Stock Market Basics

Reviewing stock index on laptop computer.

Stock Market Basics

The US stock market capitalization is collectively worth more than $36 trillion—holding the portfolios of massive institutional powerhouses, the hopeful investments of individual investors, and the accumulated retirement wealth of generations. Close to 40% of the US stock market is owned by individual investors who purchase shares of individual companies. Owning stock in a company means owning a piece of it—a share.

Many investors aren’t active traders – they invest in stocks in a peripheral or more passive way by owning exchange-traded funds (ETFs) or mutual funds for investment vehicles like IRAs and 401(k)s. They may also put their money in mutual funds—which buy individual stocks and investors can purchase shares in the fund.

Today, the sages at MoneyWizard provide a rundown of stocks—you’ll learn the fundamentals of stocks and shares and how the stock market collectively works.

What Are Stocks?

Stocks are a type of security that gives holders a share of ownership in a company—which can be either private or public. A public company has its shares publicly traded on a stock exchange, like the NYSE. When you buy stocks, you’re simply sharing the ownership of the underlying company.

Public traded companies issue their first shares during an Initial Public Offering (IPO). In exchange for the money you give the company, you receive a share in its assets and earnings. Companies issue stock to get money to pay off debt, expand into new markets or regions, enlarge facilities, or launch new products.

There are two main kinds of stocks:

  • Common stock entitles the stockholders to vote at shareholder meetings and receive dividends.
  • Preferred stock doesn’t give you any voting rights but you’ll receive dividend payments before a common stockholder does. Besides, preferred stockholders also have priority over the common stockholders in the event that the company goes bankrupt and assets are liquidated.

Common and preferred stocks may also fall into one or more of these categories:

  • Income stocks pay out dividends consistently—investors often buy them for the income they generate.
  • Growth stocks have their earnings growing at a rate faster than the prevailing market average. They rarely pay out dividends—investors purchase them in the hope of reaping from capital appreciation.
  • Blue-chip stocks are associated with large, well-known companies with a firm growth history. They generally pay dividends.
  • Value stocks typically have a lower price-to-earnings (PE) ratio, hence cheaper to acquire than those with a higher PE. These stocks may be income or growth stocks, and investors buy them in the hope that the stock prices will rebound

Stocks are also categorized by the size of the company, as indicated in the market capitalization. There are small-cap, mid-cap, and large-cap stocks. Penny stocks are the lowest priced stocks—they don’t pay dividends since companies may have little or no earnings.

Why Do People Buy Stocks?

Investors buy stocks for the following reasons:

  • Initial Public Offering. Traders buy stocks on IPOs since it’s priced inexpensively and they could later sell it for some good profit.
  • Dividend income. People seeking income from stocks find dividend-paying stocks a favorable investment. While not all stocks pay dividends, the dividend income is usually taxed at a lower rate than your ordinary income.
  • Price appreciation. Stocks attract many investors because of the profit you stand to make if you hold until the price traded above your initial purchase cost.
  • Voting power. People buy stocks because they present the ability to vote at shareholder meetings and influence the company, like appointing the board of directors.

Why Buy or Trade Shares?

Buying or trading shares has become an investment activity of choice for many investors, but why so?

  • Underlying value. Shares usually have an inherent value that goes beyond the face price – and this is attributed by the fact that they’re the primary medium for business ownership. Shares are essential components to investors, funds, and other businesses looking to take over other organizations or expand their portfolio—they’re a starting point from which most of the trading activities begin. Shares will always retain this in-built, underlying value.
  • Liquidity. Another reason to trade shares is the liquidity of their markets—the ease with which you can buy and sell the securities. Markets for publicly traded shares are highly liquid, constantly buoyed by demand and supply. Unlike other investments, there’s always a willing and ready counterparty should you decide to sell or buy shares.
  • Volatility. While volatility is often perceived as a negative trait, it can be the ticket to incredible profitability for the average trader. Volatility is the rate at which prices change over a given period, and stock markets are adequately volatile to give you a real incentive to hop in. Compared to other static commodities, shares create an attractive prospect for traders looking for a take-home profit or capital gains.
  • Transparency. Stocks are among the most transparent asset classes—both in terms of how they’re standardized and their value interpreted. Stock prices are directly related to the underlying company’s worth, so when the market news is positive, prices will rise. Also, the rigorous oversight by the stock exchanges to ensure fair, standardized, and transparent markets gives you the peace of mind knowing that you’re in a fair market.

How Do You Buy and Sell Shares?

Buying and selling shares is accessible to just about anyone in any of the following ways:

1.       Direct Stock Plans

Some companies let you buy or sell their shares directly through them. In this case, you won’t use a broker, hence saving on commissions. However, you may incur other costs, including if you transfer your shares to a broker to sell them. Some companies will limit direct stock plans to existing shareholders or company employees.

Direct stock plans won’t let you buy or sell shares at a specific market price or time. Instead, the company trades the shares at set times—say weekly or monthly—and at an average market price.

