Public companies issue shares so that investors can purchase a piece of the enterprise. This is a way that companies raise money. The shareholders get a slice of the profits and dividends, plus any appreciation in the price of the shares. They can also watch their investment shrink or disappear if the company does poorly.
How does the stock market work?
To understand the stock market, it’s important to understand what a stock is, says Jessie X. Fan, professor at the University of Utah.
“Stocks are shares of ownership in companies,” Fan says. “You buy stock and you basically own a part of the company. Although it can be a very, very, very small part of that company.”
The stock exchange is where investors connect to buy and sell stocks and other financial investments. Deals are made, and a stock is bought or sold at a certain price, Fan says.
“And that price – depending on the size of the demand, the size of the supply, it could go up or could go down,” Fan says. “And basically it fluctuates every day, every second … in the stock market. So that’s how the price changes.”
What should you do if you lose a lot of money?
Going into investing, you need to know that it’s possible to lose your money since stocks don’t have principal guarantees. If you’re looking for a guaranteed return, perhaps a CD might be better for you.
The concept of market volatility can be difficult for new and even experienced investors to understand, says Dan Keady, CFP, chief financial planning strategist at TIAA.
“One of the interesting things is people will see the market’s volatile because the market’s going down,” Keady says. “Of course, when it’s going up it’s also volatile – at least from a statistical standpoint – it’s moving all over the place. So, it’s important for people to say, that that volatility that they’re seeing on the upside, they’ll also see on the down side. Because it’s usually pretty close.”
Investing safeguards for beginners
The best safeguard is don’t invest unless it’s money that you’re willing to lose. Also, new investors need to be aware that buying and selling stocks frequently can get expensive. It can create taxes, fees and commissions.
“So all those things can greatly, greatly hurt your returns over time,” Keady says. “So I think it’s best for people to try to avoid [frequent] trading. If they’re convinced that they can do it, and they want to do it, take a relatively small amount of money, and use that as the money that you’re going to ‘trade your way to make profits.’ And then have the bigger amount invested in a diversified portfolio, such as a mutual fund.”
Capital gains taxes are something that investors should be aware of. When you sell a stock for a gain will determine how it’s taxed. If you buy and sell the asset within a year, it will fall under short-term capital gains will be taxed as regular income.
What is the stock market?
Stocks, which are also called equities, are securities that give shareholders an ownership in a public company, according to investor.gov. When people refer to the stock market, they are referring to many things and different exchanges.
When people say, “the market was up today,” typically they are referring to the Dow Jones Industrial Average – a look at how 30 large companies together have fared on that day of trading. People also may look at the S&P 500 when referring to the stock market.
The S&P 500 is made up of the 500 largest listed companies. But even though people are referring to the Dow and the S&P 500 as “the market,” those are really indexes.
A stock exchange – such as the New York Stock Exchange (NYSE) – is a part of the stock market and is a place where you could physically buy and sell stocks, Fan says.
“But modern days of course it’s all done electronically,” Fan says. “So what happens is you have people who want to buy stocks and you have people who want to sell the same kind of stocks. And in this exchange, there’s demand and there’s supply.”
1. How to buy the right stock
Buying the right stock isn’t a skill that can be taught. Since diversification is the key to a successful portfolio, one stock shouldn’t make or break your holdings.
“When you start looking at statistics you’ve got to remember that the professionals are looking at each and every one of those companies with much more rigor than you can probably do as an individual, so it’s a very difficult game for the individual to win over time,” Keady says.
Looking at a company’s fundamentals – earnings per share (EPS) or a price-earnings ratio (P/E ratio) is always a good idea. For the analytical type who’s taken finance courses, Keady says it’s fine to research these figures.
Keady says going out and buying stock in your favorite product or company isn’t the right way to go about investing. Also, don’t put too much into past performance because it’s no guarantee of the future.
2. Be ready for a downturn. Can you handle a loss?
The big question is: can you handle a loss in this stock? As long as you diversify your portfolio, any single stock that you own shouldn’t have too much of an impact on your overall portfolio. If it does, this might not be the right choice.
