Understanding the Stock Market – Making Heads or Tails of all the Numbers
The stock market can seem complicated, but it’s an important vehicle for building wealth. Learn how to get started investing today.
For many, the stock market seems more like a complicated form of gambling than it does a way to save and earn money; however, the stock market isn’t actually that complex. While it’s easy to get overwhelmed by the sheer amount of data, trading volume, and terms involved in stock trading if you want to start investing it’s easier than you’d think to get the information you need.
The key to making any investment is understanding how it works. Just like you’d never buy a car if you didn’t understand its features, it’s critical that you avoid jumping on the bandwagon of different stocks just because of something you read online. In order to build sound financial habits, you need to have some foundational knowledge of what you’re doing and why.
Read on to learn more about how the stock market works and to get an overview of the sorts of investments that might make the most sense for your own financial goals.
- The bottom line
What is the purpose of the stock market?
It’s easy to know about the stock market without actually having a full grasp of how it works or what its purpose is. That being said, the stock market actually has a function to play in the economy, for both businesses and consumers. Understanding this simple fact can help you better understand why the market fluctuates—as well as why volatility on the secondary market of stock exchanges is sometimes related to real-time economic events.
The role of shares for companies
When a company is looking to get off the ground, it obviously needs money. While angel investors or business loans are certainly one way to raise funds, another way for a company to increase its assets is to sell shares to the public.
Most CEOs and founders will already own a number of shares in their company and may give larger investors a portion of ownership over the company during the valuation phase, too. For example, common stock is a type of stock that entitles stockholders to voting rights on various policies within a corporation, including their board of directors.
However, when a company switches to an initial public offering (or IPO), the general public is able to purchase shares of stock in that business. The share price is then left to the whims of a broader range of investors on Wall Street and beyond as the stock price fluctuates as investors buy and sell stocks.
Rather than traditional valuation methods that analyze a company’s past performance, current assets, and liabilities, market capitalization is a way of valuing a company based solely on its share of the market and the price of its stocks.
In order to calculate the market capitalization (commonly abbreviated to “market cap”) of any given company, simply take the stock price of a current share and multiply that number by the number of outstanding shares on the market. For example, a company may have its stock offered at $50 and have 25,000 shares on the market. This means that that company’s market capitalization is $1.25 million dollars—a figure that helps you compare the size of one company against another.
How shares help individual investors
Obviously, a company selling its shares is a great way to raise some working capital in order to run business operations—but how do shares help individual investors? Put simply, the stock market offers a way for investors to grow any amount of money at a much better rate than a traditional savings account.
This is possible thanks to the fact that buying stocks at a low price and selling them at a higher price can often net you a much greater return than the low-interest rates offered by savings accounts.
Of course, investment accounts do require you to assess your risk tolerance, since there’s always a chance that you can lose money in the stock market as well. That being said, if you look at long-term metrics about how the stock market has continued to rise through wars, downturns, and, now, pandemics, it’s clear that if you avoid short-term thinking you can make a sizeable profit from investing. This is why so many retirement accounts leverage the stock market to help grow
Common investment vehicles
When it comes to figuring out which trading strategies are right for you, it’s important to think about your risk tolerance and how risky you’re willing to be with your money. You can never fully know whether a stock will go up and down, and some people inappropriately treat the stock market as a casino, hoping to win big.
While there are certain types of stocks that offer a huge boom or bust in a short amount of time, it’s much better to focus on laying the foundation of a steady, consistent investment strategy before you start playing with other investments. Here are some of the most common types of stocks you’ll want to think about investing in as you start your investment journey.
If you’re worried about picking the best stocks on your own, mutual funds are a great way to achieve a level of diversification that’s paired with a goal of yours for the future. Think of mutual funds as a bundle of stocks and other assets that help to even out some of the volatility in the market while still helping you achieve what you want to through investing.
A great analogy for mutual funds has to do with grocery shopping. The mutual fund is like the cart that you carry your groceries in, whereas the food you’re buying in the cart is the different assets and securities you’ve invested in. Since the value of your mutual fund is based on the fluctuation of everything in your “cart” (rather than just the price of oranges), you have a much more even way to invest and spread your risk out.
Some mutual funds are actively managed by investment professionals while others, called index funds, are passively managed. If your mutual fund is actively managed, you may pay a small commission fee on your earnings—generally an annual percentage of your overall holdings.
