The stock market seems incredibly complicated and risky for beginners who don’t understand its fundamentals. Getting over this initial hump is the first step to building wealth through the stock market. This post will cover the stock market for beginners so that you can begin your journey toward financial independence.
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What is the Stock Market?
The stock market is a platform for investors to buy and sell portions of public companies. Each of these companies has its own stock, divided into shares.
A stock is a representation of a company on the stock market. Each stock has a short ticker that represents it. For example, Microsoft is represented by the ticker MSFT on the stock market.
The performance of a stock is generally directly related to the performance of its underlying company. If Microsoft has a good quarter and increases revenues, its stock will likely jump in price. This is not a hard and fast rule, as thousands of external factors affect a stock’s performance.
A company’s stock is divided into shares. These shares are what investors purchase. If a company is split into one million shares, then purchasing one share gives you .0001% ownership of the company.
This ownership is important. You aren’t simply playing a game pretending to own a company. You are purchasing a portion of a public company and becoming a part owner.
The price of an individual share fluctuates as they are bought and sold. When you add up the value of a stock’s shares and multiply it by its current share price, you have a company’s market capitalization.
A stock’s market capitalization is loosely related to its total value or the price you would need to pay to purchase the entire company outright. More concretely, this market capitalization is the size of a stock on the stock market. Sticking with Microsoft, its market capitalization is $1.84 trillion.
You can even purchase partial shares of stock. This allows anyone to invest with as little as $1, regardless of the price of a whole share.
Anyone who purchases share(s) is an investor. When you buy a portion of a company, you invest in them. You are providing funds to help them grow in exchange for some of that growth being kicked back to you in the form of returns or dividends.
Investors can be individual investors (retail investors) like you or me or a larger fund. Retail investors make up around 52% of the stock market. The rest is made up of large entities.
This demonstrates that much influence on the market isn’t even by individuals. Large funds have a huge say in stock performance.
Funds usually pool many peoples’ assets and combine them to use as they see fit. They promise they will use their clients’ funds to make them more money than they would have.
However, note that only 10-20% of professional investors succeed in beating the market.
Some stocks decide to pay a dividend to their investors. This is in the form of a regular (usually monthly or quarterly) payout for every share of stock an investor owns. If you own 100 shares of a company, you will receive 100 dividend payouts.
Not every company pays a dividend. A company may instead decide to use the money used for dividend payouts to reinvest in the company.
Companies that decide not to pay dividends and instead completely reinvest are growth stocks. The debate between dividend and growth stocks is a popular one. To learn about this debate and which kind of stock you should go with, read this post on dividend vs. growth stocks.
Companies that pay dividends are using it as an incentive for investors. Investors like it when they have guaranteed returns, which dividends are. A good company will only increase its dividend over time so that you will receive greater guaranteed returns.
Dividends are a fantastic supplement to growth. You can generate returns through dividend payouts even if a stock isn’t growing quickly. Even a 2% dividend yield can cover inflation for the year so that your growth returns aren’t knocked down.
The most powerful aspect of dividends is dividend reinvestment. Dividend reinvestment programs, or DRIP, are available at most brokerages. DRIP will reinvest your dividends into the company that paid them to you.
This removes the temptation to withdraw dividends and automatically increases your number of company shares over time. Even if you don’t deposit another dollar to invest, you will purchase more of the company over time through its dividends.
Stock Market Behavior
What Makes the Stock Market Fluctuate?
The stock market fluctuates due to thousands of factors. These include investors’ outlook, America’s prosperity, global prosperity, inflation, unemployment, companies’ performance, and many others. These factors can never be predicted – at best, educated guesses can be made.
At its core, fluctuations are caused by stocks’ buying and selling, or trading. If a stock is widely sold off due to fear, its share price will drop. Conversely, if a stock is widely bought due to hope, its share price will increase. This buying and selling could be caused by anything that affects an investor’s trust and outlook of a stock or the market.
You constantly hear people talking about the stock market. It’s up one day and down the next. The outlook is excellent one day, and we may be in a recession the next. This is because there are so many factors to keep track of and predict, and so much of the market reacts to news as they get it.
Many factors that affect the market are external and unrelated to a given stock. This could include fear of global conflict or rising unemployment. Since these factors are not associated with a specific stock and affect the market, treat these as out of your control.
