How do stocks work? That seems like a question you should know before investing. However, with the billions of dollars invested in employer retirement plans, many people have no answer to that question.
We’ll do our best to give you expert-level knowledge of the ins and outs of how stocks work and why they matter to investors here, as well as a quick dive into what you need to do to find success when you put your money in them.
What are shares?
A stock represents a means for companies to raise capital outside of a regular income stream. When companies sell stock, they are selling a small piece of property that interested investors can buy. In addition, investors receive voting rights, dividends and any profits from rises in the stock market.
Stocks and IPOs
Companies start as privately owned and are not listed on any stock exchange. The leaders must decide to start selling shares to the general public through an initial public offering (IPO).
Companies choose how many individual shares they want to make available during the IPO process and the initial price of each share. This process, also known as ‘going public’, usually takes about six months. After completing this initial offering, publicly traded companies will list on the stock market.
Once listed on an exchange, a company’s stock price can fluctuate depending on several specific elements.
What determines share prices?
In a sense, stocks are priced based on supply and demand. Companies have a finite number of shares, and any investor looking to buy shares must decide whether the price justifies a purchase. When a stock is in the spotlight, prices rise and investors want a piece of the pie. Conversely, a lack of demand leads to too many people selling stocks and no one willing to buy.
The main factor driving demand for certain stocks revolves around a company’s ability to make money and ultimately grow. In general, when a company’s profits rise, so do stock prices. Since a stock represents a share of ownership in a company, most investors want to buy shares that will increase over time.
While often directly related to a company’s success, other circumstances can affect the stock price.
We’ll talk more about this later, but understanding a company’s potential for long-term profits can play a role in stock prices beyond short-term success. Successful companies that have paved the way for greater profits over time usually seem fit to invest.
A country’s economy can play a role in the current market price of a stock. Unemployment rates, inflation or gross domestic product can have a major impact on the stock market in general.
Any event that affects the entire stock market can affect the price of a stock. The S&P 500 can pull stock prices upward or spiral downward, depending on how the index is doing.
Changes in import or export laws or changes that have a significant impact on a country’s economy can cause significant shifts in stock market prices. Political tensions or new international deals can also play a role.
How do you make money with stocks?
There are a few basic ways to make money investing in stocks. You can make the stock market work for you, buy and sell for quick capital gains, or grab stocks that pay dividends.
As quotes gain momentum on the stock market, prices rise. Buying stocks at low prices and selling them when prices are higher results in a capital gain, earning you the difference between the buy and sell price.
It’s never that easy, but investors tend to choose one of a few different paths when making money through price increases.
One option is growth stocks, categorized by their potential to appreciate over time. Investing in this is a long-term process and it can take years before it pays off. These stocks usually generate the most money if you are willing to wait for them.
While it’s not a bad idea to keep an eye on your investment, these stocks require no attention and will continue to grow over the long term. Think of some of the largest companies in the world that started small and have seen incredible growth since they first went public.
Investors who like to keep their hands on the stock market from bell to bell may be more inclined to day trade. In this case, traders look for stocks on different exchanges to buy and sell on the same day. Such stocks are usually low in price and prone to market volatility that causes many changes in a short period of time.
This approach is not for the faint of heart. Investors should thoroughly research the stocks with the highest growth potential while weighing how much risk an investment will be.
In addition to any funds earned from price increases, some stocks pay dividends to shareholders with an active investment.
Stock dividends represent a cash amount per share. Companies usually pay dividends on a quarterly basis. While dividends are only a few percent, owning multiple shares of stock in a given company can still lead to decent profits.
Companies are not obliged to pay dividends. Many do this to encourage stock purchases. Dividends change based on a company’s earnings and ability to pay, but many companies pride themselves on paying out regularly.
Despite stock prices, this approach provides a relatively stable way to invest in the stock market. Dividends probably won’t make you rich, but they can provide additional income to fuel another investment.
How to invest in stocks
There are two avenues investors can take when looking at stocks: direct ownership and indirect ownership.
The most common way to invest, direct ownership, involves investing in stocks directly from the stock markets themselves. In this way, investors buy shares (or sometimes fractions of shares) of a particular stock to hold or flip and sell.
With indirect ownership, investors acquire shares in a slightly different way. The most common forms of these are mutual funds and exchange-traded funds (ETFs).
A mutual fund offers several investors the opportunity to collectively pool funds to place in stocks, bonds and more. These collective investments become a portfolio that rises and falls depending on the assets within the fund. A money manager decides what to buy and sell as needed.
Anyone who invests in a mutual fund can see what’s in it and what it does, but cannot change the portfolio. Fortunately, this diverse set of investments goes a long way toward minimizing risk. These particular funds are traded only once per day.
ETFs are a collection of different stocks or bonds that usually fall within a specific category. For example, it is possible to find ETFs specific to energy, gold or even cybersecurity.
Some of these stocks can be expensive on their own. An ETF offers the opportunity to get a piece of that stock at a lower price. While traders own a portion of the ETF, they do not own any assets within it.
ETFs offer as much flexibility as stocks and trade when the market is open.
Make the investment
Once you are ready to begin your journey in the stock market, you will need the resources to do so. One of the easiest ways to trade stocks is to set up a brokerage account.
Brokerage services act as a medium that you can use to buy and sell stocks on the fly. An online broker like Robinhood makes the process as simple as a few clicks. Best of all, online brokers allow trading anywhere using a computer or mobile device.
What should you pay attention to when selecting stocks?
When analyzing stock investment options, investors study a few numbers to determine whether to buy or sell stocks. Shares quoted for a specified dollar amount can be spot-on, over- or undervalued.
Price to Earnings Ratio (P/E)
A company’s stock has a price-to-earnings ratio that reflects value in the stock market over time. The value comes from a simple calculation of stock price divided by earnings per share. There is no definitive number or numbers that indicate when shares should be bought and sold; However, there are guidelines to consider.
Many investors use the P/E ratio for the S&P 500 as a basis for a stock’s value, with ratios seen as high or low on either side.
A low P/E ratio represents a value company with a predictable strategy. These companies trade below their value, but can yield significant returns in the short term.
On the other hand, high P/E ratios indicate growth companies that can outperform the stock market in the long run. These companies focus on reaching the top of a particular industry before focusing on profit.
Market capitalization, or market capitalization, represents the total value of a company’s stock. You can get this number by multiplying the share price by the number of shares outstanding.
In many ways, this information indicates a company’s size to help determine its financial position.
Large-cap companies have a market cap of more than $2 billion. Many consider these companies to be more stable. These companies may not grow as fast, but they are less risky than a company with a lower market capitalization. As a result, medium and small businesses are more volatile and can grow.
When investing, don’t rule out a company’s past performance in the market. Even if they are currently in a downtrend, some companies have shown through experience that they can overcome and rise again.
Are stocks a good investment?
Stocks offer incredible investment potential and can lead to huge profits if executed correctly. While admittedly rare, individuals have achieved their financial goals by investing in the stock market.
Playing the stock market can be a risky business, and there is also the possibility of losing money. Before making any investment, always do extensive research and due diligence to ensure you are getting a good and not a bad deal.
If you’re not sure where to start, consider seeking investment advice from a financial advisor.
How do stocks work: last words
Thanks to modern technology, investing in the stock market is more accessible than ever. Everything you need to make an informed stock decision is just a click away. With this article, you should have everything you need to make a name for yourself in the world of stocks.
This article originally appeared on Wealth of Geeks.
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