How the Stock Market Works: A Simple Explanation For You and Your Kids

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The stock market is a place for investors to buy and sell shares in companies — simple enough, right? But when it comes down to how these trades take place, who can actually make these deals, which companies can sell shares, and most importantly, what you should do with all this information, many people draw a blank.

For most, the stock market is similar to the economy: they understand what it is, but how it works is another thing altogether. Yet even if you aren’t an investor or interested in finances, understanding the stock market is essential. That’s because the stock market can affect millions of everyday things we take for granted, like the products available to us, which jobs markets are growing, and which houses we can afford to call home.

Despite this complexity, the stock market also makes an excellent learning tool for kids of all ages. This is because understanding it requires learning valuable concepts like assessing risk vs reward, supply and demand, and the difference between saving and investing. Whether you’re a parent wanting instill financial savvy early on, or a teacher looking to provide a real-world perspective to a unit on finances, the stock market is a great place to start.

Table of Contents:

What is the Stock Market? 

As we mentioned before, the stock market is a collection of shares in various companies that can be bought and sold, and often serves as an indicator of the health of the economy. The concept of sharing ownership can be traced back to the East India Company, which was devised in 1604 as a way for investors to share the risk of sailing goods across the treacherous open seas. While not every ship would reach its destination, the majority did, and no single investor had to bear the financial loss of a ship individually.

Today’s stock market exists as a way for many people to contribute to and profit from companies, while decreasing individual risk. In the United States, most of the trading takes place in the three main exchanges: the New York Stock Exchange (NYSE), National Association of Securities Dealers Automated Quotations (NASDAQ), and the American Stock Exchange (AMEX).

These stock exchanges are different than indexes like the S&P and Dow Jones, which are designed to be an average of one segment of the market. These indexes offer a more complete picture of the stock market and are often referenced when assessing the health of the economy.

The function of the stock market relies on investors and brokers, handling stocks, and stock exchanges. We’ll dive into greater detail on these topics in the rest of the article.

Explained Even Simpler: 

The stock market is like a grove of fruit trees. The trees rely on their numbers to thrive, yet the survival of the forest as a whole does not rely on the success of any single species of tree.

Concepts and Activities for Kids:

When explaining how the stock market distributes risk among many owners and investors, this is a great time to explore the concept of risks and rewards with your child. Explain that often greater risks can reap greater rewards, but that the surest way to come out ahead is by assuring the risk is truly worth it, or not risking anything at all.

Activity: Dice and Candy Game

Give your child five Skittles, and tell them they can get more if you roll 3–6 on the die. If you roll a 1 or 2, they lose all their Skittles. Allow them to choose to roll the die or not. Play with adjusting the odds, and work with them to determine when they should roll and when they should not.  Use our handy risks and rewards scale to visualize the balancing of risky choices and their rewards:

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What is a Stock? 

More than a slice of a company, there’s plenty to understand about stocks. Though they are often described as a small ownership in a company, stocks don’t actually translate to much power. Sometimes, owning stocks allow you to a vote on company issues like electing a new board member.

There are two types of stock: common and preferred. Common are what we typically think of as being traded on stock exchanges and allow you to vote in the company. Investors in common stock get periodic dividend payments from the company. However if the company goes bankrupt, they are the last to be paid.

Preferred stock holders do not get to vote, but receive a predetermined amount in dividends, which means their payments will not fluctuate as much as with common stock. This can make them slightly less risky investment options, though their opportunity for reward is less.

If a company gives away some of its power and profits each time it sells stocks, why would they offer them? Many businesses decide offer shares in what’s known as an Initial Public Offering (IPO) in order to raise capital. In addition to gaining money, offering stocks also allows companies to use stock options to attract and retain top talent, gain exposure with the public, and win the attention of additional investors.

Explained Even Simpler: 

Holding stock is like owning a few of the trees in the forest. You can buy more, or sell your trees to others. If apple trees become really popular or start growing better than other trees, they may be in high demand, and their prices may rise. If the trees are healthy, they’ll slowly grow over time, making them worth more. A few times a year, they produce fruit that are valuable.

Concepts for Kids: 

For younger children, this can be great time to discuss the concept of sharing and the power of teamwork. In the stock market many parts may come together as a whole to achieve something greater. Explain how dividing work makes dividing the rewards worth the process.

Activity: Building Blocks

Using Legos or your child’s favorite building blocks, create a building or construction together, explaining how it is possible only with many pieces coming together to form a whole business. For an additional fun, have a race to see who can build a structure the fastest, with more people on one team than the other. Try out our savings and investing jar labels to help your child see the compounding benefits of investing.

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What is a Stock Exchange?

A stock exchange is essentially a marketplace for investors to buy and sell stocks. While in the past these would have always been real locations where people met and made transactions, today a large portion of the trades made in stock exchanges are done electronically.

