how does the stock market work in simple terms
Investing 101

How Does the Stock Market Work?

If you are like many Americans, you find the stock market intimidating and confusing. According to a 2020 poll by Gallup, only 55% of Americans own stocks. 

You may have heard horror stories of people losing all of their savings on a single investment, and terms like “capital gains” and “S&P 500” make you think stocks are concepts you could never understand.

However, participating in the stock market is not limited to professional investors. Everyday consumers, too, can benefit from making profitable trades and keeping a foot in the stock exchange—and doing so may not be as confusing or risky as you think. 

Read ahead to learn what the stock market is, how it works, and how you can make money by investing in shares

A brief history of stock markets

During the 17th century, The Dutch East India Company sent expeditions to Asia and imported trade goods into Europe. Due to pirates and stormy seas, these voyages were inherently risky, and they required more capital than a single entity could provide on its own. 

To solve these problems, investors pooled their money and became co-owners of the company. In 1602, the Dutch East India Company became the first joint-stock company. The East India companies issued shares on paper, which investors started trading among themselves in coffee shops, which were the first “stock exchanges.”

What is a stock?

Stocks are investment securities representing pieces of ownership in a company. Corporations go public and issue stock to:

  • Raise more capital for business expansion
  • Increase liquid assets
  • Grow their market value
  • Attract human-resources
  • Acquire other businesses

As an investor, you can purchase stock directly from an issuing company during the initial public offering (IPO) or through the secondary market. More on this later. 

The terms “stocks” and “shares” both refer to the equity of a company. However, stock refers to company ownership in general, while shares are the units of ownership. For example, you can say you own stock in Daimler AG, or you can say you own 50 shares of Daimler AG stocks. 

The share that you own in a company is proportionate to your ownership of its assets and earnings. For example, if you own 0.02% of a company, you own 0.02% of all the company’s assets, and you are entitled to 0.02% of the company’s profits. A company’s share price reflects what people are willing to pay at any given moment for a portion of its ownership. 

What is the stock market?

The stock market is where individual investors come together to buy and sell shares of publicly-held companies. The U.S. Securities and Exchange Commission is a federal agency regulating the stock market in the United States. One of the commission’s roles is to ensure investors have access to accurate information on companies’ financial performance. 

Stock exchanges are the actual markets where the trade of company shares takes place. In the United States, these exchanges, or secondary markets, include the New York Stock Exchange (NYSE) and Nasdaq. Most people trade on the secondary market. 

Generally speaking, the NYSE is an auction market for established securities, while the Nasdaq is a dealer exchange listing younger and growth-oriented companies. An individual stock can trade on one of these exchanges – not both. 

As a U.S. investor, you can directly buy foreign stock on foreign exchanges, such as the Toronto Stock Exchange, Tokyo Stock Exchange, or SIX Swiss Exchange. You can also buy an American depositary receipt (ADR), which trades on the NYSE or Nasdaq and represents foreign company shares. 

If stocks don’t meet the stock exchanges’ trading requirements, they trade on over-the-counter (OTC) markets through broker-dealers and not on an open exchange. Stocks trading on exchanges are called listed stocks, and stocks trading over the counter are called unlisted stocks. 

In the secondary market, supply and demand are among the factors driving the price of individual stocks. If there are more buyers compared to sellers of a stock, its price will increase. On the other hand, if there are more sellers than buyers, the stock’s price will decrease. 

The primary market

The primary market is where the creation of stocks takes place. Professional investors buy securities directly from the issuing company, which receives additional capital. Keep in mind that when trading occurs between investors on a secondary market, the issuer doesn’t experience capital growth. 

The most familiar example of the private market is an Initial Public Offering (IPO), which is the process a company follows to offer shares to the public for the first time. 

A private placement is another example of a primary market stock offering. In this case, a company can sell shares to professional investors without making them available to the public. 

Investors in the primary market include investment banks, insurance companies, hedge funds, and pension funds. Individual investors generally don’t participate in the primary market.

Types of common stock

Understanding the different stock types is crucial if you want to formulate a goal-oriented investment strategy that fits your risk tolerance.  

