While investing might seem daunting at first, once you understand the stock market basics, it becomes much easier. There are three core concepts that all beginning investors need to grasp:
- How the stock market works.
- The difference between long-term investing and stock trading.
- The importance of diversifying your portfolio.
This guide will unravel each of these basic stock market concepts, giving you a solid investing foundation to build upon in the future.
How the stock market works
The stock market is like a swap meet, auction house, and shopping mall all rolled into one.
The stock market as a swap meet or flea market: The stock market has many vendors, including individual and institutional investors such as hedge funds, pension plans, and investment banks, buying and selling various items, e.g., public companies listed on stock exchanges.
Notable stock market exchanges include the New York Stock Exchange (NYSE), Nasdaq Exchange, and OTC Markets. Each has different listing requirements for companies that want to use their services to raise capital from investors.
The stock market as an auction house: Another aspect of the stock market is its auction-like pricing system. Unlike a retail store, where there's a set price for each item, stock prices change all the time as buyers and sellers attempt to reach a market price for a company's stock.
Many internal and external factors impact stock prices. For example, a company's earnings and its growth prospects (internal factors) can affect its share price. Meanwhile, anything from an upcoming election to how investors feel about the economy's direction (external factors) can also impact stock prices.
The stock market as a shopping mall: Finally, the stock market has a shopping mall feel to it because it's a one-stop shop. It houses all publicly listed companies, enabling investors to buy and sell any publicly traded stock they desire.
Stock market exchanges act as both primary and secondary markets for a company's stock. They allow companies to directly sell shares via initial public offerings (IPO) to raise cash and expand their businesses.
Companies can complete multiple secondary offerings of their stock when they need to raise additional funding, provided investors are willing to buy. Meanwhile, exchanges provide investors with liquidity since they can sell shares among each other.
What are bull and bear markets, corrections, and crashes?
While the stock market generally moves higher over time, it doesn't do so in a straight line. Investors have coined the following terms for big swings in stock prices:
- Stock market correction: A 10% to 20% decline in a major market index like the S&P 500 is called a stock market correction.
- Bear market: A drop of more than 20% is a bear market.
- Bull market: A more than 20% gain in a stock market index from a recent bear market is a bull market. Bull markets are often multi-year events driven by a period of economic expansion.
- Stock market crash: A sharp plunge in the major stock market indexes over a short period is a stock market crash.
- Stock market volatility: When stock market prices fluctuate very sharply, this is known as stock market volatility.
Generally, stock prices go up gradually as companies expand their operations and earnings as the economy grows, making their underlying businesses more valuable. For example, the average stock market return as measured by the S&P 500 Index -- a collection of the 500 largest U.S. listed publicly traded stocks -- has historically increased more than 10% each year.
But, there are also down periods. The worst market crash on record is the stock market crash of 1929 at the onset of the Great Depression. Concern about investing during an economic recession can trigger stock market sell-offs, although that's not the only factor that can cause a big market slump.
While stock market corrections can be challenging for beginning investors, they tend to be short-lived. Half of the stock market corrections of the past 50 years lasted three months or less.
Long-term investing vs. stock trading
We'd all love to get rich quickly. However, the stock market isn't the lottery, nor is it a casino. While some stocks deliver significant gains in short periods, they're outliers instead of the norm.
Because of this beginners should avoid stock trading or actively buying and selling stocks -- especially day trading -- and focus on long-term buy-and-hold investing.
Ideally, an investor should buy a company's stock with the intention of holding it for three to five years, if not much longer.
Long-term investing is a better approach than stock trading for many reasons, including:
- Higher probability of positive returns: While the stock market has down years, it has gone up in 40 of the past 50 years. Thus, even if you start investing right at the end of a long bull market run and endure a stomach-churning crash, simply holding for a few years will likely still yield a positive result. Contrast that with trading, which could see an investor risk the permanent loss of their capital if they buy at the top and then give up and sell at the bottom, locking in losses.
