By Stacey Ritzen, WCI Contributor
For the uninitiated, the very concept of the “stock market” can be a daunting, complex, and even anxiety-inducing entity to wrap your mind around. For those who don't know what the stock market is or how it works, the idea of putting your hard-earned money into a system that seems to favor those who are already wealthy might seem risky.
But there’s also a good reason why the stock market is such an attractive way to invest for those who earn a high salary and who have built wealth. When approached responsibly and under the right circumstances, investing in stocks can be one of the best ways to help build your net worth. In this guide, we’ll take you through some of the very basics to provide a cursory understanding of the stock market and how it works.
Definition of “Stock”
In the simplest terms possible, a “stock” is a single share in the ownership of a company. The word is often used interchangeably with “share.” When you purchase stock in a company, you essentially become a fractional owner of that company in proportion to the total number of outstanding shares held by all of the shareholders.
In addition to the value of the stock itself, stock ownership can give shareholders voting rights, as well as claims to capital gains and dividends on corporate earnings.
Depending on how many shares of stock an individual or entity has in a company, it can provide a significant position to dictate the company’s overall outlook. For example, if a company has 1 million outstanding shares of stock and someone owns 250,000 of those shares, they effectively own 25 percent of that company’s equity.
What’s the Point of Stocks?
The reason we have stocks in the first place is because, oftentimes when a company is just starting out, stocks are the easiest way for it to raise funds to build the business. Another option would be for a company to borrow from banks, but the interest and principal payments from those types of business loans can hamper the company’s cash flow.
A company might use the money generated by stock to fund various business developments, such as financing new products or initiatives, investing in growth or expanding operations, and paying off debt.
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Different Types of Stock
As with many things in life, all stock is not created equal. The two fundamental types of stock are common shares and preferred shares, and both have their benefits and drawbacks. As you might imagine, “preferred stocks” are named so for a reason. However, the primary distinction between the two boils down to voting rights.
Common stock, which is also synonymous with the term equities, implies a combined market value and capacity for trading that far outweighs preferred shares. But the main difference is that common shares carry voting rights. This allows the shareholder to participate in corporate meetings and weigh in on decisions such as appointing members to the board of directors.
But there can also be different types of classifications within common stock regarding voting rights. At the core principle, common stock offers equal voting rights of one vote per share, but companies might have different classes of stock that carry greater voting rights.
With multiple stock classes, a Class A stock may carry any number of designated votes per share, while Class B garners only the standard one vote per share. These classification structures allow corporate principals to retain the upper hand in guiding the company in strategic direction and innovation.
Preferred stock, on the other hand, does not retain voting rights. The reason why it’s called “preferred,” however, is because preferred shareholders hold priority over common shareholders in the ability to receive additional dividends or other assets, such as in the instance of a liquidation. Likewise, these dividends, which are paid to the investors when the company makes a profit, generally yield higher returns and can be paid monthly or quarterly to the shareholder.
What Is the Stock Market?
In a nutshell, the stock market is a type of marketplace where shares of publicly held companies are bought and sold, and buyers and sellers are permitted to negotiate prices and make trades.
To ensure a fair playing field, the US stock market is regulated by the U.S. Securities and Exchange Commission (SEC), which has a mission to “protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.”
What’s the Difference Between a Stock Market and Stock Exchange?
Though the two terms are often used interchangeably, stock exchanges are the various secondary markets that make up the whole of the stock market—such as the New York Stock Exchange (NYSE) and Nasdaq. By buying and selling from one or more stock exchanges, you are essentially trading in the stock market.
When purchasing a share of stock in a stock exchange, you’re not buying it directly from a company but from an existing shareholder or investor. The same goes when you eventually sell that stock. You’re not selling the stock back to the company but to another investor. These transactions occur in stock exchanges.
What Is a Stock Market Index?
A stock market index is used to track the performance of any given stocks, bonds, and other investments. When you hear about the Dow Jones Industrial Average (DJIA) or the Nasdaq Composite, these are examples of a market index. These indexes are typically grouped by industry to provide a quick glimpse into the health of any given stock so that investors can monitor the performance of their investments.
