How Does The Stock Market Work: A Guide for Beginners
Have you ever sat down to think about how the stock market works? When I was younger and inexperienced, I would hurriedly change the Tv channel when the stock market news came on, and that was because I didn’t understand what they were saying.
Over the years, I’ve come across so many people who also have no idea what the stock market is and how it operates. Well, in this guide, you’ll be learning a lot about the stock market and how it works, beginner’s style.
What is Stock?
Stock is equity that entitles the owner to a fraction of a corporation’s earnings and residual assets. Much more, it authorizes the stockholder to voting rights. Based on government regulations, investors buy and sell stocks on stock exchanges.
Where Is the Stock Market?
The stock market is a public market used by stockholders to issue, buy, and sell stocks that trade over the counter or on a stock exchange. Previously, the stock market was a physical place. However, the introduction of technology ushered in electronic markets that allowed individuals and corporate investors to meet to buy and sell shares without having to see.
With many stock exchanges in the U.S. and various parts of the world linked together, the stock market is now more effective and flexible for operation
Who Set Prices in The Stock Exchange?
When companies list their stocks to raise funds, the price of the stock begins to fluctuate immediately, trading starts. Investors will begin to assess and reassess the value they would get before buying the stock.
So if a company demonstrates long term value, it will attract more buyers. As more buyers request the stock, the stock price increases, and as more sellers decide to sell, the stock price decreases eventually. The stock price is mostly determined by the market forces of demand and supply.
The World’s Largest Exchanges
There are various exchanges in the world, but the two largest exchanges in the world are:
New York Stock Exchange: The New York Stock Exchange, which is also known as The Big Board, is the world’s largest stock exchange by market capitalization of over 25 trillion U.S. dollars (as of April 2020).
As over 2400 companies are listed on the exchange, NYSE accounts for over 40% of the world’s stock market capitalization. It is located at 11 Wall Street, Lower Manhattan, New York City.
The NASDAQ Stock Exchange: The Nasdaq stock exchange is the second-largest global electronic marketplace for stockholders and investors.
With over 10 trillion market capitalization, the stock exchange has experienced constant growth since its development. It is located at One Liberty Plaza in New York City.
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Stock Market Vs. Stock Exchange
A stock market is a place where companies’ stocks are listed for public investors to buy, thus enabling those companies to raise enough capital for growth and enhancement. It’s a place where financial instruments are bought and sold. Depending on market forces of demand and supply, the stock market can either be a bull market or a bear market.
The bull market is a market where more investors look to buy stocks in anticipation of a rise. In contrast, the bear market is a market where investors look to sell off their financial instruments in anticipation of a fall. In a stock market, electronic trading, OTC trading, and stock exchanges occur.
A stock exchange is a verified entity that facilitates stock trading by providing trading services to participants. Also, revealing the conditions for listing and keeping track of trading volumes and price fluctuations.
As an entity that operates under the stock market on a profit motive, it brings the buyer and seller together, individual and corporate investors buy stocks that are only listed on an exchange. In the U.S., the major stock exchanges are the New York Stock Exchange and the Nasdaq Stock Exchange.
While the stock market broadly covers various market activities, the stock exchanges are only a part of the market system.
Stock Market Index
A stock market index reveals how stockholders feel about economic trends. The index is used to collect data from investors across industries. The data is ultimately used to compare past price rates and current price rates and allocation guides.
Some indexes focus on a small part of the market, while others focus on almost all market participants. Nasdaq stock exchange index, for instance, focuses on companies in the technology sector.
The performance of the general U.S. stock market is tracked by its three principal indices which include;
- The DOW Jones Industrial Average or DJIA – Asides being one of the oldest indexes, it is also one of the most used indexes in the world. This index only includes the top 30 U.S. companies, high-end companies with consistent dividends. While there are market-weighted index and price-weighted index, stocks in DJIA are displayed in proportion to price. By being a price-weighted index, a percent change in the index is not usually seen as a confirmed indication that the stock market has also dropped by that percent.
