What you need to know about: The stock market

Here’s what you need to know to understand the basics of stocks, asset classes, and risk so you can start learning how to invest.

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Stock market basics

Stock market basics

You likely know you need to save your money. Keeping the cash you make in a safe place, like an account at a bank, can be a critical first step to strengthening your financial future. Once you’ve saved enough to establish an emergency fund to cover any unexpected expenses and paid down high-interest-rate debts like credit cards, you may be interested in investing.

The stock market is one way to invest your money. You can buy assets — shares in individual companies or shares of mutual funds that hold shares of multiple companies — that hopefully increase in value over time. Because the market is prone to ups and downs, however, it’s not a place to save money (although you can hold cash in the market, through a money market account).

You purchase an asset, like a stock, on the market for a certain price. The goal is to eventually sell that stock for more than you bought it for, which provides you with a profit. The difference between what you bought and sold the stock for is your return, minus any taxes you pay, which are called capital gains tax.

There are a number of factors that influence how much of a stock people buy or sell — and therefore whether the price goes up or down — including:

  • News about a particular company: Do they have a new product that’s set to take the market by storm?
  • Estimates of a company’s value: What do financial analysts think about the company’s future?
  • A company’s earnings: How well is the company performing?
  • Social or political issues: Are changes in the marketplace or new policies poised to impact the company’s operations?

There are countless other factors that influence stock price — and trying to guess if a stock’s price is about to rise or fall is a losing game for the average investor. Historically, people aren’t very good at guessing what the stock market will do next, and trying to “time” the market by buying or selling at just the right time is considered a poor strategy for the average investor.

Types of investments

Types of investments

What is a stock? It’s a portion of ownership in a company. If you hold stock in Apple, for example, you own a percentage of Apple (and are known as a shareholder). Cool, right? The more shares of stock you have, the more of the company you own.

Each stock you own is actually represented by a certificate, but this is something you’ll likely never see in the digital age. Everything is done and processed on computers, so physical papers are rarely necessary.

The stock market doesn’t just contain individual company stocks that you can buy or sell. There are other types of assets on the market, too, categorized by asset classes.

Asset class Examples What it is?
Equities Stocks A share of a company that you can buy and sell.
Fixed Income Bonds or certificates of deposit (CDs) Essentially, debt: buying something like a bond means you lend money to another entity (like the government) and earn interest on that money.
Cash Money Literally the paper bills in your possession (or in your checking account). You can put cash into a money market account in the stock market.
Real Estate Property Homes, buildings, and other physical structures or land. You can also buy shares in real estate investment trusts (REITs) if you don’t want to buy investment property on your own.
Commodities Energy, metals, and agricultural products (including crops and livestock) Like real estate, commodities are literal things or property you can own (and therefore buy, sell, or trade), such as cotton, oil, and gold.
Understanding risk

Understanding risk

The goal of investing, whether you buy a stock or a different type of asset, is to earn a return by eventually selling your asset at a higher price than you bought it.

But it doesn’t always work out that way. All investments come with a degree of risk, generally described as the likelihood that you’ll lose money on your investment.

You might buy a share of stock for $10 and when you sell, it’s worth $15. You would make a $5 profit on that stock. That’s the ideal situation, and the goal of investors who buy assets on the stock market. But you could also buy a share of stock for $10 — and eventually sell it for $5. In this case, you lose $5 on that stock.

In the stock market, there are several types of risk:

Type of risk    What it is
Market Risk The chance an asset, like a stock, will decline in value.
Interest Rate Risk The chance that an investment’s value will change due to rising or falling interest rates.
Credit Risk The chance that an investment’s issuer (like the government who issues a bond) does not live up to its financial obligations (like repaying investors, with interest).
Liquidity Risk The chance that you will be unable to sell an illiquid investment and receive the asset’s cash value (i.e., selling a home).
Industry, Economic & Political Risks The chances that a specific industry will experience a downturn, the entire economy as a whole will struggle, or the government will change policies in a way that is unexpected or unfavorable to the market.
Managing risk

Managing risk

All investments carry some degree of risk. None are guaranteed to provide you with a return. That sounds like a big problem, but thankfully, there’s a way to manage the risk you take on.

Just like you’ve been told not to put all your eggs in one basket, if you have all of your money in one type of investment, you may be missing out on the opportunity to enjoy greater returns by diversifying into other investments. And, the best way for average investors to reduce risk is the diversity.

Diversification is spreading your money across various investments, like stocks, bonds, and cash alternatives. There are many types of asset classes inside the stock market — such as company size, geographical market, industry and sector. The more asset classes you invest in, the more opportunity you have to diversify your portfolio.

Whatever you invest in, it’s important to understand when you need your invested money to determine how much risk you can realistically take. If you know you’ll need access to your invested money in the near future, you should reduce the amount of risk in your portfolio.

Risk will always go hand-in-hand with investing. Successful investors are those who manage that risk wisely.

