Takeaways
- A stock market facilitates the buying and selling of stocks between investors.
- Stock markets like the NYSE and the NASDAQ account for most stock trades in America.
- Each stock market may be known for listing different types and maturities of companies.
- The Securities and Exchange Commission regulates stock markets.
- Stock markets facilitate the efficient discovery of prices and offer easy ways to transact between buyers and sellers.
If you are new to investing, the terms and definitions can feel overwhelming. With a deluge of buzzwords like earnings reports and market movers, it can seem confusing to beginner investors to know where to begin. Understanding how the stock market works, how to invest in stocks, and how to earn passive income from investing can take years to absorb. Luckily, conquering the basics is manageable for beginner investors and can set you up for lifelong successful investing. The first step is to understand how the stock market works.
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What is a Stock Market?
A stock market refers to a stock exchange that facilitates the buying and selling of equity securities. When people refer to the stock market, they mean the collection of different stock exchanges such as the NYSE, NASDAQ, or LSE. The performance of stock markets, or stock market indexes, acts as a barometer for the health of the economy.
Stock markets are full of companies that list their shares, or ownership in their company, to the public. As a retail investor, you can buy and sell these shares quickly, efficiently, and cheaply via an online brokerage account. These shares are traded electronically between buyers and sellers who believe the value of the stock will either increase or decrease. Investors try to buy stocks at a low price and sell at a higher price.
What is a Stock?
A stock is a piece of ownership in a company. Stocks are financial securities issued by companies to investors to raise capital to support their business. A company first lists its shares on an exchange through an Initial Public Offering (IPO). Investors buy shares in the company and begin trading these shares with other investors in the stock exchange, which facilitates a marketplace for the company’s shares.
Companies can issue stock to raise capital to invest in a new business idea, pay off debt, purchase another company, or support ongoing operations. The shares the company sells are listed on a stock exchange, where investors can easily buy and sell stocks in real time. Investors who purchase stock are called shareholders.
Historically, trading stocks has been done in person and with pen and paper. Now, however, almost all trades are completed online.
How to Trade Stocks
You can trade stocks from your couch with your online brokerage account. Here is a step-by-step guide on how to start trading stocks.
Create a Budget: The first step to investing is knowing how much discretionary income you can afford to invest in stocks. Start by creating a budget and figure out what percentage of your take-home pay you can allocate to investing. You can use the 50/30/20 budgeting strategy to help you set allocations.
Open an Account: Once you know how much you can invest, the next step is to open an online brokerage account. Some brokerage accounts are offering fantastic incentives. See Smart Money’s list of best brokerage accounts to compare offerings.
Choose an Investment: Once you have funded your account, it is time to put your capital to work. Do your research on the best types of investments that make sense for you. Beginner investors can take several approaches, but an investment strategy should drive your decision-making. To kickstart the process you can choose to invest in a company you use regularly, high-yield dividends stocks, or diversify your investment in an exchange-traded fund or mutual fund.
Start Investing: After your due diligence is complete, it is time to select your investment and buy your stock. Once you purchase your investment, you will receive a trade confirmation for the date, time, price, and security purchased. Now you can move on to investing more.
Think Long-Term: The best investors in the world think about investing over many decades. Some elite professional investors evangelize the idea that once you purchase an investment, you shouldn’t sell it. While this is more to make a point about holding stocks for the long term, having a long investment horizon can help alleviate the short-term fluctuation of individual stocks or investments.
Factor In Taxes: Taxes can seriously impact your overall return on investment. Your tax rate is of course based on many different variables: your income level, type of investment, how long you have held the investment, and other factors. If you sell a stock too soon, you may be subject to short-term capital gains. On the other hand, if you hold investments for long enough, they might be eligible for long-term capital gains tax treatment.
Bull vs. Bear Markets
Investors use the terms bull and bear market to describe different types of financial markets. While intraday highs and lows describe what is happening to a stock, mutual fund, or ETF during a single trading day, bull and bear markets describe a financial market’s trajectory over an extended period.
A bull market is a market where prices are on the rise and expected to continue to increase. A bull market also describes an extended period where securities in the market are rising. The length of bull markets varies from several months to years and is trailed by bear markets.
Bear markets, by contrast, are financial markets that experience a prolonged period of price declines. The metric investors look for to indicate a bull market is a decline in stock prices by 20% or more from recent highs. A bear market also ushers in investor pessimism and negative sentiment about the trajectory of the economy. Bear markets indicate economies are in a recession or depression, or at least heading towards one.
