I have realized that everyone needs a full understanding of what the stock market is and how it works. The market might seem quite complicated for the average person.
Ratios, financial statements, and technical analysis are words the pros use to scare away the novice investors.
If you don’t have a basic understanding of how the market works, professionals will give you the cold shoulder. The one thing money pros want is just for you to leave them alone.
They don’t want to empower you because if they did, you could do their job for them.
The truth is we should all have an understanding of the basics of the stock market. With that being said, this article is going to focus on the beginners.
I am going to break down the basics so that way you have a full understanding of what it exactly means to own shares of a company and why the prices fluctuate all the time.
Let’s dive right in. By the end of this article, you will have a full understanding of how the market works and some extra information that will allow you to be a well-informed investor.
What is “Stock”?
The universal question, what is “stock”?
What does it mean when someone says they own stock?
Stock is defined as a type of ownership in a corporation and represents a claim on part of the corporation’s assets and earnings.
In simple terms, you’re a partial owner of a company. There is a slight catch though, you’re a partial owner, not a full owner. Although you are considered an owner you can not just do as you please with the companies assets.
For example, if you owned shares of Home Depot (HD) that doesn’t exactly mean that you can walk into the store and take what you want. Yes, you are an owner of the company but that doesn’t mean that you get to do whatever you want with a company’s assets.
You will still get arrested if you choose to steal a chainsaw from Home Depot whether you own stock or not.
The difference between you and the real owners of the company is called “separation of ownership and control” you as a shareholder own the shares issued by the company. The real owners of the company actually own the company.
What is Great About Owning “stock”?
The latter might have seemed kind of depressing if you’re not entitled to all of the assets then why would you want to become an owner?
Well, there are many benefits to being a shareholder.
2 big reasons to become a shareholder is because they have voting rights and can receive dividends if the company pays them.
Voting rights allow you to have a say in who controls the company. Usually, when the board is trying to either get rid of a board member or elect a new member it goes to a vote.
This is where you come in as a shareholder.You have a vote on who runs the company you own.
Obviously, it pays to own more shares because the more shares you own the more votes you get. Usually, it’s a 1 to 1 ratio. One share equals one vote.
If you own a ton shares you have a huge say in these votes. This power allows you to directly control who is a part of the board of the directors of the company.
Another big plus to owning shares is you can receive a dividend.
A dividend is when the company pays you, as a shareholder, part of the companies profits. These can be a very powerful thing, by finding solid companies that pay a dividend can produce large returns over the course of a long time. Especially If you reinvest them through the DRIP program. (Check out my article on the DRIP program or my podcast talking about why it is so important to reinvest your dividends)
Some companies, however, will choose to not pay a dividend and instead, they will the profits and reinvest them back into the company.
This isn’t necessarily a bad thing.
Just because a company does not pay a dividend does not mean that you should not take a closer look at the company.
An excellent company that doesn’t pay a dividend is Warren Buffett’s Berkshire Hathaway (BRK.A) (BRK.B). A great company that does not regularly pay a dividend.
Where Does Stock Come From?
Stock does not just appear out of thin air.
Stock (Also known as, equities) is issued by the companies to raise capital. This is just one way of raising money for the company. Other options include getting a loan from a bank or even choosing to issue bonds.
You’re probably thinking bonds are safer than stocks so why would I choose stocks over bonds? It all comes down to risk and reward.
Stocks are riskier than bonds but can be much more profitable than bonds. The tradeoff is that you’re willing to take on a little more risk in order to seek a higher reward.
You can decide to buy stock from an extremely stable company and see much higher returns from your stock investment compared to your bond. It all depends on how much risk you’re willing to take.
Different Types of Stock
When it comes to stock, a company has the ability to offer different types of stock. There are 2 main types. Common and preferred stock.
In addition, there can also be different classes of stock. You might have noticed earlier when I talked about Berkshire Hathaway there were class A and class B.
This is the most common form of stock.
When you hear individual people talking about companies and stocks they are most likely talking about common stock.
Common shares represent a claim on profits and obtain voting rights. Most often common shares get you one vote per share.
Along with common stock, there is another type of stock offering called preferred stock.
By the name, you can understand that preferred stock is not available to everyone on the open market.
This type of stock functions more like bonds. There is usually no voting rights that come along with a share but the upside is you have a fixed dividend.
Common shares can have a dividend but it is not guaranteed. The owner of the preferred share is guaranteed their dividend.
Another advantage of owning preferred shares is that in the event of a liquidation the owners of this type of stock are paid off first.
Preferred stock also may be callable. Meaning that at any time the company has the option to purchase back the shares from the shareholder.
Different Stock Classes
Along with different types of stock, sometimes there are different classes of stock.
