Getting to grips with financial markets and the associated terminologies can be a task – it’s almost like learning a new language. However, learning the basics of the stock market and investing is essential for understanding the world of finance and provides a starting point for your investing journey.
So, here are some basics you should know about the stock market and investing, and be sure to take our free quiz at the end!
Investing vs Trading
Starting with two terms, often considered the same or synonymous, but are opposites in meaning and practice.
Investing is the buying of asset securities that increase in value with time. These securities can make regular income payments (dividends) but don’t have to. When you invest, the aim is to build wealth by holding investments for the long term (years, if not decades). That way, you benefit from compounding interest, dividends, share repurchases, and asset appreciation.
Trading, on the other hand, involves more frequent buying and selling. It includes analysing charts and buying and selling securities based on patterns to make quick profits. Traders can make multiple trades per day, week, or month, aiming to outperform investors with their ‘buy-and-hold’ strategy.
Investing and trading are two distinct ways of participating in the stock market, each with its associated risks. A risk both investors and traders face is the loss of money or, as professionals say, loss of capital. One poor purchase and you can lose a significant amount of money.
At HuliaAngélique, we lean more towards investing.
What Are Stocks?
Stocks, also known as equity, are asset securities that represent the ownership of a fraction of a company. Stocks entitle the owner to a proportion of the company’s assets and profits based on how much stock they own.
If you buy 100 shares in a company with 1,000 shares outstanding, you are entitled to 10% of its assets and profit.
What Is The Stock Market?
‘Stock market’ and ‘stock exchange’ are often used interchangeably but are slightly different.
‘Stock market’ is an umbrella term representing all the stocks that trade in a particular region or country.
Stock exchanges are the venues where buyers and sellers exchange shares of companies. The earliest stock exchanges issued paper-based share certificates, but nowadays, all investing transactions are completed online.
The largest stock exchange in the world is the New York Stock Exchange (NYSE), with an equity market cap of just over $28 trillion (at the time of writing). Market cap, short for market capitalisation, measures a company’s size – the total value of its outstanding shares. Therefore, the equity market cap of a stock exchange is the sum of the market caps of all the companies traded on it.
So, how are the performances of stock markets measured?
Enter indices (plural for index).
Indices pool the stocks listed on stock exchanges in a standardised way to measure the market’s performance. The most known index is the Standard & Poor’s 500 Index, S&P 500 for short, which tracks the 500 largest companies in the US and is used as a proxy for how the US market is doing. Another well-known index is the FTSE (Footsie) 100, which tracks the 100 largest companies in the UK.
Indices are often used as benchmarks against which investors and portfolio managers compare their investing performance. If an index outperforms an investor’s portfolio, investing in the index rather than curating a portfolio of individual stocks would have been better.
How Does The Stock Market Work?
When it comes to stock markets, it’s helpful to think of them as auctions, with the stock exchange being the auction house. Buyers offer a bid at the price they’re willing to pay for a stock, and sellers make offers at the price they’d like to sell for. When a bid and offer price match, a transaction takes place.
On another note, when you buy shares in a company, you don’t buy them directly from the company – you purchase them from an existing shareholder. Similarly, when you sell shares, they go to another investor.
Finally, a company’s stock price fluctuates as market participants (investors and traders) buy and sell – share prices rise with buying activity and fall with selling activity.
Types Of Investments On Stock Exchanges
Stocks may be the most commonly traded security on stock exchanges, but not all securities traded on stock exchanges are stocks. Other investment securities include funds.
What Are Funds?
Funds are pools of money set aside for specific purposes. In investing, funds are broadly separated into two categories: Mutual and Exchange-Traded.
What Are Mutual Funds?
Mutual funds are not traded on stock exchanges, but for informational purposes and comparison, mutual funds are actively managed funds that give individual investors access to professionally managed investment portfolios. They have fund managers who allocate capital to produce capital gains and dividend income for investors.
Mutual funds are products of investment companies like Vanguard, BlackRock, and Fidelity. You would have to buy the funds directly from them.
What Are Exchange-Traded Funds?
The second type of fund is Exchange-Traded Funds (ETFs). ETFs are passively managed funds traded on stock exchanges, hence their name. They typically track indices like the S&P 500 and FTSE 100 and sectors like the information technology sector. The weightings of the stocks in an ETF are set based on their weighting in the index they track. Therefore, ETFs are reviewed and adjusted regularly to reflect any changes in the index or sector.
Exchange-traded funds tend to be more cost-effective than mutual funds because they don’t have a manager actively trying to produce shareholder value.
Investing Strategies – How Investors Make Money In Stocks
The great thing about investing in the stock market is that there isn’t one set-in-stone way to make money. When done right, any investment strategy can make you wealthy.
