News shows, Hollywood films, and TV all assume that you know what the stock market is and how it works. Everyone knows that you can make a lot of money in the stock market if you know what you’re doing, but beginners don’t often understand how the market works and exactly why stocks go up and down. Even fewer understand how to make money in the market.
What is the stock market?
When people refer to the stock market, they are referring to several things and several exchanges where stocks are bought and sold. Broadly, the stock market is the aggregate of those stocks trading publicly, those that anyone can readily purchase on an exchange.
Stocks, which are also called equities, are securities that give shareholders an ownership interest in a public company. It’s a real stake in the business, and if you own all the shares of the business, you control how the business operates. Even if you don’t own all the shares, if you own a lot of them you can still help direct how the company operates, as you’ll see in those boardroom battles in film.
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Where does stock come from? Public companies issue stock so that they can fund their business. Investors who think the business will prosper in the future buy those stock issues. The shareholders get any dividends plus any appreciation in the price of the shares. They can also watch their investment shrink or disappear entirely if the company runs out of money.
The stock market is really a kind of aftermarket, where people who own shares in the company can sell them to investors who want to buy them. This trading takes place on a stock exchange, such as the New York Stock Exchange or the Nasdaq. In years past, traders used to go to a physical location — the exchange’s floor — to trade, but now virtually all trading takes place electronically.
When news people say, “the market was up today,” typically they are referring to the performance of the Standard & Poor’s 500 or the Dow Jones Industrial Average. The S&P 500 is made up of around 500 large publicly traded companies in the U.S, while the Dow includes 30 large companies. These track the performance of the collections of stock and show how they fared on that day of trading and over time.
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However, even though people are referring to the Dow and the S&P 500 as “the market,” those are really indexes of stocks. These indexes represent some of the largest companies in the U.S., but they are not the total market, which includes thousands of publicly traded companies.
How the stock market works
The stock market is really a way for investors or brokers to exchange stocks for money, or vice versa. Anyone who wants to buy stock can go there and buy whatever is on offer from those who own the stock. Buyers are expecting their stocks to rise, while sellers may be expecting their stocks to fall or at least not rise much more.
So the stock market allows investors to wager on the future of a company. In aggregate, investors set the value of the company by what price they’re willing to buy and sell at.
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“And that price – depending on the size of the demand, the size of the supply, it could go up or [it] could go down,” says Jessie X. Fan, professor at the University of Utah. “And basically it fluctuates every day, every second … in the stock market. So that’s how the price changes.”
While stock prices in the market on any day may fluctuate according to how many shares are demanded or supplied, over time the market evaluates a company on its business results and future prospects. A business growing sales and profits will likely see its stock rise, while a shrinking business will probably see its stock fall, at least over time. In the short term, however, the performance of a stock has a lot to do with just the supply and demand in the market.
When private firms see which stocks investors favor, they may decide to fund their business by selling stock and raising cash. They’ll conduct an initial public offering, or IPO, using an investment bank, which sells shares to investors. Then investors can sell their stock later in the stock market if they want to or they can buy even more at any time the stock is publicly traded.
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The key point is this: investors price stocks according to their expectations of how the company’s business will perform in the future. So the market is forward-looking, with some experts saying the market anticipates events about six to nine months away.
Risks and benefits of investing in stocks
The stock market allows individual investors to own stakes in some of the world’s best companies, and that can be tremendously lucrative. In aggregate, stocks are a good long-term investment as long as they’re purchased at reasonable prices. For example, over time the S&P 500 has generated about a 10 percent annual return, including a nice cash dividend, too.
Investing in stocks also offers another nice tax advantage for long-term investors. As long as you don’t sell your stock, you won’t owe any tax on the gains. Only money that you receive, such as dividends, will be taxable. So you can hold your stock forever and never have to pay taxes on your gains.
However, if you do realize a gain by selling the stock, you’ll owe capital gains taxes on it. How long you held the stock will determine how it’s taxed. If you buy and sell the asset within a year, it will fall under short-term capital gains and will be taxed at your regular income tax rate. If you sell after you’ve held the asset a year, then you’ll pay the long-term capital gains rate, which is usually lower. If you record an investment loss, you can write that off your taxes or against your gains.
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While the market as a whole has performed well, many stocks in the market don’t perform well and may even go bankrupt. These stocks are eventually worth zero, and they’re a total loss. On the other hand, some stocks such as Amazon and Apple have continued to soar for years, earning investors hundreds of times their initial investment.