A specific type of mutual fund that’s designed to mimic an index in the stock is called an index fund. These are passively managed since the only work that needs to be done is in reference to an index that already exists, such as the S&P 500 index, NYSE Composite, Dow Jones Industrial Average, or NASDAQ Composite. Put simply, each of these indexes provides a specific lens through which to view the stock market’s performance, by focusing on different cross-sections of businesses and their aggregate shares’ performances.
ETFs (exchange-traded funds)
ETFs, also known as exchange-traded funds, are similar to index and mutual funds in that they are different securities bundled together. However, unlike mutual funds, ETFs aren’t actively managed. Instead, an ETF tracks a segment of the stock market. For example, SPDR S&P 500 tracks the performance of the S&P 500 and is thus similar to investing a little bit in each of the companies in the S&P 500.
Especially if you’re looking to diversify your stock holdings, investing in an ETF can be a great way to choose unrelated securities that may mix well together. You can use ETFs to buy stock in specific sectors like energy, oil, or biotech which helps you fill in different holes in your portfolio.
As the name suggests, individual stocks are shares bought in one specific company. For example, you may purchase stock in a company like Apple or Amazon if you think that they’re bound to have steady growth over the next several years. While some individual stocks certainly offer consistent returns, it’s important to remember that by putting all of your eggs in one basket, you do run the risk of riding out a company’s highs and lows. Even a PR scandal can tank a company’s stock, so it’s best to buy individual stocks after you’ve set up more stable investment accounts, too.
While most people think of real estate as a place to live, it’s possible to invest in real estate as well. Whether that means purchasing land that you think will be attractive to developers in the future or simply treating the purchase of a second home as an appreciating asset, there are a variety of ways to invest in real estate.
One benefit of investing in real estate is that it can also provide you with a relatively passive income stream while it appreciates. For example, if you buy a vacation home in Michigan or Florida, you can rent it out via Airbnb or VRBO when it’s not in use, allowing you to tap the property for a new revenue stream in the short-term while property values gradually increase.
Many people think that when it comes to trading on the stock market there’s some secret tip or trick to success. In actuality, that couldn’t be farther from the truth. In fact, two simple concepts—diversification and holding on to your assets—are all you need in order to be successful at investing. Learn more about each of these philosophies below.
Diversification can be thought of as spreading out your risk across a variety of investment vehicles in order to mitigate any losses you may experience while investing. For example, rather than only investing in oil, it’s a good idea to invest in other companies and industries so that you have a well-rounded portfolio.
If all of your money was invested in oil and a new law was passed that severely hampered oil companies’ ability to make a profit, you would lose a lot of money. However, if only a portion of your money was invested in oil, and that same law boosted profits for renewable energy companies, you’d likely lose a lot less on your investment—and maybe even turn a profit!
Diversification is one of the main reasons that for new investors it makes so much sense to invest in mutual funds or ETFs. This is because these sorts of investment vehicles ultimately ensure that you’re spreading out your risk by diversifying your holdings for you.
“Holding” for the long-term benefit
One thing to keep in mind about the stock market and investing is the importance of time. When it comes to earning money in the market, the fact that your stocks will grow over time at a higher percentage than traditional savings accounts is the reason that the market is such a valuable engine for building wealth.
As such, it’s crucial that you remember not to pull out the money you’ve invested as a knee-jerk reaction. Remember that the stock market is going to have natural ups and downs, but, on average, it always goes up in average over time.
This statement has been true over the course of multiple wars, different presidencies, market crashes, and even disease. In fact, even across a total of 26 market corrections, the overall trajectory of the market is an upward slope, with the average stock market return over the past 10 years being more than 9%. As such, it’s important to ride out dips and continue to steadily invest with your ultimate goal in sight years into the future.
How to get started investing
It’s only logical for new investors to feel a little apprehensive about selecting their first stock or investment. That being said, it’s important to not let this trepidation get to you. In fact, since compound interest is an important component of why your returns in the market will grow over time, the sooner you can get into the market, the better.
There are a few different approaches you may want to take when it comes to investing. Some of these paths to investing require certain contribution levels, while others are better suited for new investors or those with a lot of money.
In order to get started buying and selling stock, you’ll want to set up a brokerage account with a brokerage firm. Brokerages act as intermediaries to help facilitate the buying and selling of stocks. You can deposit money to a brokerage firm and then use it to buy different assets and securities.