“Anytime the market changes we have this propensity to try to pull back or to second guess our willingness to be in,” says Tony Madsen, CFP at NewLeaf Financial Guidance LLC.
3. Buying individual stocks not advised for beginners
Everyone has heard someone talk about a big stock win or a great stock pick.
“What they forget about is that often they’re not talking about those particular investments that they also own that did very, very poorly over time,” Keady says. “So I think sometimes people have an unrealistic expectation about the kind of returns that they can make in the stock market. And sometimes confuse luck with skill. You can get lucky sometimes picking an individual stock. It’s hard to be lucky over time and avoid those big downturns also.”
It takes a lot of luck to beat the stock market.
“There’s tons of smart of people doing this for a living, if you’re a novice the likelihood of you outperforming that is not very good,” Madsen says. Keep in mind too that every seller in the stock market, there’s a buyer for those same shares who’s equally sure they will profit.
Mutual funds, which are baskets of stocks that you can buy a slice of, can replace individual stocks in many instances. For the person who’s interested in receiving quarterly dividends, a mutual fund may be a less-risky way of achieving that goal, Keady says.
Unlike stock, mutual funds may have annual fees. But the diversification – of not just owning a single stock but dozens or even hundreds – may be worth it if it’s a low-fee product.
4. Beginners should try a simulator before investing real money
One way to enter the world of investing, without taking a risk, is to start by using a stock simulator. Using one of the many online trading accounts with pretend dollars won’t put your real money at risk. You’ll also be able to determine how you would’ve reacted if this really was your money that you increased or lost.
“That can be really helpful because it can help people overcome the belief that they’re smarter than the market,” Keady says. “That they can always pick the best stocks, always buy and sell in the market at the right time.”
Asking yourself why you’re investing can help determine if investing is for you.
“And if their thought is that they’re going to somehow outperform the market, pick all the best stocks, maybe it’s a good idea to try some type of simulator or watch some stocks and see if you could actually do it,” Keady says. “Then if you’re more serious about investing over time, then I think you’re much better off – almost all of us including myself – to have a diversified portfolio such as provided by mutual funds or exchange traded funds.”
5. How to create a broad portfolio
The easiest way to create a broad portfolio is by buying an Exchange Traded Fund (ETF), target date-fund or a mutual fund. The products have diversity built into them.
“It may not be the most exciting, but it’s a great way to start,” Keady says. “And again, it gets you out of thinking that you’re gonna be so smart, that you’re going to be able to pick the stocks that are going to go up, won’t go down and know when to get in and out of them.”
When it comes to diversification, that doesn’t just mean many different stocks. It also means investments that are spread among different sectors – since stock in similar sectors may move in a similar direction.
6. Stay committed to your long-term portfolio
Patience and not looking at your portfolio too often are great tips for beginners. Keady says investing should be a long-term activity. He also says you should divorce yourself from the daily news cycle.
“Some of the news cycle … at times it becomes 100 percent negative and it can become overwhelming for people,” Keady says.
Try to limit checking your portfolio if you’re in this for the long haul. One strategy is to set up a calendar and predetermine when you’ll be evaluating your portfolio. Sticking to this guideline will prevent you from jumping out of a stock during some volatility – or not getting the full benefit of a well-performing investment, Keady says.
7. There is no perfect time to start
Choosing the perfect opportunity to jump in and invest in the stock market typically doesn’t work well. Nobody knows with 100 percent certainty when’s the best time to get in. And investing is meant to be a long-term activity.
“One of the core points with investing is not just to think about it, but to get started,” Keady says. “And started now. Because if you invest now, and often over time, that compounding is the thing that can really drive your results. So one of the things is, if you want to invest it’s very important to actually get started and have … an ongoing savings program. So that we can reach our goals over time.”
8. Investing for the short-term, may mean you shouldn’t be investing
Understanding whether you’re investing for the long-term future or the short term can also help determine your strategy – and whether you should be investing at all. Sometimes short-term investors can have unrealistic expectations about growing their money.
“When I’m advising clients … anything under a couple of years, even sometimes three years out, I’m hesitant to take too much market risk with those dollars,” Madsen says.
Depending on your goals for this money, a savings account, money market account or a short-term CD may be better options for short-term money.