There are many stock exchanges across the world. The largest stock exchanges after NYSE and NASDAQ are the Tokyo Stock Exchange, the Shanghai Stock Exchange, and the Hong Kong Stock Exchange.

Not every stock is listed in a major exchange. Some companies list their stocks in over-the-counter markets known as OTC or the Pink Sheets. Stocks listed in the Pink Sheets have no reporting requirements and don’t have to register with the Securities and Exchange Commission (SEC). They are often foreign stocks or stocks that have fallen too low and have been deregistered from an exchange. There are many legitimate stocks on pink exchanges, but you should be more cautious when considering a OTC stock as they can be less transparent and more volatile.

How are stocks actually bought and sold? Stock exchanges work like auction houses. A seller and a buyer both submit an asking price and selling price through a broker or an online platform. If an asking price and selling price match, the orders are filled. In large markets this can happen instantaneously, but in small markets it can take quite a while or not happen at all.

Explained Even Simpler:

The stock exchange is like a marketplace where you can buy and sell the trees you own. To do this, people post asking and selling prices on a bulletin board. Once two match, the sale is made.

Concepts for Kids: 

If you’ve ever shopped with your child, they are likely already familiar with the process of buying and selling. Take the time to explain how buying stocks are similar to making purchases at the supermarket, yet different because the prices change more rapidly.

Activity: Auction House

Set up a sale or auction house of small rewards like toys or treats. Using either real or play money, have at least two children or family members bid on items or toys in the auction. You may choose to make the items things they already own, or new items given as rewards for good behavior.

How are Prices Determined?

To many people the price of a stock seems fluctuate randomly, often making investments feel like a gamble. While no one will be able to see the future, the truth is that skilled investors know how to make an educated approximation of the value of a stock. These are the following factors usually taken into consideration:

  • Revenue growth
  • Earnings per share
  • Price to earnings ratio
  • How often dividends are distributed
  • Management credibility

However, no one actually sets a stock’s prices. The value of a stock is expressed through how investors handle them. So the price of a stock is ultimately determined by supply and demand. The price listed online is the fair price determined by which price the most trades take place.

Explained Even Simpler:

Investors assess tree’s growth, production of fruit, and make an offer. A seller sets the highest price they can reasonably get. When many people all want the same tree, the seller can price their tree higher, since their tree is more scarce. When no one wants a particular tree, the seller is forced to lower their prices in order to sell.

Concepts for Kids: 

Supply and demand is an essential early skill for your child to master. At this point, they probably understand that some things are more valuable than others, but not why. Explain how the value is not intrinsic, and everything has a perceived value, including stocks. Try drawing a chart that demonstrates how price goes up when demand goes up and supply goes down.

Activity: What’s for Dinner?

Using marbles or our provided printables, give your child a small amount of change or play money, and instruct them to buy as many marbles of any color or dinner item they choose. Then, change the prices according to which colors are most and least popular, and have them repeat the process. Have a discussion about how changing the prices changed their buying behavior.

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How Can You Invest in the Stock Market? 

When the average person thinks about investing in the stock market, they may think of their favorite companies or success stories of early Apple shares buyers. While the dream may be to pick a lucky stock and get rich, the reality is that the way most people will invest successfully is with a diverse portfolio.

You may not realize either that your retirement account is an investment in the stock market. Both the many types of IRA and 401(k)s allow you to make decisions on where to invest your money or hire someone to manage them for you.

Outside of a retirement account, you’ll need a brokerage account and broker to actually buy and sell stocks for you. The average person can’t walk into a stock exchange and buy stocks directly.

So how do you choose where to invest your money? Well many experts recommend placing your money across many different companies and industries. This is because historically the market has always grown. This is thought of as the best way to insure you don’t lose money. When you try to cherry-pick a handful of stocks you believe in, you may get lucky and earn more than the market average, but you’re also much more likely to lose money.

Explained Even Simpler:

In order to acquire your trees and their fruit, you’ll need a farmer who has specialized knowledge on the buying and selling of trees. You can get in contact with one through your place of work, or online. Once you begin looking into buying trees yourself, consider diversifying your purchases. With a range of apple, orange, peach, and other fruit trees, you won’t lose all your money if a disease wipes out oranges, or peaches loose popularity.

Concepts for Kids

Now that you’ve explained every major aspect of the stock market, it’s time for them to practice their skills. If you have anything invested in stocks, show them your own investments and have a conversation about how they have changed over time.

Activity: Stock Market Games

There are many online stock market simulators designed to help your child figure out the basics of investing and evaluating companies, all without actually risking any money. These include Wall Street Survivor and How The Market Works are both good options. You can also have your child select a stock and pretend to invest in it using our stock market tracker, while they update their share value each month.

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Sources: Bebusinessed | Fool 1, 2 | BusinessDictionary | WealthHow | Wall-Street

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