How the Market Works
The idea of investing in the stock market may seem scary especially if it is your first time trying it. Many people end up being discouraged by the sad stories of investors losing most or all of their money.
But the stock market also provides plenty of opportunity to grow your wealth with the click of a couple buttons on your computer. So let’s take a look at how the stock market works and how you can use it to your advantage.
What is a Stock?
Also called a share or equity, stocks are a financial instrument that signifies a percentage of ownership in a company or a corporation. It represents a claim on a fraction of a company’s assets and earnings.
A stock owner is a person who owns a certain percentage of the corporation that is equivalent to the number of shares held which is a fraction of the company’s total outstanding shares. For example, if an investor owns 200,000 shares of a company with 4 million outstanding shares, he or she would have a 5% ownership stake in it.
Different Types of Stocks
There are three types of stocks:
1. Common Stock
The common shares carry the voting rights which enable an investor to have a say in the company’s meetings. However, voting rights are not equal. Companies may give the shareholder one or two or multiple votes according to the shares held.
2. Preferred Stock
The preferred shares, on the other hand, do not come with the voting rights because one gets to choose the preference in an organization to receive dividends and assets in case of liquidation. In other words, if a company becomes bankrupt, preferred stocks dividends will be paid after the company debts.
3. Dividend-Producing Stock
A company may decide to pass a dividend to the shareholders depending on the profit they have earned. Dividends are some form of reward to an organization’s shareholders and are totally determined by the company, which means that the corporation may increase or decrease the dividends as it pleases.
How Do Stocks Work?
The stock market is like an auction platform where investors buy and sell shares of stocks based on the highest price willing to be paid by a buyer and the lowest price a seller is willing to sell their shares for.
Stock prices are a representation of supply and demand and when it is lopsided prices move. For example, if there are more sellers than buyers then supply outweighs demand and prices will fall and vice versa.
Sellers try to sell each shares as high as possible hoping that they will get more than what they paid for it while stock buyers strive to get the lowest price possible to obtain the best deal.
The difference between what a seller is willing to sell for and what a buyer is willing to pay is known as the spread. So if a stock has a buyer at $10 and the lowest seller is at $10.25 then the difference between those two numbers is the spread, which is $0.25.
How do I invest in the Stock Market?
Unfortunately, only investors with large accounts can trade on the floor of the stock exchange. However, if you want to trade stocks you can open an account with an online broker for a generally cheap commission. Your options include hiring:
• Financial Advisors who usually charge an annual fee or per transaction fee
• Large banks which in addition to executing trades will also provide financial planning
• Online brokers who charge a small fee for every transaction
A majority of investors will buy stocks through mutual funds, which are companies that buy a collection of stocks and hold them in a fund and then sell shares of that fund to investors. Instead of owning shares in the mutual fund, the investor can choose to buy the stocks directly depending on your financial goals and time horizon. Mutual Funds are a diversified investment which means they tend to carry less risk than owning a single stock outright.
However, some investors like picking the companies they own and will buy them individually. The best way to do this is by selecting strong companies with a track record of growth or sustainability. This reduces your risk and gives you a better chance at making a profit.
What Determines the Stock Price?
Stock prices tend to go up and down over time depending on the supply and demand. The change in prices is a direct result of supply and demand. If a stock is on high demand due to the recent success of the company or a strong industry sector, its prices tend to go up because their are more buyers than sellers.
On the other hand, if investors are not willing to buy a stock due to the company posting weak earnings or guidance, its price will fall because there will be more sellers than buyers creating more supply of the stock in the marketplace.
With any investment, there are risks, and the stock market is no different. By understanding how the stock market works you put yourself in a better position to make smarter, more informed decisions.