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How Do the Stocks Work? Your Guide to Stock Market Basics

I f you aren’t experienced in investing, you might be asking, ‘how do the stocks work?’ As a beginner, you can start with this guide to understand what exactly stocks are and how to buy and sell them on the public stock market. We’ll also explore why stocks are such an important component of meeting financial goals like saving for retirement.

Key Takeaways:

  • Purchasing stock gives you a share of a company’s profits but also its losses.
  • When you invest in stock, you can take advantage of interest and dividends, profit from price increases, and even enjoy voting rights.
  • You can buy stock through an online stockbroker exchange, but review the associated fees before joining a trading platform.
  • Holding stock shares for at least five years increases the likelihood that you will receive a generous return on your investment.
  • You have to pay taxes on stock market profits but can offset the taxes by deducting capital losses.
  • You can also invest in the stock market through your 401(k) or individual retirement account, buy stocks directly from a company, or invest in your company’s employee stock program.

What Are Stocks?

When you buy a stock, you are actually buying a share in a company. As the company earns profits, the value of your stock increases. If you own a stock that pays dividends, you will also receive a portion of the company’s profits through either cash dividends or share repurchases. Reinvesting your stock market earnings allows you to build compound interest, which facilitates the exponential growth of your initial investment.

A company ‘goes public,’ or decides to issue shares of its stock for sale on public stock exchanges, to raise money for expansion and new initiatives. Most companies issue two main types of stocks: common stock and preferred stock. Common stock provides shareholders with voting rights, while preferred stockholders have voting rights as well as preferential treatment for dividends and in the event of a liquidation.

Stock markets originated in 16th-century Europe, popping up in trading cities like London, Amsterdam, and Antwerp. However, these stocks were more similar to bonds than modern stock since they did not offer equity. The concept moved to America when the Philadelphia Stock Exchange opened in 1790, followed by the New York Stock Exchange in 1792.

In the United States, stock exchanges must meet the ethical guidelines of regulatory organizations. These include the Financial Industry Regulatory Authority (FINRA) and the National Association of Securities Dealers (NASD).

Stock Classifications

The most common ways to categorize stock are by sector and market capitalization. The Global Industry Classification Standard is used to classify stocks by 11 industry sectors:

  • Materials.
  • Energy.
  • Industrials.
  • Consumer staples.
  • Consumer discretionary.
  • Information technology.
  • Financials.
  • Health care.
  • Communication services.
  • Real estate.
  • Utilities.

Market cap, or market capitalization, is the number of a company’s outstanding stock shares multiplied by the current trading price of a single share. Companies with a market cap of at least $10 billion are considered large-cap stocks. Medium-cap stocks have a market cap of $2 billion to $10 billion, while small-cap companies have a market cap of at least $300 million but less than $2 billion.

Benefits of Investing in Stock

Some of the advantages of investing in the stock market include:

  • Shareholder voting rights for the companies in which you own stock shares.
  • The ability to sell stock for a profit if it rises in price.
  • The right to receive periodic shareholder payments called dividends that some companies offer.
  • An average return on investment of 10%, adjusted to about 7% or 8% after considering inflation.

Drawbacks of Investing in Stock

While it’s great to own stock in a growing company to profit from that growth, remember that you also share a company’s losses if the stock price declines. This will result in a decline in the overall value of your stock portfolio. Because stock prices change all the time for plenty of different reasons, investing in the stock market carries inherent risk.

The Process of Trading Stock

Image via Flickr by David Blaikie

Most investors trade stock on a brokerage firm’s online trading platform. Here, you buy shares from another investor instead of directly from the company. You can also sell stock to other investors seeking shares on the platform, which links directly to the major stock exchanges, like Nasdaq and the New York Stock Exchange in the United States.

To become eligible to trade, you have to open an account with the brokerage firm. Typically, you can transfer money from your bank account to your brokerage account when you’re ready to purchase stock.

When you buy a stock, you offer a bid. This expresses the highest amount you’re willing to pay per share. The seller, in turn, responds with an ask, which is usually higher. The buyer and seller must bridge this so-called bid-ask spread to make a deal — meaning the seller goes down in price or the buyer comes up.

Most online broker platforms have resources and tools that can help you make smart trades. These often include a company’s financial details, performance history, and other types of analysis. If you’re looking to buy stock from a specific company, you can look up its ticker symbol to find it on the trading platform.

When you make a stock trade, you must also pay a commission to your broker as well as a transaction fee. When choosing an online broker, review the fees carefully to ensure that you aren’t overpaying for your trades or for specialized tools you don’t need.

Throughout the trading day, stocks change in price based on supply and demand. If only a few people want to buy certain shares, they drop in price. If traders are clamoring for shares in another company, the price of those shares goes up as demand exceeds supply.

Holding stocks for years or even decades helps mitigate the risk associated with the stock market. Usually, despite the market’s regular price fluctuations, portfolio values rise over time. You can also decrease risk by diversifying your portfolio, which means holding various types of stock shares and financial assets with different risk levels from various economic sectors.

To track the activity of the stock market or a specific asset, traders review the activity of a market index. These indexes — most notably the Standard and Poor 500 or the Dow Jones Industrial Average — consist of a selection of companies used to represent the stock market as a whole.

Tax Considerations

If you sold stock this year, you have to pay taxes on the profit. If you had the shares for at least a year before selling them, the profit is subject to federal long-term capital gains tax on a sliding scale of 0% to 20% based on your income (usually 15%). If you sell shares that you have owned for less than a year, your regular tax rate applies. Dividends are also taxed.

Don’t forget to deduct the expenses you incurred while selling the stock, such as fees and commissions. You can also deduct losses you suffer in the stock market from your capital gains, including up to $3,000 from your income if your losses exceed your gains.

Other Ways To Buy Stock

B esides buying stock from a broker, you can invest in the stock market in a few other ways. You might already own stock if you contribute to your company’s 401(k) or another retirement plan. These plans often include mutual funds, which contain a selection of stocks, bonds, and assets.

If you want to invest in a specific company, you can check if they allow you to buy shares from them directly. This may or may not be a better deal than buying the shares through a broker, so be sure to read the details carefully before you decide what to do.

Additionally, your employer might offer stock options or even let you negotiate stock as part of your salary. Again, review the details to make sure you can’t get a better deal on shares through your own broker.

Another alternative to the traditional stock market is over-the-counter bulletin boards (OTCBB), which are less regulated than traditional stock exchanges. As a result, they carry a much higher level of risk. Companies that do not meet the criteria to qualify for the NYSE or Nasdaq often trade on these smaller OTCBB exchanges, so they do not need to prove their value or profitability to shareholders.

While investing in stocks can seem overwhelming at first, most traders manage to avoid risk by holding shares over time. Attempting to make quick profits, on the other hand, may result in significant financial loss. In general, it’s important to do your research and fully understand the market before you start investing in stocks.