Sometimes investing discussions quickly move from basic to complex. As such, new investors find it hard to join the discussion as they have never learned the fundamental differences. This article focuses on stock market basics to meet the the needs of new investors who plan to start their own investing plan.
Stock Market Basics
The stock market consists of over 7500 single stocks. People who wish to own part of a company (in order to share in it growth) can buy publicly traded stock. A stock represents a partial ownership in a company. The most well known place where such stock exchange happens is the New York Stock Exchange. When the stock market is open, people can buy and sell their stocks (partial company ownership). Of course, the goal of every investor is to buy a stock when it is low and sell it when it is high. That is harder than it sounds when you try to time the market.
How do you make money in the stock market?
The way to make money in the stock market is by purchasing stocks of a company whose stock becomes more valuable. Any number of things like increased sales, new products, and positive financial reports may help the price of a stock increase. As more people are interested in buying the limited number of stocks, the value of each stock increases.
On the other hand, it is important to note that a company stock may also lose its value. If a company’s sales are decreasing, profits slipping, or it is getting poor media attention, one should expect that the stock price will decrease. As the demand for the stock lessens, so does the price.
What does it mean when people say the stock market is up?
Essentially, the stock market is the sum of the individual stocks.
Three Common Methods For Tracking Stock Market Performance
Dow Jones Industrial Average (DJIA)
The DJIA is one of the best known indexes. Interestingly, it is also one of the most specific, and so in many ways, one of the poorest indicators of stock market performance. The DJIA reports the activities of only 30 of the strongest and largest companies. When the DJIA goes up, that means the collective value of those 30 companies went up. This does not mean that your stock went up, but only that the price of this group of stocks increased.
Standard and Poor’s 500 Index (S&P 500)
The S&P tracks (can you guess?) 500 stocks. It is composed of some of the largest companies from different sectors or areas of the stock market. Again when the S&P 500 goes up, that means the collective price of these 500 companies went up.
Russell 2000 Index
Both the DJIA and the S&P 500 give little attention to smaller companies. So the Russell 2000 Index tracks 2,000 smaller sized companies.
Which is the best index for tracking market performance?
That depends completely on what types of investments you own. If, for example, you only have investments in the largest companies, you might pay special attention to the DJIA. If you primarily invest in smaller companies, the Russell 2000 would be a more accurate index. Regardless, at the end of the day what is important is how your stocks perform.
How do these indexes help me?
Many people wonder why it matters how the indexes perform. Quite simply, the indexes provide a point of reference (also called a benchmark). If you own only small company stocks and your performance is less than the Russell 2000, over a long period of time you know the stocks you own are actually ‘underperforming the market’. In other words, the results are lower than similar stocks.
Three Common Ways of Owning Stocks
Single Stock
If someone owns a single stock, this means they have purchased ownership of one company. This might mean you own a stock in something like General Motors or McDonald’s.
This is a risky investment as you are relying on the performance of a single company.
Typically, if someone is not a single stock investor, they embrace one of two ways of investing – mutual funds or index funds.
Mutual Fund
Mutual Funds represent money collected by many different investors. The money is sent to the specific company, and they have a team of researchers and decision makers who pick the stocks that they think will perform the best.
Those who like mutual funds like the fact that you get access to a lot of different individual stocks, and that a professional will be able to manage your stock selection. Those who dislike mutual funds focus on the extra fees and the fact that mutual funds lag the market, in general.
Index Fund
Remember our discussion about the S&P 500. Some people just want to buy the exact same stocks as the S&P 500. They don’t seek to beat the market, nor are they interested in lagging. They respond by buying the exact same stocks as are owned by each index.
Those who prefer index funds like that you get a lot of diversity and minimal fees. Those who dislike index funds typically think this is a boring investment style and you should seek to beat the market.
Before you ever start investing, it is important that you know and understand some basic things about the stock market. As a new investor is it essential you understand everything that will be happening with your money. Finding a good financial advisor should help you make wise choices. By the way, a good financial advisor is one that will explain things to you – not dictate your course of action.
Photo by rednuht.
Any other important stock market basics?
{ 6 comments… read them below or add one }
Another well written post Craig. I’m not sure if this is “basic” or a bit more advanced, but I think beginning investors also need to be aware of the costs of investing.
Whether its an upfront sales load, annual expense ratio, or commission on a stock trade, investing in the market is rarely done for free. These costs have a direct impact on the returns your stocks achieve. It would be good for investors to be informed of what they’re paying to get into the stock market.
another way stocks “make money” is by distributing dividends. although most people invest in stocks for their growth potential and not their dividends (which is small in comparison to the potential gain through capital appreciation), over a long period of time, those dividends add up and compound if they are used to purchase more stock. If you have chosen stocks due to higher dividend yields, they may better be served to be in a tax-advantaged account (IRA, Roth IRA, 401k, etc.) because the dividends are typically taxable at regular income tax rates.
Thanks for a lucid article. This is the kind of piece I could show to my 14 year old and he’d understand (and not be bored). I always wondered what the indexes covered.
Hi. Thanks for the post. If there one rule for investing in the stock market, I’d say that you should only invest money you can afford to lose. Make sure you have all the essentials (food, rent, pension, saving) covered. If you still have spare money then you can start to invest in the stock market.
I concur Craig. A great introductory article indeed.
Thanks for the overview! Picked up a couple new things.