What you should base your decisions on is a stock’s individual situation. If a given stock is laying off workers when the rest of the market isn’t or plummeting in price after a CEO change when others are performing well, this may indicate an internal problem. This is when you should consider selling out of that specific stock.
What is the Goal of the Stock Market?
The goal of the stock market is to earn money for investors and the companies they invest in. This is primarily done through the fluctuation of share prices over time. In general, money is made when share prices increase.
The Goal for Stock Market Investors
Investors make money through the market by selling their investments for more than they paid. If you buy a share of a stock for $100 and sell it for $150 a year later, you profit $50, not factoring in inflation.
If you instead held on to that $150 share, you would have $50 in unrealized gains. This is because the value of your investment may have increased by $50, but you have yet to sell your investment to profit $50 in cash. These unrealized gains are not a guarantee of your return, as the share price could fluctuate.
The stock market should be thought of as a mechanism for long-term investing. The stock market works best when given 10 or 20 years to average out short-term fluctuations such as recessions. Unless you are an experienced trader, don’t plan on investing for less than one year.
The Goal for Stock Market Companies
For companies, money is made through the increase in market capitalization as share price increases. A higher market capitalization can help a company in a few ways. It can obtain bigger loans proportional to its market capitalization, gain increased brand recognition since investors notice companies with larger market capitalization, and enter funds that raise its investor exposure.
Market capitalization’s effect on a company is less direct than it is for an investor. However, it can be far more powerful. A 5% gain for an investor could mean billions of dollars in additional revenue for the company due to the above factors.
Average Stock Market Returns
The S&P 500 comprises the 500 largest companies on the stock market, weighted by market capitalization. The S&P 500 index best tracks the overall market. This index has returned an average of 10% over the past 100 years, not including inflation.
Past returns are never a guarantee of future returns. However, with 100 years of historical data, we can feel confident that the future will be very close.
Remember, these past 100 years have seen the Great Depression, World Wars, 9/11, natural disasters, the 2008 market crash, COVID, and many other tragedies. Yet even through all that, the market has generated 10% gains on average.
Because of this, we can be confident in the market’s ability to withstand anything the future throws at it.
Stock Market Compounding
The primary method of long-term wealth-building on the stock market is compounding. Compounding allows for a small investment, such as $200/month, to turn into $100,000s. Without compounding, a 5% or 10% gain would be minimal.
Compounding is the process of generating gains from previous gains. For example, if you earn 10% off a $10,000 investment, you profit $1,000 and now have $11,000. Now, if you make another 10%, you profit $1,100. Your profit increased because you generated a 10% gain off your first $1,000 return.
Now imagine this happening year after year for decades. See below the wealth you can generate from $200/month for 20 years based on 10% average gains.
See how the red line, your portfolio, begins outpacing your contributions faster over time. This is compounding in action.
Your gains are generating gains from previous gains over and over. Eventually, the portfolio generates far more than you are even putting in. After 20 years, the portfolio has generated an additional $90,000 on top of your deposits.
How Do You Trade Stocks on the Stock Market?
Stock market trading must be done through a middleman called a brokerage. A brokerage allows you to deposit funds into your account and use those funds to trade shares of stocks. These brokerages are available online and sometimes have physical locations.
Different brokerages offer different features and stock data. Much of the decision comes down to personal preference and what you prioritize when investing. Check out this post on the five best online brokerages to determine which one is right for you.
Once you have picked a brokerage, it’s just a matter of signing up and depositing funds to trade with. Don’t deposit any funds you want to access for at least a few years. You can pull money out of the market quickly, but it is terrible to interrupt compounding unnecessarily.
Finally, you need to pick stocks to invest in. As a beginner, investing in the S&P 500 is an easy method that will still beat many professional investors. Think of it as just tracking the overall market.
For more in-depth steps to start investing, check out my post on just that.
Different Kinds of Investing Accounts
In general, investing accounts are split into tax-advantaged and standard taxable accounts. The most common form of tax-advantaged accounts is retirement accounts. In comparison, taxable accounts are usually individual investment accounts.
Tax-advantaged accounts are powerful for the obvious reason – tax advantages. This is through tax-free growth for your investments. As you earn that 10% from the market annually, you pay no taxes on those gains. This is massive for compounding, which can take advantage of the higher returns that aren’t hampered by taxes.
Different tax-advantaged accounts have their perks. For example, a 401K allows you to invest with pre-tax funds. While a Roth IRA uses taxed funds so that your funds grow tax-free and never get touched again.
