For many people the stock market seems mysterious — and somewhat dangerous. Stories abound of fortunes made and fortunes lost. For beginners, the stock market can appear random and chancy, but a better understanding shows the prudent wealth accumulation facilitator it really is.
Why Stock?
The first question to consider for stock investing is: “why stock?” If there’s more risk than other investments, then there must be a compelling reason for us to take on that additional risk. And also ways to manage it.
The “why stock?” question has a definitive answer: No other type of asset has performed as well across long periods of time.
Stock investments are necessary to grow your wealth in any appreciable fashion.
You can grow your wealth without them, but it will not be easy. For example, to accumulate sufficient funds for a comfortable retirement, you would need to invest several times as much money in non-equity (non-stock) investments to get to the same place.
Most people are concerned they don’t have enough money right now to be able to invest as much as they need to. Investing several times as much to get to the same place simply isn’t realistic. If we’re going to get ahead in investing, we’re best served by investing in stocks.
What Is a Stock?
A share of stock is a representation of ownership in the company that issued the shares. When you own shares in a company, you are part owner of that company.
Companies need money to grow. They may need to invest in plants or equipment or other capital-intensive projects in order to become larger and more profitable. To do this, they may need to raise money from outside the company.
They have multiple options for raising capital. They may be able to borrow it outright, issue bonds (which are a form of debt), or they might issue stock. Different avenues have their own advantages and disadvantages.
To raise capital via issuing stock to the public, a company needs to be listed on an exchange or become listed if they aren’t. If they have never issued stock to the public before, they would do an initial public offering, or IPO. The downside to the company is that once they’re listed on an exchange they need to adhere to standards of reporting and disclosure required for publicly traded companies. It will cost a lot to become publicly traded, but it provides access to needed capital.
When you purchase stock you become an owner in the company, which gives you some rights.
Types of Stock
There are a couple forms of publicly traded stock. You can purchase preferred shares or common shares.
Most stock that is bought and sold on exchanges is of the common stock variety, and both common and preferred shares give you an ownership interest.
Preferred shares pay a periodic dividend, typically as a percentage of a declared par value. They don’t have voting rights. They are perpetual, but the company may have the right to recall them after a set period of time. Their value is primarily determined by their dividend; they act more like a bond than a stock from a performance standpoint.
Common shares make up the vast majority of the stock trading volume. These shares fluctuate in value depending on market conditions. Understand that it is the appreciation of these prices across time that has made investing in the stock market so rewarding.
Companies may issue different classes of common shares. The most common differentiator is voting rights. Some companies have the voting rights of their stock concentrated in one class, while a class with lesser rights, or even no voting rights, is available to the public.
Most often there is only a single class of shares, you have voting rights, and own a share of the company equal to the percentage of shares you own.
What Is an Exchange?
There needs to be a place where buyers and sellers can trade, where theses shares can be sold and purchased. These markets are called exchanges.
The purpose of an exchange is to match buyers and sellers. You aren’t generally buying stock from the company itself; you’re buying it from someone else who owns it. A market where existing buyers sell their shares to other investors is a secondary market. It is on these secondary markets, the most common form of market, where most transactions occur. Major markets such as the New York Stock Exchange or the NASDAQ are secondary markets.
The person who is willing to sell their shares has a price in mind, the price at which they are willing to sell. This is their asking price, or “ask.”
A potential buyer also has a price in mind, the price he or she is willing to pay. This is their bidding price, or “bid.”
When the selling (or ask) price, matches the buying (or bid), price, a sale is made. These matchups are now generally made in real time via computer.
When there is a gap between the bid and ask, the price will move based on market conditions. If there are more sellers than buyers, some sellers may be willing to take a lower price and the ask moves toward the bid. If there are more buyers, some may be willing to pay a higher price to obtain the stock and the bid moves toward the ask.
Information and Perception
Most investors are buying now believing that the price of the shares of a particular company will be higher at some point in the future. They may believe this based on some information, or on their perception of what will happen.
The information could be historical, such as recent share price increases leading a potential investor to believe this trend will continue. Or they may know that sales of a particular item or type of item are becoming “hot” and believe this will translate into higher share prices.
Perception plays a large part in share pricing. Investors have beliefs as to what the markets will do and how that will impact share prices. Often, perception has a herd effect: People as a group believe that markets will move up or markets will move down and this correspondingly drives prices.
The Long-Term and the Short-Term
Stock investments have historically been the best way to make money in the long-term. They have also historically been a great place to lose money in the short-term if you’re not careful.
The idea is to find investments whose value will increase across a long period of time — that is the essence of investing.
Looking for an investment whose value will increase in the near future isn’t investing; it’s speculating. Speculating involves a lot of risk that investing doesn’t have.
If you’re investing in a quality company for long-term appreciation, day-to-day fluctuations aren’t important. It really doesn’t make a difference what happens in the next week or the next quarter; what matters is the value a number of years down the road. In investing, time is your ally.
If you’re seeking immediate gratification from day-to-day price movements by speculating on price changes, time is your adversary. Any minor news or information can affect the price and cause a temporary drop in value. That’s not how you consistently make money in the market.
The money you invest in stocks should be for long-term goals. The money you may need in the near-term should not be in an investment that is subject to price fluctuations.
The Bottom Line on Understanding the Stock Market
Most Americans’ single largest asset is the equity in their homes. For wealthy Americans, it is most likely their stock investments.
Stocks have been the best performing assets across the last 100-plus years, and real estate comes in second to stocks — and well ahead of any subsequent contender.
Both are somewhat volatile, but stocks have ready markets and can be easily and inexpensively traded by nearly anyone. As your portfolio grows, you’ll want to add some real estate and other investments. But your first step in equity investing should be understanding the stock market. Be careful, but be invested.