The good news is that investors can make money in both bull and bear markets. By using investing strategies like dollar-cost averaging, you can ignore the noise of recent market machinations and focus on building a long-term-oriented portfolio.
Individual Stocks vs. Diversification
As an individual investor, your choice of investments is almost endless. As a long-term-oriented investor, you will experience both bull and bear markets. Bull markets make you feel wealthier, while bear markets snap you back to reality. If you aren’t careful, bear markets can seriously damage your portfolio returns and net worth.
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If you are new to investing, investing in individual stocks can be riskier than investing in a basket of stocks. By investing in a single company's stock, you are taking on a high degree of investment risk. If that one company performs poorly, causing the stock to decline in value, so too will your investment portfolio. The counter is also true.
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Diversification can help alleviate this problem. By investing in investment vehicles like an ETF or mutual fund, where investors invest in a pool of money that owns hundreds of stocks, you spread your risk of loss among many investments. If one stock performs poorly it can be offset by a well-performing company. On balance, your investment will rise as the companies in the ETF, or mutual fund, perform well and decline when the basket performs poorly. The benefit of diversification is that you are not investing all your money in one stock but spreading your risk among multiple equities.
Trading vs. Long-Term Investing
Most investors use the stock market to build a well-diversified portfolio of stocks, ETFs, mutual funds, and target date funds to solidify their retirement nest egg. They invest in 401(k)s, Traditional IRAs, and Roth IRAs over a long-time horizon and watch their investments grow over time.
Smart Tip:
Investing in exchange-traded or mutual funds that track certain market indexes, like the S&P 500, can increase your diversification. Investing in these is simple when you open an online brokerage account.
But some investors want a little more action in trading stocks. Stock traders are investors who focus on buying and selling stocks daily and monthly based on industry insights, trading dynamics, macroeconomics, and short-term volatility.
Traders try to profit based on short-term market events, sometimes buying and selling a stock multiple times a day. Other traders arbitrage information asymmetry or a binary short-term investment thesis.
Smart Tip:
The S&P 500 has averaged an 8% return over the last four decades. Selecting a set-it-and-forget-it approach to investing could save you time and money. Let investment professionals do the heavy lifting while you sit back and enjoy juicy returns. Take the next step and set up an online brokerage account.
Smart Summary
Here’s the truth: investing in the stock market is one of the best wealth-producing opportunities. Investing early and often is a proven strategy to help you win over the long term. The stock market is a collection of companies and investors who raise capital and trade stocks. Understanding how the stock market works is essential for beginner investors. Once you absorb how it works, it can be an excellent time to put your knowledge to work and start investing in your future. Investing is as easy as selecting the best online brokerage account and beginning the process.
Frequently Asked Questions
Before you start investing, do your research. Make sure that you understand the basic terminology, language, and definitions of investing.
Reading this article to understand how the stock market operates is a great place to start. If you want to get smart with your money, read Smart Money’s Investing section. Some of our most popular investing articles include 9 Investment Strategies for Beginners and Investing Made Easy: 10 Steps to Start Investing in Stocks. You can also check out the 9 Best Investing Books You Absolutely Must Read.
There is no exact amount that a beginner investor needs to start investing. You can start investing with only $5 or $10. Getting started is the hard part when it comes to investing.
A 401(k) program can be an excellent place to start investing and get free money added to your account with a 401(k)-matching program, which juices your returns. 401(k) programs are great investment vehicles because companies usually provide a curated list of diversified mutual funds and ETFs to invest in.
Before you start investing, refer to your budget to see what you can afford to start investing. Keep adding to your investments over time and diversify your positions.
The key difference between active and passive investment is the time dedicated to keeping up with an investment.
Active investing means investing in funds where a portfolio manager (the person in charge of allocating capital for investments) selects investments based on an independent assessment of their worth. The portfolio manager tries to select investments with the highest returns that align with the portfolio’s investment strategy. This might mean buying positions and reversing course for another option in only a few months.
Passive investing is more of a hands-off index-style investment strategy. Passive investing generally means investing in indexed mutual funds and exchange-traded funds, which offer lower fees and transparency, and are tax efficient. Passive investing is more of a long-term buy-and-hold approach. Passive investing has gained considerable traction because its returns have started to beat actively managed funds.
Active and passive investment fund performance varies. No strategy is a one-size-fits-all approach because your investment strategy should align with your long-term financial goals and risk appetite.
