Stock Market Basics
Investing is a worthy endeavour, but the language of investing is filled with words and phrases that can scare people away. Stocks, shares, stock market, trading—all words that we know well, but the meaning of which we don’t always fully understand. Money Wizard is here to clarify what all this means to help you start investing with the greatest asset an investor can have: knowledge.
What Are Stocks?
Stocks are a valued portion of a company; or, more technically, they are secured equity in part of a company. When you buy stocks, you are purchasing part of that company’s value based on how others have valued it. These stocks are often traded on stock exchanges like the Toronto Stock Exchange or the Neo Exchange.
Imagine a company owner. Let’s call him Billy. Billy owns a coffee shop and has been very successful.
He wishes to expand his business. But although he has been successful, he lacks the funding to expand it on his own. In order to raise the necessary funds, Billy can offer the value of his company to other people in the form of stocks. He is inviting something like a public loan, or a lot of individual public loans.
This first period of selling is called an initial public offering (IPO). People may buy shares of this initial offering to directly invest in Billy’s coffee shop.
What’s the Difference Between Stocks and Shares?
“Stocks” and “shares” are often used interchangeably, but tend to be used in different contexts. “Stocks” is a more general term designating ownership in a company or companies; “shares” typically pertain to the individual units of ownership of a particular company. For example, you own stock in a company; you own three shares of the company.
Why Do People Buy Stocks?
People buy stocks to make money from them or to help develop the company (and often both, of course). This can happen in various ways.
Shareholders can make money from capital appreciation—which occurs when a stock rises in value. They can sell when the value has increased from what it was when they bought the stock and make money from the difference. If someone buys one share of Billy’s stock at $5 and sells it at $20, he makes $15 from the transaction.
Companies sometimes distribute their profits to shareholders through dividend payments. These reward the stockholders for their investment and foster trust between the companies and their stockholders. If Billy offers dividends, he may pay his shareholders 10% of the value of the stock, or $0.50 for each share.
When people own a large number of shares in a company, they can vote during shareholder meetings and therebyinfluence the practices of the company. Investors whose total shares in a company have a low value rarely if ever have a right to vote; but wealthier stockholders of large companies often do.
Why Buy or Sell Shares?
People buy or sell shares to make money from dividends, to take advantage of changes in stock prices, or to cut their loses if the value of a stock is declining.
If the stock value of Billy’s company is rising, an investor may choose to sell and walk away with that profit. However, if the value of the stock is declining, a shareholder may choose to cut his losses and recover as much money as he can.
What Are the Risks of Trading Stocks?
The biggest risk of trading stocks is losing money. Although stocks tend to perform well over the long term—especially large groups of stocks such as those represented in stock indexes— there is always the chance that the value of a particular stock will plummet. And many stocks may tumble simultaneously if a sector of the economy or the economy as a whole suffers a major downturn.
If Billy’s coffee shops start losing business, the price of its stock may fall. Other factors can also cause a stock price to decline. Perhaps the rising prices of coffee force Billy to increase what he charges, which scares shareholders, who therefore start to sell stocks. Perhaps a major disaster like the 9/11 causes the economy to take a nosedive.
There are many ways to limit these risks: investing money in stocks only when you’re comfortable seeing the shares fluctuate in value, investing in blue chip companies that have a long track record of steady growth, and having a diverse investment portfolio in which gains will tend to balance losses if a particular stock or sector declines.
How Does the Stock Market Work?
The term “stock market” refers to all the stock exchanges in the world, including the Toronto Stock Exchange and the Neo Exchange. At these exchanges, traders buy and sell stock for themselves or others.
The stock market is somewhat like an auction house; stock is auctioned off at a certain price, and the price raises as more people bid for a stock.
In Billy’s initial public offering, he allowed people to buy stock directly from him on the primary market at a set price. Let’s say the initial price was $5. If a company is popular with investors, such initial public offerings of stock are purchased quickly.
In the secondary market, people buy, sell, and trade stocks between themselves. Investors who own shares of Billy’s initial $5 offering may sell them for $15 if and when their value increases to that extent. The new buyer can then wait until the stock rises again before selling it, meanwhile collecting dividends. The same shares can be traded again and again, indefinitely. This secondary market constitutes most of the stock market.
Pros and Cons of Stocks
Advantages of Stocks
- Long-term growth. Investing in stocks can be a great way to earn dividends, which may be as high 8% to 10% a year. This means that a $10,000 investment can return $1,000 every year (if the dividend is stable). If you collect that dividend for ten years, the return is $10,000 if the value of the stock continues to be at least $10,000.
- Quick liquidation of investments. Unlike buying and selling real estate, which can pay off but which often requires a lot of time, stocks can be traded very quickly if you wish to take a profit, cut your losses, or simply leave the market.
- Easy Investing. Modern technology makes it easy to buy and sell stocks. Nowadays, people can start with a small amount of money and easily work with a broker or financial planner who will buy, sell, and manage stocks on their behalf.
Disadvantages of Stocks
- Risk of losing money. Sometimes buying and selling stocks looks like gambling, since the value of the stocks may suddenly plummet. There are methods of reducing such risk. But it is almost inevitable that at least some of the stocks in a diverse portfolio will substantially decline in value.
- In a bankruptcy, stockholders are the lowest on the totem pole. If a company goes under, ordinary stockholders are last in line—behind preferred stockholders and bondholders—to receive any payout.
- It’s a time sink. Learning to trade on your own, which includes properly studying the market, takes a lot of time.
- It’s an emotional ride. Much of your money may be invested in stocks that are flourishing one day, putting you on top of the world—and collapsing the next, sending you into a slough of despond. Whether you are careful or impulsive, your buying and selling decisions can lead to long-term regret if those decisions aren’t the best. Especially if your decisions tend to be impulsive.
Frequently Asked Questions
What are Penny Stocks?
Penny stocks are stocks valued below $1 a share. These stocks are often issued by smaller companies and may be traded over the counter or in digital markets. They aren’t often traded on the major stock exchanges. Penny stocks tend to be very risky investments that rarely pay off well.
How do Beginners Buy Stocks?
It’s wise to buy stocks when you have enough money to commit to the market.
First, set aside some money as an initial investment. $1,000 is a good starting point. Then, insofar as your budget permits, regularly set aside a small amount of money to invest—perhaps a percentage of every paycheck.
Second, learn about the stock market in detail: the terminology, how it all operates, and what is happening in the news that may affect stocks. Regardless of how you wish to invest your money, it’s important to invest your time in learning about what you’re investing in. MoneyWizard is a great resource for learning about the stock market.
Third, choose your investment style. Do you want to focus on conservative investments that reward you in the long term? Or on aggressive but riskier investments that may substantially increase in value in the short term?
Can I lose my 401K if the Market Crashes?
Yes. Like stocks, your 401K retirement plan can vary in value. If the stock market crashes, the value of your 401K can certainly crash as well.
However, your 401k is a long-term investment. If the market crashes, it’s usually best to wait out the dip. Historically, the market has always come back in the end—and stronger than it was before. So if your 401K plan crashes, don’t panic. The value of your 401k has dropped, but it will probably recover in time.
Should I Invest Today or Wait?
No matter what the market looks like, it’s always a good idea to invest in stocks. If the market is at an all-time low, stock prices will be low and you’ll have to wait for them to rise. You’ll also have good buying opportunities. If the market is at an all-time high, then there’s a good chance that the market will continue to be robust. If there is a dip in the market, it’ll eventually bounce back in time. Patience is one key to successful investing.