Brokerages are designed for different purposes. For example, an IRA or a 401k are both examples of retirement brokerage accounts. Different brokerage accounts have different tax implications, so it’s important to know what sorts of penalties and fees you may incur through your investment activity. Most retirement accounts have certain tax advantages that impact when you pay taxes on your gains.
One benefit of investing in the 21st century is the ability to tap online brokers to make lightning-fast transactions. Online brokerages can be set up in under 15 minutes, helping lower the barrier to entry of new investors. An online brokerage account also offers you a quick and easy way to monitor your investments and make changes in real-time.
There is a broad range of online brokerages available to investors, all with a variety of features that may or may not fit your needs. For example, Fidelity has a lot of educational materials that can be helpful for an investor interested in digging into more information about their account, whereas TD Ameritrade is praised for its beginner-friendly tools and a platform like Robin Hood is notable for its accessibility.
Ultimately, each brokerage has its pros and cons, so be sure to do some research before you make a choice.
Working with a financial advisor
Depending on the amount of money you’re looking to invest or how complex your goals are, working with a financial advisor may be a good idea. The best financial planners and advisors can help tailor your investment strategy and allocations to your future goals, whether that’s retiring in style, funding your child’s college fund, buying a second house, or a mixture of multiple goals.
One thing to note about financial advisors is that they likely take a percentage cut or charge a commission on your account management. While larger portfolios won’t be too negatively impacted by these sorts of fees, these are worth noting, especially if there are other fees associated with other stock transactions since they will eat into your profits.
Of course, if you’re getting a return of 9% or more annually, giving up a percentage point or two isn’t going to be the end of the world—although it may be more of a problem during years when your portfolio underperforms..
Using a robo-advisor
A low-cost alternative to traditional financial advisors is using a robo-advisor instead of a living human. Robo advisors are often commission-free or very low-cost, meaning that they’re a great option for first-time investors with smaller amounts of money to invest. For simpler portfolios with a low value, a robo-advisor is generally quite competent at advising you appropriately.
Some robo-advisors, such as the popular platform Robin Hood, even offer the chance to purchase fractional shares in a specific asset. This means that if you don’t have the money to buy one full share you can get your foot in the door by buying a portion of that share. Fractional shares allow you to get started buying stocks in the companies you’re interested in without having to fork over the full price of the stock as you’re beginning to invest, which can be very compelling for investors who are particularly interested in owning a share of a certain company.
Other financial terms you might come across in the stock market
Although the above overview is certainly going to help you on your journey to growing your wealth in the stock market, it’s a good idea to know a few other key terms before you start investing, too. If you want to be able to talk the talk and walk the walk, the following definitions will help you keep up with your friends at work as you discuss your portfolios at the water cooler.
When someone describes the stock market as bullish or a bull market, they mean that it’s rising or on the rise. A bull market is ideal, as it means that your existing portfolio’s value is growing as the market grows. Many people feel encouraged to buy during a bull market since prices are rising.
The opposite of a bull market, a bear market is when stock market prices are falling. During a bear market, novice investors may be tempted to sell to avoid bigger losses. That being said, a smart investor will buy on a downturn if they believe that the market will rebound eventually since more money is to be made on shares purchased during a bear market.
Capital gains describe the money you earn on the sale of stock. Taxes are imposed on any profits generated from the sale of an investment, so it’s important that you factor in capital gains taxes when you’re weighing the positives and negatives of a stock sale.
The bottom line
It’s easy to get overwhelmed with the depth of information and opinion pieces about the stock market. That being said, you don’t need to have the same skills as the stockbrokers on Wall Street in order to make money in the stock market. As long as you have a basic understanding of how the market works, you can make money investing.
Understanding the distinction that general understanding is more important than deep knowledge is crucial if you want to really leverage the stock market to generate more wealth. Many people wait longer than they should to start investing because they get caught up in stock charts or lists of numbers; however, if you just start to dip your toes into investing, you’ll likely be surprised with how straightforward it is.
In fact, by keeping the strategies of diversification and holding your investments for the long-term in mind, you can take a passive approach to investing that still results in major growth over time. Thus, there’s no better time to start investing than today, even if you only have $500 or $1,000 to get the ball rolling.