The Stock Market For Beginners
Find Out How the Stock Market Works and How Stocks Are Valued
Are you a stock market beginner? Are you confused on how to get the edge using the best day trading software or trading techniques? Well, the stock market is a creature in and of itself. At times it makes sense and at other times, no one can explain why it acts the way it does. What is clear is that, over the long run, the stock market will climb and climb faster than almost any other traditional investment. With that said, there are also moments (that sometimes last years) when the value of the stock market gets out of whack with the underlying companies and with the economy. We’ll try to explain our views below.
- How the stock market works.
- How stocks are valued.
- Why the stock market is a good investment (in the long term).
- Why the stock market gets out of whack with reality.
- Recommended ways to invest in the stock market.
How the stock market works
The stock market is called a market because it is the place that buyers and sellers converge to buy and sell stock. It's also called an exchange, because it's where investors go to trade their stock for cash and their cash for stock.
Over a hundred years ago businesses started raising capital by selling ownership in their business. After a while, the stock market developed as a place where this could be done. Back then, orders were taken in person and processed manually. All buyers and sellers had to be at the same location. Since then, technology has made the stock market a much larger, more liquid, and efficient marketplace. Now, buyers and sellers can place orders over their computers, phones or tablets and a computerized stock exchange matches their order with someone else with the opposite order.
Stock prices move as supply and demand changes. If there is more demand for a stock then supply, the price rises. That's why individual stock prices move sharply after they report good or bad news. ABC Stock Investing offers a more thorough definition of how the stock market works.
How stocks are valued
Stocks have two types of valuations. One is a value created using some type of cash flow, sales or fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for a particular share of stock and by how much other investors are willing to sell a stock for (in other words, by supply and demand). Both of these values change over time as investors change the way they analyze stocks and as they become more or less confident in the future of stocks. Let me discuss both types of valuations.
First, the fundamental valuation. This is the valuation that people use to justify stock prices. The most common example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio. This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices.
The other way stocks are valued is based on supply and demand. The more people that want to buy the stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower the price will be. This form of valuation is very hard to understand or predict, and is often drives the short-term stock market trends.
Why the stock market is a good investment (in the long term)
It’s all about risk and return, and because your money is at more risk in the stock market than if you park it in a savings or CD (by the way, the money you invest in a CD is probably reinvested by the company offering the CD), the potential return is higher. It’s true that the gyrations in the stock market can cause both large losses and large gains, but if your investment time horizon is long enough, these short-term fluctuations will result in relatively high returns. It is generally accepted, that the average long term return from investing in stocks is 10-12%. This is much higher than the average CD or savings rate of 4-6%.
Why the stock market gets out of whack with reality
Over the long term, the stock market is driven by underlying economic, financial and global growth. But in the short run, the market is driven by simple greed and fear, which are dictated by human emotions. During periods of prosperity, the stock market often rises faster than underlying earnings. During tough economic times, political uncertainty, and low consumer confidence, the stock market often performs worse than the underlying fundamentals predict.
Recommended ways to invest in the stock market
- Don’t try to time the market. As tempting as it is to try, it is not possible to time the stock market. People have written millions of pages of research on this topic and NO ONE has ever found a legitimate way to determine its trends.
- Use cost averaging. By buying stocks on a periodic basis (like once a paycheck, once a month or even once a year), you will always be buying at an average price. If you try to time the market, you may be buying at a high or low valuation.
- Take taxes into account. When you buy stocks, try to hold them for more than one year so you get taxed at the long term capital gains rate, which is currently 18%. If you sell your stock before one year, you will be taxed at your ordinary income tax rate, which is almost always higher than 18%, sometimes twice as high.
- Invest as much as possible into tax-sheltered 401K, 403B and IRAs. By investing in tax deferred plans, you are able to invest money and not worry about the tax implications. With 401K and 403B plans, you get to invest your earnings before taxes, so the investment will grow on a higher base. For example, if you received a paycheck for $2,000 gross pay and taxes were taken out, you'd be left with only $1,200 or so to invest. The investment return on $1,200 could be substantial, but if you could invest that same $2,000 in a tax deferred account, you would be investing and earning a return on $2,000 instead of $1,200. Also, many employers offer matching investments that could make that $2,000 investment equivalent to a $4,000 investment. Put as much as you can into these tax deferred investments.
- Diversify your investments. Don't just invest in stocks. It is better if you diversify your investments into other asset classes including real estate (a house), cash (savings account or CD) and maybe even bonds. That way, if one asset class really underperforms, you will have some exposure to the better performing assets.
- Diversify your stocks (mutual funds). When investing in the stock market, don't load up on just one or two stocks. Diversify your investments across many stocks. If your portfolio is not large enough to buy 15 or more different stocks, you should consider purchasing one or more mutual funds to ensure diversification. There are thousands of different investments out there including stocks, bonds, mutual funds, exchange traded funds (ETFs), commodities, futures, currency, binary options and even CFD Trading accounts.
We hope you've enjoyed and learned a lot from this stock market tutorial.
See Also: Investing Guide for Beginners