What’s the first thing you think of when you hear the word “investing?” If it’s not Wall Street, millionaires, or CNBC, then it’s probably the stock market. Everyone’s heard of stocks and the stock market, but how many people actually understand what they are and how they work?
Sure, you know that people can get rich by “playing” the market. You also know that people can lose every last cent. It’s definitely risky business, but chances are that you’ll buy stocks at some point in your life if you ever plan to retire. Even if you don’t buy them yourself, your 401(k), IRA, or other investment tools will buy into the stock market for you.
Honestly, it’s not super important to understand every last detail of stock market investing. There are thousands of strategies people have used to try to do well in the stock market. Knowing all of these is basically impossible, and even the best strategies aren’t guaranteed to succeed. However, a basic understanding of what stocks are and how the stock market works will be beneficial to your financial future.
Plus, when your uncles are arguing about what “the market” will do in the future, you’ll have some idea as to what they’re talking about. Or, at the very least, when your parents ask what you learned on your first day of school, you’ll have something to tell them.
What is a Stock?
The first step to understanding how the stock market works is to understand what is actually being traded in said market. These are known as stocks, or shares. For our purposes, stocks and shares are pretty much the same thing, so it is likely that I will use them interchangeably.
A stock is basically a small fraction of ownership in a company. That means that if you own one share of a company, you own 0.000001% (depending on which stock) of that company. This was just a random percentage to show how little ownership you get in the company with one share. Depending on the company, this percentage varies widely. For example, one share in Apple means you own 1/5.4billionth of the company, or 0.00000002% of the entire company.
But, hey, if you buy one share in Apple, you’re now co-owner of the world’s most valuable company. That’ll cost you about $107 as of August, 2016, but congrats!
Conversely, some companies have fewer shares outstanding (shares owned by people, businesses, etc.). For Warren Buffett’s company, Berkshire Hathaway, one share means you own 0.00006% of the company. Still tiny, but a lot more significant than that you’d get with Apple. However, one share of Berkshire Hathaway’s stock will set you back around $224,000 as of August, 2016. That’s out of reach for most people, but if you can afford it, it’s proven to be a pretty strong investment.
Anyway, because you’re now part owner of these companies, that means you have gained the ability to help make decisions. So, when a big decision arises, shareholders for the company will be able to vote for which route they would like the company to take. Your voting power depends on the amount of shares you own. So, your one share of Apple won’t have a lot of weight on their decision making, unfortunately. Billionaires and different investment funds often own a big chunk of major companies, meaning they will have a larger say in the company’s decision making.
Chances are you won’t really care what they choose as long as you make some money off it, so sit tight and leave it to the professionals.
In addition, stocks are only available publicly (anyone can purchase them, as long as they can afford it) for companies that are corporations. A corporation is a type of business that is set up so that shareholders are the owners. Usually these will only be bigger companies. It is unlikely that you’ll be able to buy shares in a local restaurant, or your grandpa’s grocery store (unless your last name is Walton). I’ll explain why this is in the next section.
To summarize, owning a share in a company means you own a portion of that company, so if a share’s price goes up, you make money. The company’s success is (usually) your success as well.
What is the Stock Market?
In very basic terms, the stock market is the market in which stocks are traded. The stock market is the general term for all stock trading done across all of the different stock exchanges. A stock exchange is the actual location and specific market in which a stock exists and is traded. You’ve probably heard of the New York Stock Exchange, which has become the largest and most famous in the world.
Just a few decades ago, shares were literally a piece of paper that said you were an owner of a part of a company. This is why older movies feature scenes at the stock exchange where everyone is running around and yelling like crazy trying to buy and sell stocks. People still do that to an extent, but technology has made it much easier to buy and sell shares. You can now use an online trading program to buy stocks that are traded through the New York Stock Exchange from wherever you’re at.
As of 2016, there are about 20 large stock exchanges all over the world. When selling their first shares, a company must choose which stock exchange to be listed, or bought/sold, on. In the US, the two major exchanges are the New York Stock Exchange (NYSE) and the NASDAQ. Put in incredibly oversimplified terms, the NASDAQ has a lot more tech companies and newer industries, while the NYSE has basically everything else. This probably isn’t incredibly relevant to you, but knowledge is power.
You’re probably wondering why a company would even want to join an exchange and sell ownership to their company. Wouldn’t the current owners just want to keep it all and get even richer? Good question. The main reason for a company to sell shares is to raise more money. This is why bigger companies often begin selling shares. It’s silly for your neighbor’s shoe store to try to raise money when she could just go to the bank and take a $25,000 loan. However, if a company needs $1 billion to continue growing, it becomes a lot more difficult to go to a local bank.
At this point, a company might decide to have an Initial Public Offering (IPO) to sell ownership in the company to raise money. People will buy these shares if they believe that the company will continue to grow and be successful. If my $1,000 investment allows the company to become $2,000 more valuable, then I just doubled my money. The tricky part is knowing whether or not your investment will actually end up earning you money.
Whether you buy shares when a company first begins selling them or you buy them from another person who is trying to sell their older shares, the main goal is to try to get the value of that share to increase. It doesn’t make sense for you to buy shares in a company that you don’t think will do well. Again, your success is somewhat tied to the company’s success. Figuring out whether a company will do well in the future is what makes investing in stocks tricky.
How Do You Use This Information?
Well, like I said earlier, this probably isn’t going to be an actionable plan and won’t give you some great strategy to make money. Sorry. However, understanding what your invested money is doing and why you should even consider stocks in the first place is a good idea.
Knowing what “the market” is doing and what it means can help give you an idea of what’s going on in the business world. This is scary, but technically the price of a share is unrelated to how well a company is doing. A company could have just earned a record profit, but if people buying and selling shares in the company believe that the company is going to struggle in the future, the value may actually go down.
Similarly, during a stock market crash, many companies may have their share prices fall to half of what they once were even if they are performing the same as they always have been. The price of a share is set by people who trade the stock. The more people that want to buy the stock, the higher the value rises because it is more in demand. The more people that want to sell the stock, the lower the price falls because there is less demand. So, even though a company is performing wonderfully, if people don’t want it, the price could fall.
And as we all know, people always make decisions based on completely rational thinking and by using all of the facts… (sarcasm)
Despite the risks involved, the stock market has proven to be a solid place to invest over the long term. You hear a lot about people making a fortune, or about everyone losing their fortunes in recessions, but don’t let these affect your opinion. The return of the stock market through the past 100ish years has averaged around 10% a year. Obviously, this rate isn’t guaranteed going forward, but it’s a good indication that it is a strong tool for the long term. Losing 20% of your investment every 5-10 years may suck, but gaining 10-15% each year between those losses will usually more than make up for it.
No pain, no gain.