So investors have two big ways to win in the stock market:
- Buy a stock fund based on an index, such as the S&P 500, and hold it to capture the index’s long-term return. However, its return can vary markedly, from down 30 percent in one year to up 30 percent in another. By buying an index fund, you’ll get the weighted average performance of the stocks in the index.
- Buy individual stocks and try to find the stocks that will outperform the average. However, this approach takes a tremendous amount of skill and knowledge, and it’s more risky than simply buying an index fund. However, if you can find an Apple or Amazon on the way up, your returns are likely going to be much higher than in an index fund.
Of course, you’ll need a brokerage account before you start investing in stocks. As you’re getting started, here are eight more guidelines for investing in the stock market.
How to invest in the stock market: 8 tips for beginners
- Buy the right investment
- Avoid individual stocks if you’re a beginner
- Create a diversified portfolio
- Be prepared for a downturn
- Try a simulator before investing real money
- Stay committed to your long-term portfolio
- Start now
- Avoid short-term trading
1. Buy the right investment
Buying the right stock is so much easier said than done. Anyone can see a stock that’s performed well in the past, but anticipating the performance of a stock in the future is much more difficult. If you want to succeed by investing in individual stocks, you have to be prepared to do a lot of work to analyze a company and manage the investment.
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“When you start looking at statistics you’ve got to remember that the professionals are looking at each and every one of those companies with much more rigor than you can probably do as an individual, so it’s a very difficult game for the individual to win over time,” says Dan Keady, CFP, chief financial planning strategist at TIAA.
If you’re analyzing a company, you’ll want to look at a company’s fundamentals – earnings per share (EPS) or a price-earnings ratio (P/E ratio), for example. But you’ll have to do so much more: analyze the company’s management team, evaluate its competitive advantages, study its financials, including its balance sheet and income statement. Even these items are just the start.
Keady says going out and buying stock in your favorite product or company isn’t the right way to go about investing. Also, don’t put too much faith in past performance because it’s no guarantee of the future.
You’ll have to study the company and anticipate what’s coming next, a tough job in good times.
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2. Avoid individual stocks if you’re a beginner
Everyone has heard someone talk about a big stock win or a great stock pick.
“What they forget about is that often they’re not talking about those particular investments that they also own that did very, very poorly over time,” Keady says. “So sometimes people have an unrealistic expectation about the kind of returns that they can make in the stock market. And sometimes they confuse luck with skill. You can get lucky sometimes picking an individual stock. It’s hard to be lucky over time and avoid those big downturns also.”
Remember, to make money consistently in individual stocks, you need to know something that the forward-looking market isn’t already pricing into the stock price. Keep in mind that for every seller in the market, there’s a buyer for those same shares who’s equally sure they will profit.
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“There are tons of smart people doing this for a living, and if you’re a novice, the likelihood of you outperforming that is not very good,” says Tony Madsen, CFP, founder of NewLeaf Financial Guidance in Redwood Falls, Minnesota.
An alternative to individual stocks is an index fund, which can be either a mutual fund or an exchange traded fund (ETF). These funds hold dozens or even hundreds of stocks. And each share you purchase of a fund owns all the companies included in the index.
Unlike stock, mutual funds and ETFs may have annual fees, though some funds are free.
3. Create a diversified portfolio
One of the key advantages of an index fund is that you immediately have a range of stocks in the fund. For example, if you own a broadly diversified fund based on the S&P 500, you’ll own stocks in hundreds of companies across many different industries. But you could also buy a narrowly diversified fund focused on one or two industries.
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Diversification is important because it reduces the risk of any one stock in the portfolio hurting the overall performance very much, and that actually improves your overall returns. In contrast, if you’re buying only one individual stock, you really do have all your eggs in one basket.
The easiest way to create a broad portfolio is by buying an ETF or a mutual fund. The products have diversification built into them, and you don’t have to do any analysis of the companies held in the index fund.
“It may not be the most exciting, but it’s a great way to start,” Keady says. “And again, it gets you out of thinking that you’re gonna be so smart, that you’re going to be able to pick the stocks that are going to go up, won’t go down and know when to get in and out of them.”
When it comes to diversification, that doesn’t just mean many different stocks. It also means investments that are spread among different asset classes – since stock in similar sectors may move in a similar direction for the same reason.
