Last Updated on November 24, 2023 by Bernd Skorupinski
When it comes to making money smartly and fairly, many people suggest investing in the stock market. Investing in the stock market is growing in interest as more people try to make their money work for them. Reportedly, in 2020, there were 10 million new brokerage accounts in the US. However, investing in the stock market is a matter of understanding reward and risk. But if one understands how do stocks and markets work in a disciplined way, it is potentially one of the best ways to make your money work for you.
Fast Facts About How Do Stocks Work:
- Stocks represent equity ownership in a company. For example, common stock shareholders get voting rights and a claim on corporate earnings through dividends and share repurchases.
- On stock market exchanges, institutional and small investors purchase or sell shares of companies through a bid and ask process with their brokerage.
- On the stock market exchanges, share prices get fixed based on supply and demand, i.e., the number of buyers and sellers who place orders.
- Market makers on stock market exchanges help maintain order flow, liquidity, and bid-ask spreads so that the market performs smoothly.
- Companies list on stock market exchanges to raise capital. However, publicly traded companies have more regulations.
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What is a Stock?
A stock is a financial instrument representing ownership in a publicly-traded company. Stocks are also known as shares or equity of a company. A stock represents a fractional share in a company. For example, if you own 100 shares in a company with 1,000,000 total outstanding shares, you have 0.01% ownership interest in the company. Most companies have millions to billions of outstanding shares.
Types of Stocks
There are two types of stocks: common and preferred. Common stock has voting rights. Most shareholders will own common stock. Some companies have more than one class of common stock. For instance, Berkshire Hathaway (BRK.A, BRK.B) has a dual-class structure. The ‘A’ shares are worth 30 times the ‘B’ shares. The ‘B’ shares were issued in 1996 to make ownership more accessible due to the high price of the ‘A’ shares. There are other differences too. For instance, the ‘A’ shares will never conduct a stock split while the ‘B’ shares may.
Some companies have multi-class structures with more than two types of shares. Dual-class and multi-class structures are designed to allow founders to maintain control over the company.
Preferred stocks usually do not have voting rights. However, shareholders of preferred stock have priority over common stock for dividends and in the event of liquidation.
After understanding the concept of a stock, it’s essential to understand how do stocks work to be a part-owner of a company.
Why Do Companies Sell Stock
Generally, companies sell their shares to raise money. They use that capital in various ways, such as funding new products or product lines, investing in growth, paying the debt, expanding their operations, and mergers & acquisitions (M&A).
When a company plans to sell its share and raise money, it undergoes a process known as an initial public offering (IPO). Once a company lists its stock in the market, investors can buy and sell shares on a stock exchange. From the perspective of a retail investor, the process of how stocks are bought and sold is central to understanding how do stocks work.
How Are Shares Bought and Sold
It’s common that when an investor buys a stock, they may not get it directly from the company. Instead, they can purchase shares from another investor who wants to sell their shares. Similarly, when you sell shares, you will sell them to another investor. Investors usually place trades online with their broker, who in turn automatically directs the order to a stock exchange. The broker is obligated to seek the best execution.
In the United States, common exchanges are the New York Stock Exchange (NYSE), NASDAQ, Investors Exchange (IEX), and BATS Global Markets. Some important international stock exchanges are the Shanghai Stock Exchange, Euronext, Japan Exchange Group, Hong Kong Stock Exchange, London Stock Exchange, Bombay Stock Exchange, and the Toronto Stock Exchange. The NYSE and Nasdaq are the largest stock exchanges by market capitalization and trading volume in the world.
Alternatively, a broker may direct the order to a market maker, typically brokerage firms or individuals buying and selling stocks for their own account. This action allows buyers to purchase shares quickly instead of waiting for a seller to sell the exact number of shares. For example, if you want to buy ten shares of Company XYZ and a seller is only selling eight shares, the order cannot be completed, and a buyer may be waiting for a seller to sell ten shares.
However, a market maker may sell ten shares to the buyer to complete the order quickly during market hours. A market maker continuously buys and sells stocks. They effectively maintain liquidity while making a profit on the bid-ask spread. Market makers may also pay brokers for order flow.
Electronic Communications Network
A third option is for a broker to direct the order to an electronic communications network (ECN) that automatically matches buyers and sellers.
Once the trade is executed, the shares are delivered to your account or subtracted from your account.
Types of Orders
The three common types of orders are market orders, limit orders, and stop orders.
A market order is an order to buy or sell a stock immediately. A market order will execute at a price near the current bid or ask price. However, the stock price upon execution may be higher or lower than the price shown for the last trade. A market order has precedence over a limit order.
A limit order is where the buyer or seller specifies a certain price. A buy limit order is executed at or below the limit price. A sell limit order is executed at or above the limit price.
A stop order is also known as a stop-loss order. This type of order is usually used to prevent further losses on a stock with a declining price. Once the stop price is reached, the stop order becomes a market order.