- Not missing out on even bigger gains: One of the biggest mistakes many beginning investors make is selling too early. That can cause them to miss out on much greater returns over the long term. For example, while it might be tempting to cash in after a 10% or even 100% gain, great companies tend to continue producing winning returns.
- Benefiting from compound interest: While stocks can correct and crash without warning, they generally move higher. As noted earlier, the S&P 500 has historically produced a more than 10% total annualized return. That general upward trend, despite all the volatility, adds up over time. For example, investing $550 a month in an S&P 500 index fund has historically grown into a $1 million nest egg in about 30 years.
- Saving on taxes: Stock sales are taxable unless they’re made in a tax-deferred retirement account like an IRA. For stocks held long-term, which is more than a year, the capital gains tax rate is either 0%, 10%, or 20%, depending on your income and tax bracket. However, short-term capital gains taxes are much higher because they correspond to an investor's ordinary income tax bracket, which ranges between 10% and 37%. Thus, taxes can eat a significant portion of an investor's gains if they're trading in and out of stocks, especially those in higher tax brackets.
While buying and holding over the long term generally yields the best returns, it's also essential to know when to sell stocks. Situations where selling is a smart move include when the reason you bought no longer applies, the company is getting acquired, you are rebalancing your portfolio, or you need the cash to make a big purchase because you see a better investment opportunity.
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Diversifying your portfolio
Another important investing essential is understanding the benefits of having a diversified portfolio. That means owning a diverse group of stocks across different stock market sectors. Portfolio diversification reduces an investor's risk of a permanent loss and their portfolio's overall volatility. In exchange, the returns from a diversified portfolio tend to be lower than what an investor might earn if they picked a single winning stock.
There are many ways to build a diversified stock portfolio, depending on whether you want to be an active or passive investor. An active investor will research stocks to find a collection of at least 10 companies across various industries that they believe will be winning investments over the long term. Meanwhile, passive investors let others do that work for them. As a result, they can quickly diversify by purchasing shares of a mutual fund, index fund, or exchange-traded fund (ETF) that hold a diverse group of stocks. As previously noted, an S&P 500 index fund has 500 stocks, giving investors broad exposure across the largest U.S. stocks.
Owning a diversified portfolio of stocks will help cushion the blow during a correction or bear market so that an investor doesn't experience an irreversible loss of capital.
However, active investors also need to be careful not to over-diversify since holding too many stocks reduces returns without as much of an incremental benefit from a reduction in losses or volatility. Once a portfolio contains more than 100 stocks, it can become hard to manage. Further, it would likely produce returns that match that of an index fund.
The stock market can be a wealth-creating machine
Investing in stocks might appear complicated, but it's not once you grasp the basics.
The seemingly chaotic blend of a flea market and auction house, where prices are moving all over the place, is a free market system that allows companies to raise equity capital from investors who are then free to buy and sell those shares openly. Prices tend to fluctuate -- wildly at times -- which is why investors should take a long-term approach and own a diversified portfolio of stocks. Those who embrace those basic steps often enjoy an enriching experience as they benefit from the stock market's ability to produce high returns that compound over time.
What are the different types of stocks?
Here are the major types of stocks you should know.
- Common stock
- Preferred stock
- Large-cap stocks
- Mid-cap stocks
- Small-cap stocks
- Domestic stock
- International stocks
- Growth stocks
- Value stocks
- IPO stocks
- Dividend stocks
- Non-dividend stocks
- Income stocks
- Cyclical stocks stocks
- Non-cyclical stocks
- Safe stocks
- ESG stocks
- Blue chip stocks
- Penny stocks
How do you buy stock?
Fortunately, the process of buying your first shares of stock online is relatively quick and easy. Here's a step-by-step guide to commencing your stock investing journey.
- Open a brokerage account
- Decide which stocks you want to buy
- Decide how many shares to buy
- Choose an order type
- Place the stock order with your brokerage
- Build your portfolio
How many shares of stock should I buy?
There are a few factors to consider when deciding how many shares of a particular stock to buy. In addition to how much capital you have available, you should consider diversification and whether you can buy fractional shares of stock.