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4. Be prepared for a downturn
The hardest issue for most investors is stomaching a loss in their investments. And because the stock market can fluctuate, you will have losses occur from time to time. You’ll have to steel yourself to handle these losses, or you’ll be apt to buy high and sell low during a panic.
As long as you diversify your portfolio, any single stock that you own shouldn’t have too much of an impact on your overall return. If it does, buying individual stocks might not be the right choice for you. Even index funds will fluctuate, so you can’t get rid of all of your risk, try how you might.
“Anytime the market changes we have this propensity to try to pull back or to second guess our willingness to be in,” says NewLeaf’s Madsen.
That’s why it’s important to prepare yourself for downturns that could come out of nowhere, as one did in 2020. You need to ride out short-term volatility to get attractive long-term returns.
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In investing, you need to know that it’s possible to lose money, since stocks don’t have principal guarantees. If you’re looking for a guaranteed return, perhaps a high-yield CD might be better.
The concept of market volatility can be difficult for new and even experienced investors to understand, cautions Keady.
“One of the interesting things is people will see the market’s volatile because the market’s going down,” Keady says. “Of course, when it’s going up it’s also volatile – at least from a statistical standpoint – it’s moving all over the place. So it’s important for people to say that the volatility that they’re seeing on the upside, they’ll also see on the downside.”
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5. Try a stock market simulator before investing real money
One way to enter the world of investing without taking risk is to use a stock simulator. Using an online trading account with virtual dollars won’t put your real money at risk. You’ll also be able to determine how you would react if this really were your money that you gained or lost.
“That can be really helpful because it can help people overcome the belief that they’re smarter than the market,” Keady says. “That they can always pick the best stocks, always buy and sell in the market at the right time.”
Asking yourself why you’re investing can help determine if investing in stocks is for you.
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“If their thought is that they’re going to somehow outperform the market, pick all the best stocks, maybe it’s a good idea to try some type of simulator or watch some stocks and see if you could actually do it,” Keady says. “Then if you’re more serious about investing over time, then I think you’re much better off – almost all of us, including myself – to have a diversified portfolio such as provided by mutual funds or exchange traded funds.”
6. Stay committed to your long-term portfolio
Keady says investing should be a long-term activity. He also says you should divorce yourself from the daily news cycle.
By skipping the daily financial news, you’ll be able to develop patience, which you’ll need if you want to stay in the investing game for the long term. It’s also useful to look at your portfolio infrequently, so that you don’t become too unnerved or too elated. These are great tips for beginners who have yet to manage their emotions when investing.
“Some of the news cycle, at times it becomes 100 percent negative and it can become overwhelming for people,” Keady says.
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One strategy for beginners is to set up a calendar and predetermine when you’ll be evaluating your portfolio. Sticking to this guideline will prevent you from selling out of a stock during some volatility – or not getting the full benefit of a well-performing investment, Keady says.
7. Start now
Choosing the perfect opportunity to jump in and invest in the stock market typically doesn’t work well. Nobody knows with 100 percent certainty the best time to get in. And investing is meant to be a long-term activity. There is no perfect time to start.
“One of the core points with investing is not just to think about it, but to get started,” Keady says. “And start now. Because if you invest now, and often over time, that compounding is the thing that can really drive your results. If you want to invest, it’s very important to actually get started and have … an ongoing savings program, so that we can reach our goals over time.”
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8. Avoid short-term trading
Understanding whether you’re investing for the long-term future or the short term can also help determine your strategy – and whether you should be investing at all. Sometimes short-term investors can have unrealistic expectations about growing their money. And research shows that most short-term investors, such as day traders, lose money. You’re competing against high-powered investors and well-programmed computers that may better understand the market.
New investors need to be aware that buying and selling stocks frequently can get expensive. It can create taxes and other fees, even if a broker’s headline trading commission is zero.
If you’re investing for the short term, you risk not having your money when you need it.
“When I’m advising clients … anything under a couple of years, even sometimes three years out, I’m hesitant to take too much market risk with those dollars,” Madsen says.
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Depending on your financial goals, a savings account, money market account or a short-term CD may be better options for short-term money. Experts often advise investors that they should invest in the stock market only if they can keep the money invested for at least three to five years. Money that you need for a specific purpose in the next couple years should probably be invested in low-risk investments, such as a high-yield savings account or a high-yield CD.
The bottom line
Investing in the stock market can be very rewarding, especially if you avoid some of the pitfalls that most new investors experience when starting out. Beginners should find an investing plan that works for them and stick to it through the good times and bad.