- The S&P 500 – This index reveals the stocks of 500 large-cap U.S. companies. The S&P index represents up to 70% of the total value of the U.S. stock market. Unlike the DJIA index, stock in the S&P index is displayed in proportion to its market capitalization. So if the market value of a company stock drops by 5%, the index will also reduce by 5%.
- The Nasdaq – Like the S&P 500, the Nasdaq composite index is a market-weighted index that tracks stocks of technological companies, in and out of the United States. While it generally includes large and small firms, the index also includes many speculative companies with small market capitalizations.
Asides the companies tracked by these indices, others are also tracked. For instance, Russell 2000 reports the performance of up to 2000 small-cap companies.
The five biggest stock markets are:
- Hong Kong
- Euronext exchanges
In the stock market, the indices track reveals the hypothetical records of stocks representing a particular segment. Amongst several indices, the MSCI tracks stocks in emerging market countries like China, India, and Brazil.
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Why Do People Invest in The Stock Market?
- To build net worth: People invest in the stock market to enjoy investment gains. Although market forces of demand and supply cause individual stocks to rise and fall, stock markets are generally known to rise in value. Much more, people who research well and invest in stable companies tend to make more profits in the stock market
- To receive dividends: Some stocks, especially stable ones, provide dividends to stockholders. Even when the stock’s value drops, the dividend is a stable payment that tops the profit of the stock. Although not every stock provides dividends, many people still look forward to investing in a stock that provides additional income in the form of a dividend.
- Returns beat inflation: While inflation affects almost every type of investment, stock investment returns have proven to beat inflation over time. Whether you invest in a value stock or growth stock, returns tend to beat the effect of inflation.
- Buying and selling is flexible: The flexibility of stock is rooted in the fact that stockholders can be flexible with its sales and purchase while still earning an optimized return
- Unmatched liquidity – the stock market has unmatched liquidity. Stockholders can easily buy and sells shares of a stock without substantially affecting the market price.
Types of Stock
There are two major types of stock
- Common Stock – Common stock is a generally traded stock. Using capital growth, it yields a higher return than other investments. However, the risk involved is stated in the fact that when a company liquidates, bondholders, preferred shareholders, and creditors will be paid before the common shareholders are paid.
- Preferred stock – Preferred stock is a type of stock that gives the shareholder some level of guarantee over their investment. Unlike the common shareholders, the preferred shareholders are given a fixed dividend forever. In terms of value, the value of the preferred stock is determined by interest rates to rise.
What Is a Bull Market?
A bull market is a market where stocks are on the rise. During this time, investors are willing to buy more than sell, as there is a sustained increase in price.
What Is a Bear Market?
A bear market occurs when the value of stock begins to fall. In the bear market, the value keeps reducing and price becomes very volatile thus causing investors to look for people to buy
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How to Make Money in Trading Stock
- Through day trading: Daily trading of stock is one of the most effective ways of making a significant amount of money in the stock market with little investment. However, due understanding of the different market forces is required in initiating such trade. Analyze market forces, take note of moving averages, and ensure to set stop-loss limits to cut the potential of depreciation.
- Through long term investment: Initiating a long term investment will require you to buy a stock at a favorable or low price and hold for a while, when demand is high, to sell at a higher price and take profit or to reap the rewards of the company’s incremental growth.
- By earning dividend income: Companies pay dividend income to stockholders. Receiving such income asides, the profit gained on the stock surely helps in building wealth.
Risk of Stock Market Investing
- The stock price may fall to zero: Usually, the stock market is regarded as a full bear market when a stock price falls beyond 20% of the initial cost. Such a reduction is already considered a loss. However, a drop from the initial price to zero means that the stockholder has lost all their investment. It means that no one wants the stock at any price. Even before it eventually drops to zero, exchanges would have delisted the stock. Stockholders who are not certain about the possible value of a stock should avoid short-selling.
- Bankruptcy: When a company goes into liquidation and cancels existing stock, its stock becomes worthless, including yours. At this stage, the company would have to sell its liquidated assets to pay stockholders. Depending on the type of shares they hold, a stockholder may receive a percentage of the assets or not. Usually, common stockholders often receive nothing as they are last in line to receive payment.