Occasionally you will see a company that offers A shares and B shares like BRK.A and BRK.B. The only big difference between these shares is the voting rights and sometimes the share price.
A company will create different classes of shares in order to keep the voting rights in a concentrated area.
For example, Class A shares might allow you to have 10 votes per share whereas Class B might only give you 1 vote per share. The company is set up so that a shareholder of Class A shares have much more voting power than an owner of class B shares.
Just remember that most of the time when you purchase shares of stock they are common shares.
How to Buy Stock
All public trading of stocks is done in the secondary market. Where the transaction is shareholder to shareholder. Which means when you buy a share on the other side of that transaction there is someone selling a share.
Purchasing your shares are very simple. In order to get access to the market, you have to go through a broker.
A broker is a middleman in the transaction. They give you the access to the market, allowing you to buy shares. Without a broker, an average person of the public will be unable to have access to the market.
If you’re an average person who wants to invest in their own setting up an online brokerage account is a common choice.
There are many out there to choose from.
If you’re just starting out I recommend you look for an online broker who has low commissions, little to no fees and has a low minimum deposit. Having all of these criteria will allow you to be investing right away.
How Do Stocks Get Their Price?
The all magical question: What makes this company worth more than the other ones.
Why is that stock price higher than other companies?
Every stock is priced through a certain type of auction process. There are constantly buyers and sellers bidding up or down the price of each company.
When you take a look at a stock price you will notice that there is a bid-ask spread. The bid is how much your willing to pay for a stock.
An offer or ask is how much your willing to sell the stock for.
When you see Bid think to buy. This is how much you would pay in order to buy the stock. On the other hand, when you see the word Offer or Ask, that is how much you would be willing to sell your share for.
Here is what the bid-ask spread looks like for Apple (AAPL)
How Do Stock Prices Move?
The movement of stock prices directly comes from the bid-ask spread changing.
For example, let’s say a company releases an earnings statement and it is all good news. Because of this more people want to buy the stock, so you will see more people bidding to buy the stock.
This will cause the sellers to sell at a higher price, because, a seller will always want to sell at a higher price. This increase in bidding will send the stock price up.
When the price goes down, the opposite happens. There are more sellers than buyers.
The sellers want to get out of the stock as quickly as possible, they will be willing to take a lower price because they want out. In this case, the buyers have the pricing power.
A lot of stock price fluctuation comes from the simple laws of supply and demand.
When a company is in a higher demand you can expect to see the price increase due to the lack of supply. Whereas, when the demand is lower and supply is prominent the stock price will decrease.
Related: Supply and Demand Can Change Your Life
The Bid-Ask Spread
The price moves when the Bid-Ask changes.
When you look at the Bid-Ask; I want you to pay attention to a small detail. The difference between the two.
This is what we call the spread. The spread is a good indicator if the stock is liquid or not.
Liquidity is a term used to describe the ease of getting in and out of stocks. If you invest in an illiquid stock, then it might be hard to get out. This is not a position you want to be in.
High-quality stocks will have spreads of a penny, maybe even less than a penny.
Low-quality stocks will have spreads that can be up to a dollar wide.
Here is a good example of a liquid stock
And this is what an illiquid stock looks like
It is in your best interest to stay away from stocks that have a large bid-ask spread. There is a reason they are not liquid and you do not want to be the one who finds out why.
What Drives Prices?
Now that we know how stocks get their prices, what makes them move? This is a question that people have been trying to answer for a long time.
The main component that drives stock prices is news.
Usually, news about a company is a big driving factor. The tricky part is when you try to time the market this can turn out badly.
Here is an example: If a company releases earnings and they blow the analysts out of the water. The company is running great and they crushed this past quarter.
You would expect that a seriously positive quarter would send their stock price through the roof, right? Most of the time it happens, but then there are these select times when they crush earnings and the stock drops.
There is no explanation for this short-term move, but here is something that you can rely on.
If you pick a company that is run well, delivers good financial results, and does so consistently; you can expect to have a good return on your money in the long term. Good companies reward their shareholders over years not days.
When you see stocks have huge price changes in the matter of a few days this is usually due to the news.
This is why it can be deadly if you try and time the market, you can buy a solid company that beats earnings and they see a huge drop.
Buy a company because they are a good company not because their price seems to always go up.
What is the DOW, S&P, and the Nasdaq?
If you have ever watched the news at night you will most likely see these 3 terms at the bottom of the screen.
These are what we call stock market indexes, they are an indication of the market overall. I’ll break down each of them so you have a full understanding of each of them.
The Dow: The Dow or Dow Jones Industrial Average is a market index that is used the track a select 30 companies during the course of a trading session. The index is made up of the large name companies in the market like Home Depot, Nike, Procter and Gamble, and Disney.