Market indexes can also vary wildly when it comes to size, and there’s no set standard. For instance, the DJIA has just 30 stocks, whereas the S&P 500 consists of—you guessed it—500 companies that issue a total of 505 stocks. The important thing is that each stock market index provides a large enough sampling that gives an accurate context to the overall behavior of the market.
What Does Stock Market Volatility Refer to?
In every stock market transaction, there is a buyer and a seller. When there are more buyers for a specific stock than sellers, the stock price trends up. However, if there are more sellers than buyers, that stock drops in value. Stock market volatility measures the short-term fluctuation of the stock’s overall value.
Though the term generally applies to the market as a whole, individual stocks can also be considered volatile,.
External events can also affect volatility, such as the COVID-19 pandemic and the Russian invasion of Ukraine, which can cause panicked buying and selling. Critical events like quarterly earnings reports can also temporarily cause an individual stock to become more volatile.
There are also different types of market volatility. Historical volatility measures how volatile an asset was in the past, while implied volatility uses a variety of metrics to predict how volatile an investment will be in the future.
Additionally, the type of stock may also affect volatility, and some are more volatile than others. For example, technology, commodities, and healthcare sectors tend to have high stock volatility. On the other hand, blue-chip stock from large, well-established, financially sound companies with excellent reputations tend to be more predictable.
How Are Prices Determined in a Stock Market?
As mentioned above, every stock transaction requires a buyer and a seller. In the auction process, a “bid” refers to the price at which an individual hopes to buy a stock. An offer, or ask, is the price dictated by the seller. A trade is agreed upon when the bid and ask coincide.
There are millions of investors trading on the stock market at any given moment, and they all have their own opinions on how much a stock is worth and how much they are willing to pay for or unload it. When taken as a whole, the inherent laws of supply and demand dictate these thousands of transactions, which help shape the overall price of the stock in real time.
What Happens When the Stock Market Crashes?
Stock market crashes occur when stock prices take a sudden and significant decline. There are no exact set parameters for what constitutes a stock market crash; however, the term generally applies in situations in which major stock market indexes drop more than 10% in value in a short period of time.
Though some market crashes occur due to the aforementioned external events, they typically happen without warning and tend to follow a period of economic prosperity during which stock prices steadily rise. The stock market crash will often be triggered by panic-selling when investors attempt to liquidate assets quickly and curb potential losses.
Even though the stock market can crash quickly, that drop in the market can have profound, long-term financial ramifications for months or years to come.
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How Do You Invest in the Stock Market?
Contrary to popular misconceptions, the stock market is open to everyone, not just investors. But for the average person to get involved in the buying and selling of stock, they need a stockbroker who acts as the middleman between the buyer and the seller.
As such, anyone with access to a brokerage account, an automated digital trading platform, or even an employee retirement plan can trade stocks. Investing in the stock market is also an attractive option for those who like to cherrypick their stocks, as employer-offered 401(k) plans can have limited options.
But one of the easiest ways for beginners to invest in the stock market is simply to put money in an online investment account. There is no shortage of options available that allow you to invest in shares of stock or stock mutual funds. Many brokerage accounts even will enable you to start investing for the price of a single share.
How Do You Make Money In the Stock Market?
Now here’s the million-dollar question we’ve all been waiting for. Essentially, there are two basic ways investors can earn a return on their stock investment.
The first is when the stock price appreciates in value, at which point you can sell the stock for a higher price than at which you bought it to turn a profit. The profit incurred from selling a stock is referred to as a capital gain.
The second is when the stock pays dividends that a company distributes to shareholders. These payments generally are made to shareholders out of the company’s revenue and are paid quarterly.
It’s worth noting that, since 1956, dividends have contributed nearly one-third of total stock equity return while capital gains are responsible for two-thirds.
But don’t expect to get rich overnight. Though trading stocks can indeed be a great way to build your net worth, the long-term average return on the stock market is 10%—or between 7%-8% when adjusted for inflation. But again, that’s just the historical average. Obviously, some years (and some stock) have higher returns than others.
Another important factor to consider when investing is to diversify your portfolio and not simply to buy stock in just one company or industry. A well-rounded stock portfolio should include stocks from many different companies across various industries and sectors. One way to do that is to buy into a total market stock index fund.
If you’re considering investing in the stock market, the good news is that The White Coat Investor offers many resources to novice investors, and they can help you determine whether stocks are the right option for you.
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