What Is Value Investing?
Investors like Warren Buffett, Peter Lynch and the late Charlie Munger prefer the value investing approach.
Value investing refers to buying shares of great businesses when they trade at a discount to intrinsic value (below what they should be selling for) and holding on to these shares for the long term. Because of their long-term orientation, value investors benefit from compounding interest, dividends, share repurchases, and overall asset appreciation.
Besides patience, what puts off most people from becoming value investors is the work required:
- Understanding the company’s finances (financial statement analysis)
- Assessing the management team
- Creating financial models to reasonably estimate what a company’s stock should be worth in the future and what price to pay for it today
Most, if not all, of the great investors are value investors.
Value investors do not follow the crowd and believe the market overreacts to good and bad news, resulting in stock price fluctuations that don’t correspond with a company’s underlying fundamentals. When prices fall because of market overreaction, value investors see it as an opportunity to buy. When stock prices are bid higher than a company’s financials and growth outlook warrants, value investors look to sell.
What Is Dividend Investing?
Other investors like dividend investing.
Dividends are cash payouts of a portion of a company’s profit to shareholders. Therefore, dividend investing is buying shares of companies that make regular cash payouts. It requires a similar, if not the same, amount of work and research as value investing.
Dividend stocks have the potential to outperform the broader market because they offer two sources of income: dividend income and income through capital gains (asset appreciation). Dividend stocks are usually less volatile and appeal to investors who want regular income from their investments without taking unnecessary risks.
The dividend income you receive is based on how many shares you own and how much the company pays out per share.
If you own one share of XYZ Inc., which pays £0.50 per share, you’ll receive £0.50 in dividend income. If you own 100 shares, you’ll receive £50. You can do whatever you wish with the dividends received: reinvest in the same company, invest in another company, add them to your savings, or withdraw and spend them.
Dividend payments can fluctuate due to changes in market conditions, but some companies have increased their dividends annually for over 25 years. These companies are called Dividend Aristocrats. Companies that have consecutively increased their dividend for over 50 years are called Dividend Kings.
What Is Dollar-Cost Averaging?
Dollar-cost averaging is an investing strategy where you invest the same amount of money into an asset, usually a low-cost exchange-traded fund (ETF), over regular periods.
By buying regularly, regardless of the fund’s price, you get more shares at lower prices and fewer at higher prices. When the share price falls, and you buy as it falls, your cost basis (average cost per share) also falls. The lower your cost basis, the higher your return.
Let’s say you bought an ETF at £10. It falls to £5 and rebounds to £10 again. If you purchased shares as they fell and reduced your cost basis to £7, you would make a 43% return on your investment. If you waited for the share price to return to £10 without accumulating cheaper shares, you would’ve made no money – you’re back to where you started.
Dollar-cost averaging into ETFs diversifies your portfolio without buying a whole host of individual stocks. Funds allow you to own small pieces of the many companies, protecting your portfolio against downside risks. If one company in the fund isn’t performing well, it won’t affect your investment returns as significantly as a poor-performing individual stock in a portfolio.
On the other hand, investing in funds limits your returns to the index’s returns. If an ETF tracks the information technology sector that returns 5% annually, the ETF is limited to a 5% annual return. Additionally, the allocation of stocks in an ETF is based on their weighting in the index. As of 24 June 2024, seven companies account for about 31% of the S&P 500’s valuation. If those seven companies have a poor couple of months, it would have a noticeable impact on the index and, consequently, the ETF.
Value and dividend investors also use dollar-cost averaging when buying individual stocks. When shares of a company they want to own fall to a price they’re willing to buy at, they begin accumulating shares. If the price continues to fall, but the business fundamentals remain the same, they buy on the way down, reducing their cost basis.
“If you like a stock at $14 and it goes to $6, that’s great! If you understand the company, you look at the balance sheet, and they’re doing fine, and you’re hoping to get to $22 with it, $14 to $22 is terrific, $6 to $22 is exceptional.”
Peter Lynch
Summary
Investing involves buying asset securities with a long-term mindset, aiming to build wealth over years, if not decades, while trading involves more frequent buying and selling to make quick profits.
Stocks represent the ownership of a fraction of a company, entitling the owner to a proportion of the company’s assets and profits based on how much stock they own, and stock exchanges are the venues where buyers and sellers exchange shares of companies.
Value investing refers to buying and holding shares of great businesses when they trade at a discount to intrinsic value (below what they should be selling for). Dividend investing is buying shares of companies that make regular cash payouts, and dollar-cost averaging involves investing the same amount of money into an asset, usually a low-cost exchange-traded fund (ETF), over regular periods.
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