How to Buy Stocks
Buying stocks is easy. All you need is a brokerage account, robo-advisor, or an employee retirement plan, e.g., a 401(k) plan that allows stock purchases. The mechanics of how do stocks and markets work were discussed above. However, there is more to buying stocks than just this information.
Which stocks should you pick? The simplest way is to use a broker or financial advisor to assist in picking stocks. There are a lot of stockbroker professionals that can help identify undervalued and potentially profitable stocks.
However, if you are a do-it-yourself (DIY) investor, many investors use online stockbroking platforms. Investors can buy or sell stocks via the broker’s trading platform. To easily buy or sell stocks, it is required to have an account. Beyond that, you need to further your education. You can be a buy-and-hold investor or a more active investor. One way to learn more about becoming an active investor is to take a course for online trading.
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Pick the Best Stock
It’s easy to say that a beginner should buy the right stocks. But how can a beginner understand which stocks are right for them? The best way of knowing the potential of a stock is through research and more research. If you are just starting to learn about how do stocks work there are many investing books for beginners.
When it comes to researching a stock, most people only check earnings per share (EPS), price-earnings (P/E) ratio, and so on. But today, that’s not enough. In 2022, the market is different than in the past and much more volatile due to the US Fed tapering, potential of rising interest rates, and geopolitical issues. That’s why as a beginner, you must explore many more topics such as the company’s management team, financials, competitive advantages, risks, income statement, balance sheet, and so on.
Along with analyzing all these items, you should refrain from performance temptation and chasing performance. Good short-term performance is not the ultimate indicator for a stock investment.
Try to Avoid Individual Stocks
For successful stock investing, you should never confuse skill with luck. Unrealistic expectations will always lead to bad decisions, and you will fail to check the effectiveness of a strategy. In addition, individual stocks come with risks that beginners cannot overcome with just luck. For instance, owning a few stocks can lead to a volatile portfolio with negligible diversification. In this case, your initial investment principal is at risk in a bear market. Therefore, an investor needs 20 to 30 stocks to help reduce risk in a portfolio and improve diversification.
Sometimes, it’s better to continue with alternatives to individual stocks. A fantastic option is passive index funds. Index funds can be either an exchange-traded fund (ETF) or a mutual fund. In most retirement plans, mutual funds are the primary choice. Index funds offer investors some advantages, including low expense ratios, diversification, and low turnover.
Create a Diversified Portfolio
One of the main benefits of index funds is that they contain a wide range of stocks. Hence, you will get the chance to buy stocks across various industries in one investment vehicle. For example, the iShares Core S&P 500 ETF (IVV) owns all 500 stocks in the S&P 500 Index. Owning this ETF gives an investor exposure to most of the market with more diversification. Investors should consider a lazy portfolio of passive index funds or ETFs if they are uncomfortable with stocks.
According to expert investors or traders, diversification is critical. It effectively helps in reducing the risk of holding one stock that may hurt the portfolio’s overall performance. In this way, you will improve the overall portfolio performance. Here, we must remind you that buying a few stocks means keeping all your eggs in one basket, which can be risky during a bear market.
Get Prepared to Accept a Market Downturn
The world is trying to be normal again after bearing all the economic and financial challenges with the COVID-19 pandemic. The stock market is going to face a lot of uncertainties. These uncertainties can bring a downturn for your investment during corrections and bear markets. A market correction is defined as a decline from peak-to-trough of 10% to 19.99%. A bear market is a drop of 20% or more. Corrections and bear markets occur about once every two years on average.
You can pull back and second guess your investments by selling your shares. However, for investors seeking good long-term returns, you may have to deal with short-term volatility. Often beginners prefer to get guaranteed returns. If you have the same preferences for low-risk investments, you can invest in an FDIC-insured high-yield certificate of deposit (CD). However, saving is not investing and risk is inversely related to reward and low risk often means low returns.
Try Stock Market Simulators
Using a stock market simulator is a safer way to get the taste of stock investing without any risk associated. You can easily use an online trading account and virtual dollars to check your strategy in a paper trading account. In this way, your hard-earned money won’t be at any risk. In addition, it will help you better understand the market, including the uncertainties and volatility, before placing actual trades.
The Bottom Line About How Do Stocks Work
The year 2022 is a critical one. From the start of this year, the world has been trying to return to a more normal footing. Offices, schools, institutions, public venues, etc., are opening. The way we have lived before the pandemic, we try to bring that life back in most forms. But, in such a transition, everything feels unstable and unpredictable.
In such a time, predicting any stock market trend is tough. Therefore, your investment and portfolio maintenance should not be based on trends. Instead, as a beginner, you should sum up the entire situation and possibilities and plan a strategy that works over the long term.
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Bernd Skorupinski teaches the undiluted truth about trading at the best online trading academy and takes you through what it takes to be a consistently successful forex trader. His favorite moment as an expert in the online trading campus who teaches trading is the way people's eyes light up with excitement and confidence when they understand how Supply and Demand trading strategy works and how it can help win in the trading arena. He believes in building core values and discipline that ensure you do not succumb to the pressures and temptations of the market. He very much believes in following plans and strategy through.