How does the stock market work? Learn how here, including and how to find great investments. Investing Basics 101.
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Some estimates of the world stock market value suggest it's worth at least 60 trillion dollars. The world's largest stock market, the New York Stock Exchange, is worth at least $16 trillion.
There's money in stocks.
To many people, the stock market seems complicated, confusing, and even dangerous. It's full of figures and jargon and everyone seems to have a contradictory explanation for why stocks do one thing one day and the opposite thing the next. Sometimes it seems like you have to have an MBA just to start making sense of things!
Good news! You already know more than you think. If you've ever bought or sold anything, you know the basics of how the stock market works.
You're well on your way to learning what you need to know to meet your financial goals. Ready?
A Stock is a Piece of Ownership
Suppose you sell cookies. You need to raise money to buy chocolate chips, so your best friend gives you $50. In return, you will pay your friend half of the profit you make. A stock is a piece of ownership in a company. You've sold half of that ownership, so your friend now owns half of the stock of your company.
The stock market is a little bit more formal than that, but the important point is that a stock is a small portion of ownership in a company. That's it.
People Buy and Sell Businesses in the Stock Market
Suppose your cookie business takes off, and you want to build a factory to handle all of your orders. You need to raise a million dollars for this amazing plot of land in the wilds of Canada. Your friends can't afford this, so you offer to sell stocks to the public at large. You talk to a bank and set things up to offer your stock on an exchange. A stock exchange (or stock market) is a place where the public at large can buy and sell shares of your company.
They won't have a say in the day-to-day operations of your business, but they influence long-term decisions you make and have a right to proportionate shares of your profits.
The stock market is a little bit more than this, and the implications of ownership of the company are a little more complicated than this, but the important point is that a stock market is a place where people buy and sell pieces of ownership in companies. This is also known as stock trading, so to learn how stock trading works, you need to know....
You Need (some sort of) Broker to Buy Stocks
To buy a stock at an exchange you need a broker. A broker handles the hard work of getting buyers and sellers together. A stock market isn't like a grocery store, where shares in Awesome Cookie Company are on the shelf right next to the chocolate chips. It's more like an open-air market full of bartering and bargaining.
Of course, most stock sales these days don't happen with two young men in suits shouting negotiations at each other in a crowded room in downtown New York City. It's all online, so fire up your computer or smart phone and look for any of a dozen good discount stock brokers.
Finding a good broker is important. So is finding a good dentist or a good barber. You want a trustworthy professional who understands your goals and can represent them fairly. To do that, you need to understand what you can do, what you want to do, and what you can handle.
What you really need to do is to learn how to invest in the stock market, and that question is really....
How To Make Money in the Stock Market
Making money in the stock market is like making money in any business: buy something now and sell it for more later. That's it. That's the secret of how to make money in the stock market.
A stock is a little more complicated than that: because you own part of a business, you're entitled to share in the profit of that business, if it makes any. Sometimes profits get paid out as dividends —once, twice, even four times a year.
This gives you two good approaches. One, buy a good business that makes money reliably and pays out dividends. Two, buy a good business that will be worth more in the future. To do that, you have to know....
Stocks Go Up in Value When Business Improves
Because a stock is a share of a company, the value of a share depends on the value of the company. What's important to a company and its future? How much money the company can earn. That's growth. When you buy a stock, you pay for the current value of how it grows in the future.
A stock is different from a bond, which is a loan where a fixed interest rate tells you how much money you'll get every month or year. Stock prices fluctuate over time and day by day, but the stock prices of good companies reflect the value of the businesses.
How do you predict growth? Look at the historical performance of the company. The story it tells you about the possible future should be coherent. Just like you can look at your personal finances and figure out if you're doing well or poorly, you can get a sense of how a company is doing. (In most cases, you can pretty easily tell if the company might be a good value right now or not just by looking at a couple of figures and charts.)
If you're not making most (or even any) of your profits from dividends, you'll have to sell your stock to realize your profits. That's when you need to answer....
When to Sell a Stock
When should you sell? Everything depends on your financial goals. If the price of the stock has gone up and you've made a nice profit, you may want to sell to reap that profit. If the money you invested would be better off in a different company, you might sell and reinvest the money elsewhere. Maybe you own too much of a stock, and need to diversify your portfolio to minimize your risk and optimize your opportunities.
Sometimes you might even want to sell a stock to take a loss.
Your goals will guide you. What makes a good financial goal?
Good Financial Goals are Personal and Specific
Some people want a comfortable nest egg when they retire. Some people want to pay for a new house or an education for their children. Some people want to quit their jobs and become volunteers at non-profit organizations. Some people want to minimize their taxes or take advantage of capital gains tax rates. Some people want a better yield than savings bonds.
If any of these are you, great! If you have other goals, great! What's most important is figuring out:
- Why are you investing?
- How long are you investing?
- How much can you afford to invest every month?
- How much risk can you take on and still sleep soundly at night?
With your financial goals in mind, you're ready to do your research finding one or two or three great stocks. This is the part where people think the magic happens. It's not magic. It's business.
Even though it seems like the stock market is all about luck, remember that every stock ultimately represents a share of a company that sells cookies (or cars or insurance or airplanes or toothpaste). A good company is good at its business.
How do you pick a good stock? You already know good companies to invest in. You have an advantage if you stick to what you know! Find a great company you understand, one that makes money honestly and effectively. Find a company you'd like to own!
If you've found that great company, the question to ask is how much you should pay for it. Just because someone's willing to sell it for $10 per share doesn't make the price right. After all, the best way to make money is to sell for more than you paid for it.
What's the right price?
That depends on many factors! Ultimately the right price for a stock depends on how much money the company can make for each owner and how much you're willing to pay to earn that money. This is the point at which half of the potential investors break out a spreadsheet and fill in lots of complicated formulas. (See the featured daily stock, for example.)
Is this the best place to continue your investing journey?
The best time to buy a stock is when it's at the cheapest price. The second best time is now, at least if it's available at a good price. Waiting for the absolute cheapest price is a recipe for inaction, and buying only the cheapest stocks is a recipe for disaster.
However, the question of how to invest in the stock market with only a little money to start is easy to answer; buy a cheap and good index fund and squirrel money away regularly. For something more complex (and potentially rewarding), you'll have to learn a little more.
All of the articles in our How to Invest guide are written for novices. They don't assume you have an MBA or a brain full of investing jargon. All you need is a couple of hours a year and the willingness to take control of your financial future. You can learn how the stock market works and you can build real wealth in stocks over the long term.