Investing in the stock market can be an effective way to grow your money over time, but it’s important to understand the basics before you get started. Here is an overview of Basics of stock market investing explained the key concepts for stock market investing.
How the stock market works
A stock represents a share of ownership in a company. Companies issue stock to raise money and investors can buy and sell the stock on a stock exchange like the New York Stock Exchange or Nasdaq. The price of a stock goes up and down based on supply and demand. If more investors want to buy a stock than sell it, the share price will rise. If more want to sell than buy, the price will fall.
Why stocks can increase in value
There are two ways a company’s stock price can increase over time:
- The company grows: As the company increases its profits, expands operations, enters new markets etc., investors estimate the company is worth more so they bid up the share price.
- Dividend payments: Many stocks pay quarterly dividends (a share of profits) to shareholders. As dividends increase, the stock becomes more valuable.
So if you invest in a successful business at an early stage, the growth in the underlying company can make the stock price rise substantially over years or decades.
Common types of stocks
There are a few major categories of stocks:
- Large-cap stocks: Shares in large, established companies. These stocks are considered lower risk than small caps. Examples are Microsoft, Apple, Facebook.
- Mid-cap stocks: Shares in medium-sized companies, with market capitalization between $2 billion and $10 billion. Examples are Starbucks, Adobe, Paypal.
- Small-cap stocks: Shares in newer or smaller companies. These stocks have higher risk but greater growth potential. Examples are Etsy, Five Below, Veeva Systems.
- Penny stocks: Shares in very small new companies, priced under $5 per share. These are extremely speculative.
Here are some common investing strategies using stocks:
- Buying and holding: You invest in stocks of quality companies for the long term, years or decades. Over time, you benefit from the compounded growth as the share prices appreciate.
- Value investing: You invest in stocks that appear undervalued by the market and hold until share prices rise to meet their actual value.
- Growth investing: You seek out stocks of companies expected to have above average growth, such as small emerging companies.
- Index investing: You invest in an index fund that tracks a stock market index, like the S&P 500. This provides wide diversification.
How to analyze and value a stock
Before buying a stock, wise investors analyze the company’s financial statements and business model to value the stock and determine if it’s a good investment. Here are the key factors to look at:
- Earnings per share (EPS): The company’s total net income divided by number of shares outstanding. Rising EPS is good.
- Price-to-earnings (P/E) ratio: Share price divided by EPS. Compare to average market and competitor P/E ratios.
- Revenue and net income growth: Look for steadily rising revenue and net income over time.
- Profit margins: Net profit margin shows profitability of the company. Compare to competitors.
- Debt levels: Companies with high debt are riskier. Look at debt-to-equity ratio.
- Market position: Analyze the company’s position in target markets, such as market share.
Stock market indexes
Indexes provide a way to assess the overall performance of the market. Common indexes in the US stock markets include:
- Dow Jones Industrial Average: Tracks 30 large publicly owned blue chip companies.
- S&P 500: Tracks 500 large-cap US stocks from diverse industries.
- Nasdaq Composite: Covers all Nasdaq stocks, over 3,000 companies. Heavily weighted toward technology.
- Russell 2000: Tracks 2,000 small-cap US stocks.
These indexes report aggregate gains or losses each trading day based on the stocks they cover. Investors can buy index funds to get a portfolio that mirrors an index’s performance.
There are certain costs involved in stock market investing:
- Brokerage commissions: Fees to buy/sell stocks through a brokerage account. Some brokers offer commission-free trading.
- Expense ratio: The annual fee charged by a mutual fund or ETF to cover operating costs. Typically 0.5% or less.
- Capital gains tax: If you sell a stock at a gain you owe taxes on the profit, usually 15% federal tax on long term capital gains. Short term gains are taxed as income.
Aim to minimize investing costs, as high expenses reduce your overall investment returns over time.
Tips for beginners
For those new to stock market investing, here are some tips:
- Start small to get your feet wet. Don’t invest money you may need in the near term.
- Consider index funds and blue chip stocks to start out. They provide wide diversification and lower risk.
- Reinvest dividends and capital gains to benefit from compounded growth.
- Invest regularly, such as monthly. Dollar cost average by investing regardless of stock prices.
- Hold quality stocks long term. Be patient through market swings.
- Utilize a tax advantaged account like a 401k or IRA if possible.
- Don’t panic sell during dips. Volatility is normal for stocks.
Risks and challenges
While the potential returns can be sizable, stock market investing does come with risks:
- Stock prices fluctuate, sometimes wildly. The share price may fall below what you paid for years.
- Some companies go bankrupt, causing their stock to lose most or all value. Diversification helps mitigate this risk.
- Market downturns happen periodically and can last over a year, decreasing stock values across the board.
- Your own psychology can be a risk if you trade emotionally rather than sticking to a plan.
However, over long periods historically, the overall stock market has eventually recovered from downturns and crashes. A well-diversified portfolio held for long term growth potential can give your money the opportunity to grow much faster than lower risk investments like bonds or savings accounts.
Conclusion – Basics of stock market investing explained
Basics of stock market investing explained thoroughly, the stock market allows investors to buy shares of public companies that may grow substantially in value over time. By understanding how to analyze stocks, utilize effective strategies, and manage risk, investors have an opportunity to grow their wealth. With smart investing and patience, the stock market can be an engine for long-term investment returns.
- Investopedia: https://www.investopedia.com
- Charles Schwab: https://www.schwab.com/resource-center/insights/content/stock-market-basics
- Fidelity Investments: https://www.fidelity.com/viewpoints/investing-ideas/intro-to-stocks
- Securities and Exchange Commission: https://www.investor.gov/introduction-investing/investing-basics/how-stock-markets-work
- Morningstar: https://www.morningstar.com/articles/752485/a-primer-on-investing-in-stocks