Market volatility

Market volatility

Risk exists because the value of stocks and other assets change — sometimes constantly throughout the day. Prices drop, but they also rise. All that change is called market volatility.

“Volatility” may sound bad, but it really just describes changes in the market. A rising market where prices go up in value indicates a change, but most investors would agree it’s a positive one instead of a negative.

We know that at times, the stock market will rise in value. And we also know there will be times it will drop. Because the ultimate goal is to make money when you sell your assets on the market, the ideal way to invest is selling for more than you bought.

This is also where average investors get into a lot of trouble. Most people simply aren’t good at timing the market, or knowing when stock prices will rise and fall.

As a result, average investors tend to buy high and sell low, because they fail to time the market well. They hear about a stock that’s seeming to gain momentum in the market and buy in after the price has already increased dramatically. Or after seeing an asset lose a significant amount of value, they sell, hoping to exit before the bottom, only to see the asset eventually rebound. Essentially, they spend a lot of money to buy expensive stock and risk losing that money because they tend to sell when values are low.

Sounds counterintuitive, right? It happens because when stock prices are high, people’s confidence is also high. We feel good about the market and where it’s headed — and we want to buy in when things are going well.

When stock prices drop, people tend to panic. They want out of what they feel is a bad situation that’s only going to get worse. Panic can trigger a selloff, where people are simply trying to dump their stocks to get out of them.

This isn’t rational. Remember, due to market volatility, stock prices will drop and they will rise. Historically, the stock market has increased in average value. In the 10-year period between 2007 and 2016, for example, the S&P 500, one measure of the overall market’s performance, increased by about 30% despite one of the country’s worst ever recessions. Holding stocks for the long term — even through down periods — is typically a better play than trying to time the peaks and falls of the market.

There is a famous saying: You need to be fearful when others are greedy, and greedy when others are fearful. When other investors are snapping up stocks, demand is high — and so are prices.

Conversely, when other investors get scared and start disposing of stock as quickly as they can, demand drops. This creates an opportunity to buy stock at lower prices and to make money on your investment if you can hold the asset long enough for the value to rise again.

Start investing

Start investing

When it comes to investing in the stock market, you need to be educated before you invest. Obtaining that education could mean reading a bunch of quality investment books and resources, or working directly with a professional whose job is to help others invest money wisely.

If you work with a professional, make sure that person works in your best interest. There are all kinds of financial representatives that call themselves financial planners, wealth managers, or investment advisors. There are no regulations around these terms, so you can’t necessarily just judge someone by their title.

Instead, here’s what to look for before hiring anyone to help you with your finances or investments:

CFP Fee-only Fiduciary
Stands for Certified Financial Planner, and indicates this person went through years of training and education. The advisor gets paid for services from clients only. They do not receive commissions or payments from companies when clients invest in certain funds. Removes conflicts of interest. This upholds an advisor to a legal and ethical standard to provide advice that is in your best interest. Those not held to this standard only need to give you “suitable” advice.

But you don’t need a financial advisor to dip your toe into investing. It’s easier than ever with technology, but the information available and the choices you may have varies depending on which platform or site you choose. Here are a few strategies you may want to consider if you want to start investing on your own:

  • Pursue a “buy-and-hold” strategy and invest for the long term. This is safer for average investors because it allows you to avoid buying high and selling low, or losing money to fees and bad decisions when you try to trade frequently.
  • Research mutual funds and index funds. Funds give you access to a broad variety of equities without having to purchase each individually, meaning you can quickly and cost-effectively diversify your portfolio.
  • Understand risk and expect it. Manage it by diversifying and keeping some of your assets in cash.

And educate yourself! Continue reading books and articles, listen to podcasts, talk to professionals for advice, and ask questions. The more you learn, the more empowered you’ll be to invest in the stock market.

Glossary

Glossary

Asset class: A group of assets in the stock market that share financial characteristics and behave similarly

Bonds: A vehicle through which investors lend money to an entity, like a company or government, with the intention of earning a return when the borrower pays back the investment with interest

Commodities: Property like oil, metals, and agricultural products (including crops and livestock)

Diversification: A way to manage risk by investing in various different assets and commodities in a portfolio

Equities: A type of asset class that includes stocks

Index fund: A type of mutual fund that tracks a particular index in the market, such as the S&P 500®

Mutual fund: An investment vehicle that is made up of money contributed by multiple investors, that then uses the pooled funds to invest in a particular set of assets in the stock market

Return: A measure of how much profit or loss an investment provided

Risk: The likelihood or chance an investment will experience loss

Stock: A share or stake in a company that you can buy or sell on the stock market

Stock market: An exchange where you can buy or sell various assets, including stocks and mutual funds

Supply and demand: An economic theory that says the relationship between the supply of a commodity and the demand for it determines the price of that commodity

Volatility: The degree to which the price or value of an asset changes over a set period of time