Cons of Investing in The Stock Market
- Need for capital: It is essential to know that investment comes with profit and loss. So in as much as you look forward to making gains, you should also understand that you may lose. Therefore, you would need a significant amount of money, one that wouldn’t affect your daily needs to invest
- Need for adequate knowledge of the company: If you don’t do enough research about the stock you want to buy and the company offering it, you will end up raking in losses. Research the company, know what they do, their location, price-to-earnings ratio, dividends, and beta.
- Market Volatility: The stock market is highly volatile, and its volatility is closely related to investment risk. In essence, the higher the volatility, the riskier the stock.
To lessen the potential negative effect of stock investment, here are the things to do as an investor;
- Be proactive: Watch the market trend and take action before the market falls. When you anticipate a fall in the economy, withdraw from stocks, and invest in bonds. Unlike stocks, bonds offer a fixed return on investment with an initial investment. Even though bonds also contain risks, the risks are not as much as those involved in stocks.
- Go for long-term investments: The stock market correction occurs when there is a decline of 10% or more in a stock price. As corrections can last for days, weeks, or months, and in turn, cause damage for short term investors, long term investors can take advantage of the phase to buy a high-value asset. However, it is best to weigh the risks involved in purchasing as if the stock price falls above 20%, you would have to bear with the bear market for 18months.
Related: What Are Different Types of Stocks. Consider All the Pros and Cons Before You Invest
How to Invest in The Stock Market
Here are eight ways you can invest in the stock market
- Online/Discount Brokers – This type of brokers provides the least expensive way to invest in the stock market. They only interact with potential investors on the phone and do not provide investors with certified financial planners or advisors, stock tips, or investment recommendations. For them, the cost is based on a per-share basis, thus allowing people to invest with little money. However, investors are left to rely on their expertise and the online trading system’s technical support. Some of them include Questrade, Itrade, E-Trade, SoFi, or T.D. Ameritrade
- Join an Investment club: An investment club involves a group of people, usually 10-20 people who come together to make joint investments to make more profits. Not only do investment clubs teach investors about the stock market, but they also help investors take control of their money.
- Contact a full-service broker: A full-service broker is an authorized financial brokerage firm that provides investors with various services. Some of the provided services include; recommendation, financial advice, research, tax tips, portfolio analysis, estate planning, access to foreign markets, and access to IPO, and retirement planning. As full-service brokers offer customized support, investors are required to pay more.
- Employ a money manager: You can also invest in the stock market by hiring a money manager to manage your stock. Together with a team of experts, the money manager will monitor and manage the stock prudently for you.
- Employ fee-only financial planners: Investing in the stock market can also be done by employing the services of financial planners who serve as licensed investment advisors saddled with the responsibility of acting in the interest of their client. These advisors receive the same fee for their services instead of commission. Usually, this method of investment in transparent, unbiased, and has no hidden fees.
- Buy an index fund: An index fund is an exchange-traded fund that holds a significant sample of the securities in a particular index to match the performance of each. Through broad diversification, buying an index fund helps reduce total risk.
Whichever way you choose to invest in the stock market, ensure to conduct thorough due diligence on the broker or club you wish to work with.
Other Types of Financial Markets
The stock market is just one type of financial markets. So before you invest, make sure you are familiar with them all.
- Commodities – They are basic goods used in the production of other goods. They are bought and sold on the cash market and traded in exchanges.
- Foreign exchange – Forex exchange involves trading one currency for another on the foreign exchange market by a network of banks, financial institutions, brokers, and individual traders. It is the largest financial market in the world.
- Derivatives – Derivatives are secondary financial securities whose value is derived on the value of a particular security. Underlying securities on which derivatives are derived include stocks, market indexes, currencies, bonds, and commodities.
Conclusion to Beginners Guide For The Stock Market and Types of Stocks
So there you have it, a beginner’s guide to understanding how the stock market works. With a little dedication and careful study, you won’t have to change the Tv channel as I did. You can always ask questions in the comments or send me an email, and I’ll be happy to respond.
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