Blue-chip stocks

Blue-chip stocks are reputable and established companies, such as household names. Examples of blue-chip stocks include Procter & Gamble, Intel, McDonald’s, and AbbVie. 

When it comes to predictable earnings and dividend payments, steady growth, and low risk, blue-chip stocks are your best option. Blue-chip stocks’ returns are also generally higher than those of bonds. 

However, this stock type is expensive to buy. If you don’t have a large initial investment, consider some of the other stock types first. 

Income stocks

Income stocks are equity securities with a long history of paying higher-than-average and steadily increasing dividends. Generally speaking, income stocks are also not likely to cut their dividends in the future, making them a viable option for investors with a medium to low risk tolerance. 

Limited growth is the most significant drawback of income stocks. However, low growth doesn’t mean low profitability. If you only care about dividend payments and income, this stock type is worth considering. 

Examples of income stocks include Walmart, Microsoft, and Verizon Communications.

Growth stocks

Growth stocks pay little to no dividends, but their growth rates are substantially higher than that of the market average. 

Growth companies typically have a loyal and expanding consumer base, and they have a competitive advantage over other companies in their industry. Examples of growth companies include Google, Apple, Amazon, and Lockheed Martin. 

If you have a relatively high risk tolerance and capital appreciation is among your investment objectives, consider growth stocks for your next investment.

Cyclical stocks

The market performance and earnings of cyclical stocks have a close relationship with the general economy, and they tend to move with the business cycle. Cyclical corporations generally sell products and services that are in demand when the economy performs well. Examples of cyclical companies include Tesla, Timkin, Lennar, and Genuine Parts. 

Cyclical stocks are suitable for investors who can get in and out of trades more often. Before investing in cyclical stocks, remember that holding a stock for less than a year can put you in a higher tax bracket

Defensive stocks

Defensive stocks are companies that continue to perform well when the economy starts faltering. In other words, defensive stocks are counter-cyclical. 

Defensive stocks include companies that supply consumer goods at relatively low prices, such as Walmart. Utility stocks, healthcare stocks, and apartment real estate investment trusts are also defensive. 

Many investors hedge with defensive stocks like they do with cryptocurrency or commodities. 

Small-cap stocks

A small-cap is a company with less than $2 billion in market capitalization and the potential to offer above-average returns. An IPO is one example of a small-cap stock. 

With their potential for growth and undervaluation, small caps stocks are an attractive option for new investors. However, small-cap stocks have low liquidity, and they tend to be highly volatile. Small-cap companies typically also retain all their profits to maximize growth, which means low dividends. 

Mid-cap stocks

Mid-caps are companies with a market value ranging from $2 billion to $10 billion. These stocks are typically not as risky or volatile as small-cap stocks, but their growth potential is generally lower. Examples of mid-cap stocks include Livongo Health, Peloton Interactive, and Hasbro. 

Stock market indices

Stock market indexes, or indices, are portfolios tracking stock market trends over time. When you hear on the news that the market is “up” or “down,” these terms come from stock market index projections.

Two major indexes show the stock market’s performance in the U.S.: the Dow Jones Industrial Average (DJIA) and S&P 500. Other indexes, like the Russell 2000, report trends for smaller companies. 

Dow Jones Industrial Average (DIJA)

The Dow Jones Industrial Average (DJIA), also known as the Dow 30, is a stock market index that tracks the top 30 blue-chip companies in the U.S. A blue-chip company is a financially stable, nationally recognized company that consumers trust to sell high-quality products. 

A few examples of DJIA-companies are Coca-Cola, McDonald’s, Johnson & Johnson, and Microsoft. If the DJIA tracks a company, you can expect the company to be highly profitable, meaning shares will be pricey. 

S&P 500

The S&P 500, or the Standard & Poor’s 500, is a stock market index that expands its reach to include the 500 largest companies that sell shares in the stock market. The S&P does not list all 500 of its companies on its website. However, many of its top corporations are in the technology or finance sector. 

Risks of investing in the stock market

Risk management should form an integral part of your stock investment strategy. Below, we look at the most prominent risks stock investors face and strategies to mitigate them. 

