establish and grow the business, and the shares are traded on an exchange. The company only receives money from the IPO, not from the shares that are continually traded.

The "market" is comprised of brokers, traders, and investors who are continously buying and selling stocks. As the perceived value of the particular company changes over time, so will the value of your share.

Many investors diversify, or buy stocks across various sectors, to account for the up and downs of the stock market. That's because it's hard to predict when a stock price will rise or fall. Established companies may also pay dividends, or a share of the profit, to shareholders.

If you want to invest—which can be a great way to grow your income—the rule of thumb is to buy when the share prices are low and sell when the share prices are high. Of course, it's pretty difficult to predict when and how a stock will grow. That's why it is so important to diversify, investing across multiple stock options. You might also want to use a stockbroker or financial advisor, who will advise you and buy and sell stocks on your behalf.

People can track the ups and downs of stock prices by watching the indexes, which basically give an idea of how certain groups of stocks are doing. The stock prices of the group are averaged to give a general picture of how the stocks performed in a given day. The indexes include the Dow Jones Industrial Average (known as the Dow), comprising 30 stocks from leading U.S. companies; the S&P 500, including the 500 largest and most valuable U.S. companies; and the Nasdaq Composite, which measures companies listed on the Nasdaq.

Investing in the stock market can certainly help you grow your money. That said, it does involve a certain amount of risk. If your company offers stock options in addition to or as part of your salary, depending on the terms, it's probably a good call to take them. If the company does well, you'll be continuing to earn money long after you leave.

Talk to a a financial advisor to discuss your personal situation and whether (and how much) you should invest.