The downside of tax-advantaged accounts is restricted investing. If it is a 401K, you are bound to the funds available to you through your broker. If it is a Roth IRA, you aren’t able to invest in certain high-risk stocks. The restrictions aren’t a deal breaker, but they are something to keep in mind.
The primary tax-advantaged accounts to keep in mind are Traditional 401K, Roth 401K, Traditional IRA, and Roth IRA. Traditional accounts defer taxes, while Roth accounts tax upfront.
Alternatively, taxable accounts are highly flexible. You can invest in any stock or index you want. However, any gains you make are taxed as capital gains.
A note on capital gains tax is that it is much lower once you have held an investment for longer than a year. When investing in a taxable account, hold your investments for at least a year to avoid missing out on gains.
What to Be Careful of in the Stock Market
The stock market is not as complicated as most people think, but it’s also not without its dangers. Keep these pitfalls in mind to be a more successful investor.
Invest With a Long-Term Mindset
The stock market is a long-term game. Investing with a long-term mindset allows you to take advantage of compounding, avoid short-term fluctuations, generate the average return, and maximize dividends.
I spoke on compounding above. It can generate unreal amounts of wealth. But it can only be taken advantage of over long periods. Stopping compounding earlier than necessary is one of the cardinal sins of investing. It’s like stopping a snowball partway down a hill to try and start a new one at the top. You lose the advantage you’ve built by holding for a long time.
A long-term mindset also allows you to ignore short-term fluctuations in the market. The market moves up and down daily and can’t be predicted even as far as a year out. Invest with a mindset of holding for at least a few years and ignore the fluctuations that scare many investors away. You will be laughing when you generate gains when others are fearful.
Every investor wants that promised 10% annual return. However, you can only get that by continuing to invest long-term. You could see a negative return in an individual year, but it will average 10% over the next five years. Stick with it to generate the return you were expecting.
Finally, a long-term mindset is necessary for stock market dividends. To receive a dividend payout, you must be invested in that company weeks before the payout. This makes it unrealistic to dip in and out of a stock and still receive dividends. It would be best if you consistently invested for years to take advantage of dividends.
Having a positive money mindset is extremely important. To learn more about having the right mindset and how to develop it, read this post.
Stick With Reputable Companies
Investing in some small startup with the goal of 10,000% profits can be very tempting. Who wouldn’t want massive returns from a cheap stock? But this is a strategy that creates more broke investors than wealthy ones.
The reason for this is that these companies are untested. They have yet to prove that they can withstand the ups and downs that every business encounters. There is no assurance that the company won’t go bankrupt at the first speed bump.
In contrast, large blue-chip companies with massive market capitalization and long track records seem dull. But remember, only afew investors can beat the market. This includes investors who focus on small startup companies. If a professional can’t do it, it’s not worth the risk.
Large reputable companies will give you stable returns for a long time. Plus, it is more apparent when they may be taking a downturn since they are so publicized.
Dollar-cost averaging is a very popular method for generating returns that follow the market. In short, dollar-cost averaging is purchasing the same amount of the stock or index on a set interval. For example, buying $100 of Apple (ticker AAPL) monthly.
With this method, you follow the trend of the stock or index since you are consistently investing in it. If you invest a large sum of money at once, you risk getting hit hard if it falls soon after.
Dollar-cost averaging is the time-tested method to generate consistent market returns. Everyone thinks they can time the market, and 99% of them are wrong. Timing the market seldom works out how an investor expects, resulting in lost money.
If you want to invest for a long time and patiently build wealth, dollar-cost averaging is the way.
Start With Indexes
Picking individual stocks is tempting as you increase your earning ceiling to infinity. However, it’s not the way to go, especially for a beginner. Instead, investing in an index that tracks the market is much more reliable and hands-off.
The index that historically best tracks the market is the S&P 500. Comprising the top 500 companies on the stock market, weighted by market capitalization. Investing in the S&P 500 will allow you to earn your returns with minimal effort.
For steps detailing how to invest in the S&P 500, check out my post here.
I hope this overview of the stock market for beginners has aided your understanding of the stock market and helped you on your journey to building wealth. The better you understand the information provided here, the better you will perform. Investments become less risky the more you understand them.
Let me know if you have any additional questions about the market or concepts you need further explanation for. The comments below are always open so others can learn, too.
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