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Understanding How the Market Works

Jeff WilliamsJeff Williams ·

More than 50% of Americans actively invest in the stock market. Of those that don’t invest, 20% don’t comprehend how stock markets work with another 16% feeling there is too much risk associated with stocks. In reality, for many individual investors, purchasing shares of stock continues to be an effective way of creating long-term wealth once you understand how the market works.

For some, learning how the U.S. stock market works began as a child when grandpa gave us five shares of Johnson and Johnson instead of the new bike we were dreaming of. As we got older, we came to realize grandpa knew what he was doing, not just giving us an introduction to how investing in stocks works, but also providing us with our first glimpse into one of the most significant wealth building engines, the stock market.

One of the most popular investment vehicles in the U.S, stock markets can be as passive or as active an investment as you, the investor, prefers. It all depends on how involved an investor wants to be. To get started, it’s essential to understand:

  • What is the stock market?
  • How the stock market works.
  • Why do companies issue stocks?
  • What is a share?
  • How to buy a stock.
  • How to ‘play’ the stock market.
  • Stock market basics: indexes, dividends, and ETFs.

What Is the Stock Market?

An umbrella term used for the collection of exchanges and markets, stock markets are regulated exchange platforms for buying and selling individual stocks which are partial shares of a company. There are many reasons markets exist, with the most obvious being a location for exchanging stocks. Also, stock markets are critical components for ensuring fair, transparent, and secure trading practices.

A key component of our capitalist society, the stock market provides companies worldwide with the ability to sell equity in their company in exchange for a percentage of ownership, while allowing regular people to own parts of various companies.

Stock markets are not all the same, which is why it’s essential to do your research, only trading on trusted and reputable stock exchanges such as the German Stock Exchange (DAX), the Australian Stock Exchange (ASX), Canadian Securities Exchange (CSE), and the NASDAQ. The most popular stock market exchange is the New York Stock Exchange (NYSE). While any market can experience some upheaval and volatility, the general rule shows democratic nations with stable governments providing positive long-term investment returns.

How the Stock Market Works

An easy and accessible way of investing for individuals of all financial means, there is something for everyone with the stock market from low entry points for those just starting, to compound interest for those thinking long-term. While very popular, few individuals understand how the stock market works.

Investors just starting to dabble in the stock market may feel learning how it works is too complicated, while those who have been investing for sometime worry that if they haven’t learned how it works by now, they won’t ever understand it. The good news, it’s possible to learn how the stock market works, and establishing a better understanding of it can have significant benefits for your investing future.

Why Companies Issue Stocks?

It’s essential to first understand why companies trade away parts of their equity in order to gain a better understanding of how the stock market works. Companies that decide to list shares on the market are seeking to increase money for future growth and make stocks available for purchase to those interested in buying. By owning stock in a company, an individual owns a fractional piece of equity in that company.

This starts with the Initial Public Offering (IPO) process, where companies move from being privately held to being publicly traded. In 2012 Facebook went through this process, their shares going for $38 at the end of the volatile first day and finishing out 2017 at $178 a share.

Typically, when a business is private, what happens behind closed doors stays private. The public doesn’t have any expectations of knowing what a private company is doing. However, once a company decides to go public, they will need to conduct business in the interest of their shareholders and provide them with annual reports.

The IPO process gets a company’s shares into circulation. Once done, they become part of what is commonly referred to as the secondary market. This is where investors trade stocks among themselves, including those who are buying for themselves, investors who are looking to sell, and the sophisticated traders looking to take part in advanced trading strategies like shorting stocks, penny stocks, and buying options.

Once a company goes public, its shares can be publicly traded on a stock market. The price of the stock will vary from day-to-day, depending on several factors including the perceived value of the company and market volatility.

What Is a Share?

Simply stated, a share or stock is a portion of a publicly-traded company. Companies make shares available to investors as a way to raise capital, usually through the IPO process. The company retains the initial funds raised during the IPO with shares then being sold on a market to individuals. Thousands of shares from various companies are traded each day on stock markets, so understanding how to buy a share is an essential first step in getting started.

How to Buy a Stock

After a company has completed the IPO phase, it no longer receives proceeds from subsequent sales of its stock. The trading of stocks between investors happens in a secondary market. While you may find physical paper stock certificates in your grandparent’s attic, you will no longer see them on the floor of the stock market. Stock trading is now done via brokerages or digital platforms.

It’s easy for individual investors to buy and sell stocks through online brokerages such as Questrade, TD Ameritrade, E*TRADE, and more. Other options like robo-advisors take the money you want to invest and put it into funds and stocks that have been predetermined.

Once you create a brokerage account, you will need to select what company or companies you want to invest in by purchasing their stock and identify their stock ticker symbol. For example, Listen Money Matters is LMM, Microsoft is MSFT, and Apple is AAPL.

How to ‘Play’ the Stock Market

Warren Buffett once described the stock market as a device for transferring money from the impatient to the patient. The stock market has definite advantages for patient traders. An ideal investor is someone who can invest and let their money sit there for 25+ years. While the movies like to portray a fast-paced “buy, buy, buy” followed by a “sell, sell, sell” environment, the majority of investors establish their wealth through patience, capital gains, and compound interest.

Over the long-term, stock markets always go higher despite market corrections and crashes. The same can’t be said for stocks, many of which eventually fall to a zero value. For this reason, it’s never recommended that you invest all your money in one stock or fund.

Education is key. Learn about valuing a company, selecting companies that mesh with your investment strategy, and being able to tell when to sell or, in some cases, not sell a stock that’s losing its value. If you want to start trading stock actively, it’s important to understand essential topics including profit margins, price-to-earning ratios, market caps, and more. Feeling overwhelmed, let’s start with some basics.

Stock Market Basics: Dividends, ETFs, and Indexes

Below are some routine stock market terms often heard floating around CNBC and other news channels:

  • Bull Market: Used to describe a market that is growing steadily and doing well.
  • Bear Market: A market whose value is decreasing over time with investors selling stocks and driving value and prices down.
  • ETFs or Exchange-Traded Funds: Groups of stocks that usually have a commonality, such as currency, commodity or industry, but can be any collection of publicly-traded stocks and equities that aren’t managed by anyone.
  • Mutual Funds: Funds or groups of equities managed by professional fund managers for a certain percentage.
  • Dividend: A percentage of profits a company pays out to shareholders several times a year, usually quarterly, in addition to the rise or fall of the company’s stock price. For long-term investors, it’s a good idea to find quality dividend-paying stocks to invest in.
  • Short Selling: While most investors buy a stock with hopes of a price increase, investors that short sell a stock are anticipating the price will drop.

Once you have a better understanding of how the market works, you can more effectively buy and sell stocks. Once you understand what a stock market is, you can use a digital exchange platform where investors can buy and sell pieces of publicly traded companies. Once you know this basic concept, you can quickly start navigating various stock markets, even trading individual stocks when necessary.

Have more questions about how the market works? Download Jeff Bishop’s “30 Days to Options Trading” eBook for an inside look on how he’s consistently doubled his money.

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