Economic downturns

Macroeconomic factors, such as inflation, unemployment, and rising interest rates, significantly impact the stock market. The economy is volatile and goes through periods of contraction and expansion. An economic downturn can also be the result of an event, such as the September 11 attacks.  

An economic downturn generally leads to lower revenues for companies, which can amplify the reduction in corporate earnings. When investors anticipate a decline in earnings, the stock market will overreact, and share prices may lead the decline. However, when looking at the S&P 500 earnings for the past few decades, it is clear that stocks outperformed other investments over the long-term. 

If you are relatively young, staying invested and riding out economic downturns is a sound strategy. You should also mitigate economic risk by including fixed-income securities and bonds in your portfolio. 

Market value risks

Market value risk is the uncertainty associated with investment trends affecting the value of your portfolio. For example, if the market goes against your investment to chase trendy stocks, your stock’s price will decrease, even if it has a high intrinsic value. 

The most effective way to mitigate this risk is to invest in multiple sectors of the economy. When the value of a stock in one sector depreciates, the others can pick up the slack. 

The risk of conservative investing

Investors often make the mistake of avoiding risks at all costs. When formulating your stock investment strategy, consider the risk-return trade-off principle, which associates high risk with high reward. 

Consider implementing more aggressive investment strategies to increase earnings if you are a young investor with 30 or more years before retirement. If there is a downturn, you have enough time to recover. However, as your retirement date draws near, you should transition to conservative strategies to mitigate your risk of capital loss. 

Investing in the stock market

If you are new to the stock market, your biggest challenge is determining whether a stock is a profitable investment or not. Below, we look at several metrics you can use to gauge a stock’s performance over the long-run. 

Economic moats

Before buying a stock, you have to determine whether the company has an economic moat or a sustainable competitive advantage. An economic moat protects a company’s profits and market share from competitors, ensuring survival over the long-term. If a company doesn’t have a moat, don’t invest in its stocks. 

An economic moat can be loyalty to the company’s brand, trade secrets, such as a recipe or patent, or economies of scale, which allows for production at a lower input cost. 

Network effects can also be a moat. With network effects, the value of a company’s offer increases as its consumer base grows. Facebook and Amazon are examples of companies with network effects as an economic moat. 

Return on capital

Return on capital (ROC) is a metric measuring a company’s profitability, which is among the most critical considerations when evaluating a stock as a potential investment. 

ROC = (net income – dividends) / (equity + debt)

You can calculate ROC yourself using the company’s financial statements, or you can find it by doing a Google search. 

ROC indicates a company’s ability to generate profits given a fixed amount of resources. As a rule of thumb, you should only consider companies with a ROC in the double digits. For example, for the past few decades, The Coca-Cola Company maintained a healthy ROC within the 20% to 30% range. 

If a company’s ROC is lower than 10% or negative, scratch it from your list. 

Price-to-earnings (P/E) ratio 

Even if a company has a deep, wide moat and high return on capital, you don’t want to pay too much for its stock. 

With the price-to-earnings ratio, you can calculate how expensive or cheap a stock is relative to its generated earnings. 

PE Ratio = current share price / earnings per share

The lower the PE ratio, the less you are paying for every dollar the company earns. To determine whether a PE ratio is high or low, you have to compare it with companies’ PE ratios in the same sector. 

Debt

For a company to be a good investment, it has to generate enough cash flow to pay the principal and interest on its debt every month. To assess a company’s debt, you have to calculate its debt repayment period.

Debt repayment period = long-term liabilities / free cash flow

If you are a conservative investor, consider companies with a debt repayment period of three years or less. 

Final thoughts

The stock market may seem complicated and intimidating now. Still, once you understand the ins and outs of stocks, trading, and exchanges, you can begin to piece together this information to understand the market as a whole. 

However, the most effective way to learn about the stock market is to dive right in. Choose an online or in-person broker, purchase a share in a company that seems to be doing well, and watch how your money grows (or decreases) with the market trends. 

Invest a few dollars here and there and continue reading resources like this to learn more of the fine details. In no time, you will be trading shares and earning dividends like the pros. 

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