The S&P 500: The S&P or Standard and Poor’s 500 is also an index like the Dow, the difference between the 2 is that the Dow tracks a select 30 companies, the S&P 500 tracks the 500 largest companies listed in the stock market. The largest 500 companies are determined by market capitalization
The Nasdaq: Unlike the former, the Nasdaq is a stock exchange like the NYSE. The Nasdaq tracks all of the companies listed on the exchange itself. Every company listed on the exchange is used to determine the growing value of the exchange. Some companies listed on the Nasdaq include Microsoft, Apple, and Google.
Things You Should Know
I feel like there are just certain things you should know before you being your investing career that way when these things come up you will understand what is going on.
How money is made or lost in the market
I know this one seems a bit basic but it’s essential for you to understand how money is actually made.
You do not actually make or lose money until you sell your investment.
It’s great when the stock price is well above what you bought it for but it is not until you sell that investment that you actually make money off of the investment.
The same is for losing money. You do not actually lose money until you sell your investments. This can be a good and bad thing.
It can be good if you see the price is down and you wait until it goes back up to sell.
Yet at the same time, the price could tank and never come back. These are all just real situations in the market.
The main point is no money is made or loss until you decide to sell your investment.
I am sure you hear all the time that “X released earnings today” but if you’re like me you will be a little confused about what that means in the beginning.
A public company releases earnings 4 times a year, it is basically a report card for the company that tends to be measured with 2 statistics. Earnings per share and revenue.
These are the big 2 numbers people focus on.
We always like to see companies growing and turning more profit year over year. Earnings releases help us see if this company is doing well or not.
We always want to see the companies we are invested in to beat earnings all the time. Although they can miss from time to time, it is all about maintaining a consistent upward trend in both EPS and revenue.
The Financial Statements
In the earning statement, the big numbers people pay attention to are the earnings and revenue.
These numbers though come from 3 statements that are included in each earnings release. Think of it like this earnings and revenue are the pass or fail grade, the financial statements are all of the underlying details that produce those results.
Let’s take a closure look at what each of these entails.
The Income Statement: The income statement includes all of the companies’ revenues and expenses during the past period. It shows how a company turns the revenue into profit. You will see the net Income and earnings per share included in this statement.
The Balance Sheet: This statement is where all of the assets and liabilities and stockholder’s equity are listed. Its called the balance sheet because at the bottom of the statement it all balances out. The total assets always equal total liabilities plus stock holder’s equities.
The Cash Flow Statement: This one might seem a little self-explanatory. The cash flow statement shows how changes in the balance sheet accounts and income affect the cash and cash equivalents. The statement is broken down into 3 parts; operation, investing, and financing activities. Basically, this statement is concerned with the flow of cash in and out of the business.
Sometimes you will read that a company has released a program to buy back a certain dollar amount of shares back.
What that means is they are going to buy back some shares to reduce the supply of the shares in the market.
If the company is considered a smart investment the reduced supply should coherently increase the demand for each share.
The point of share buybacks is to make each share more valuable.
This can be good or bad depending on the company if you have a solid company buying back shares it can be a good thing. If the company is not good, then you would much rather have the cash be spent in other areas.
A dividend is a portion of the companies paid to you as a shareholder. Each company usually pays their dividend on a quarterly basis.
If you think about it, having a company paying you to own their shares is pretty cool.
If you combine the dividend with a DRIP program these small dividends can add up. Then over time, thanks to compound interest, you can amass a large amount of return.
Related: Beginners Guide to Dividends
Where to Research Companies?
It is imperative that you do your own homework about companies. At the end of the day, you need to be able to have a full understanding of the company before you invest in it.
If you plan to invest in the company, definitely dig deeper than these places. Go to the company’s investor relations, usually found on their website. Or just do a simple google search of ‘X company investor relations”. Read the annual reports and get a deep understanding.
Example: Apple Investor Relations
This step is crucial. Make sure you cover all ground before buying in.
If I had a simple guide like this when I began investing it probably would have saved me a lot of money and time.
If you would like to dig deeper into my introduction to the stock market I have written a small E-Book that gives you a deeper analysis of the market from a beginner standpoint. It also shows you how I analyze companies.
I hope this does you well, but the best thing I can tell you is to jump in.
The best way to learn something is to do it. You will pick up things you need to learn along the way and if you want to become the best investor possible start reading as many books as you can. (If you want to buy books I suggest going through ThriftBooks, they will save you a lot of money. In full disclosure this is an affiliate link)
The lifelong investing journey is one that can be widely rewarding, enjoy every second of it.
Peace and Love,
Please comment below and let me know what you think about the article. I would love to hear what you have to say.