2.       Discount or Full-Service Brokers

You may use a broker to buy and sell shares on the stock exchange, and you generally have two choices:

  • Discount or online brokers. The services of online or discount brokers are typically limited to execution. They facilitate the purchase or sale of shares through an online portal at a fee. These brokers require you to place trades yourself, usually through an online platform or mobile app. Trading advice is usually limited and you’ll manage your portfolio by yourself.
  • Full-service brokers. Think of a full-service broker as a financial advisor. These brokers execute trades on your behalf and offer stock market related advice to guide your investment strategy. Full-service brokers are advisors licensed by the Financial Industry Regulatory Authority (FINRA), and must alert you before making any trades on your behalf.

3.       Stock Funds

You can buy stocks through mutual funds that invest exclusively in stocks. Based on its investment objective, a stock fund could focus on a specific type of stock, like small-cap or blue-chip stocks.

4.       Dividend Reinvestment Plans

These reinvestment plans let you acquire more units of a stock you currently own by ploughing back the dividend payments into a company. Check whether the company or your broker charges a fee for this service. You must also approve the reinvestment of your dividends.

What Are the Risks of Trading Stocks?

While stock markets equally have a lot to offer, many keep off the trade because of its associated risks. For starters, stock prices move up and down—there’s no guarantee that the company whose stocks you buy will grow and perform well. As a result, you can easily lose the money you put into stocks.

In case of bankruptcy and a company’s assets are liquidated, common stockholders are usually last in line to receive the proceeds of the sale. Bondholders are paid first, followed by preferred stockholders. Common stockholders get what’s left—which may be nothing.

Your investment in stocks could also take a hit due to factors affecting the performance of financial markets—also referred to as the market risk. Stock market crashes and bubbles are good examples of market risks. Diversification won’t eliminate market risks but you can hedge against the risk through dividend ETFs, like the Vanguard High Dividend Yield ETF.

How Does the Stock Market Work?

The stock market can be extremely complex, but we will distill how it works. Simply put, we could compare the stock market to an auction house—sellers and buyers negotiate prices and place trades. It operates via a web of exchanges such as the New York Stock Exchange, London Stock Exchange, or Nasdaq. Companies list shares of their stock on exchanges through an initial public offering, after which investors buy the shares.

Traders can also buy and sell stocks among themselves as follows:

  1. Buyers place their bids and sellers offer asking prices
  2. Should the bid equal the ask, a trade will occur
  3. The difference between what the buyer pays and seller accepts is known as the bid-ask spread. A smaller spread signifies a more liquid security.
  4. The stock’s price represents what buyers and sellers collectively decide, and the exchange keeps track of the demand and supply of each stock.

As complicated as it may sound, computer algorithms perform most of the price-setting calculations.

Pros and Cons of Stocks

Advantages of Stocks

  • Easy to buy. The stock market has made it easy for you to buy equities. You can buy stocks through a broker, online, or a financial advisor. Brokers like Robinhood let you buy and sell stocks commission-free.
  • Income from dividends. Most companies will distribute a portion of their earnings to the shareholders. Dividends from stocks can be a source of passive income.
  • Easily diversified. You can invest in different types of equities in different sectors and industries—which gives you multiple growth opportunities to diversify risks. Stock sectors you can invest in include technology, healthcare, basic materials, consumer stocks, and more.
  • Highly liquid. You can easily buy and sell most of the stocks trading on the major exchanges. This lets you convert your stocks into cash when the need arises.
  • High return potential. Historically, stocks have produced the highest returns among the different asset classes over the long term.

Disadvantages of Stocks

  • Risk of losing your investment. Pick the wrong stock and you lose your investment. Similarly, if a company performs poorly, the stock price will plummet—and you’ll sell your stocks at a lower price.
  • Stockholders are paid last. Common stockholders are paid last if a company is declared bankrupt, so you may end up losing everything altogether.
  • You must analyze stocks. While there’s no harm in analyzing stocks, you’ll spend more time and effort choosing the right stock. This is unlike investing in actively managed funds where everything is done for you.

Frequently Asked Questions

What are penny stocks?

Penny stocks are low-value stocks that represent smaller companies. These stocks are priced under $1 per share, but the basket also includes stocks priced under $5 per share. The low pricing makes them more accessible to rookie investors or those with limited capital.

How do beginners buy stocks?

 Beginners can buy stocks through discount or online brokers. Renown brokerage firms like Fidelity, TD Ameritrade, and Interactive Brokers provide online trading platforms. Just pick a preferred broker, open an account, fund your brokerage account, and you’re ready to start trading.

Can I lose my 401k if the market crashes?

While you won’t entirely lose your 401k, you can expect its value to drop if the market drops. The money you put in should remain invested and should go back up when the market recovers—except you’d lose your entire 401k if you invested in a single stock that went to zero. Luckily, most 401ks invest in diversified mutual funds.

Should I invest today or wait?

Let’s face it; there’s no safe time to buy stocks but one thing is certain—you’ll have dividends if you stay invested, and you can plough back the profits into your portfolio. Just be sure to research your options so that you don’t dive into it blindly.