Have you ever wondered how some people build wealth over time while others struggle to keep up with inflation? What if you could make your money work for you instead of just saving it?
The answer to both questions is stock market investing.
For many, the stock market seems complex and intimidating – we have the professionals to blame for that. But under the hood, it’s not that bad.
So, what are the basics of stock market investing, how does it work, and what are the risks and potential rewards?
What Is Investing? What Are Stocks?
Investing involves putting money into assets and expecting a return over time.
Imagine your favourite company. When you buy its shares, you become a part-owner. As the company makes more and more money, its stock price could rise, thereby increasing the value of your investment. If the stock price tumbles due to poor company performance, your investment will tumble, too.
This is the essence of investing – putting your money into assets that rise in value over time and avoiding the ones that don’t.
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. Similarly, if the company underperforms and makes a loss, you have to share in that, too. It goes both ways.
Why People Invest
People invest with various aims, some more understandable than others. So, here are a few reasons people take the leap and put their money to work for them.
Wealth Accumulation
Historically, the stock market has delivered higher long-term returns than other asset classes. Concentrating on compounding machines (companies that consistently generate above-average market returns) and being patient is the investing success recipe…
Time and compounding are all it takes to accumulate wealth.
Beating Inflation
Inflation – the annual increase in prices for goods and services – erodes the purchasing power of your money. Because of this increase, £10 in your pocket isn’t ‘truly worth’ £10 – £10 today won’t get you the same quantity of groceries as it would’ve last year.
This is why investors invest. Stock market returns have historically outpaced inflation, thereby preserving purchasing power. If you earn 8% on an investment while inflation is 2%, your money’s purchasing power has grown by 6%.
Purchasing power = preserved.
Additional Income
Many companies pay dividends (cash distributions to shareholders), offering investors another form of investment income. These regular receipts can be used in whatever way the investor chooses: to be reinvested, withdrawn to spend or fund a vacation.
Ownership In Companies
Investing in stocks means you own a piece of a company’s success – if you own 10% of a company, you’re entitled to 10% of its assets and profits. On the other hand, some people invest in companies, believe it or not, to brag.
Don’t let this be you – you lose money faster than you make it in the stock market.
Stock Market vs Stock Exchange: What’s The Difference?
The stock market is an umbrella term that covers all the companies that trade within a particular region. Think of it as a giant auction where paintings and collectors’ items from one part of the world are bought and sold. In the stock market, shares of companies are the paintings and collectors’ items.
Some examples of stock markets include:
- US stock market: home to all the companies in the US
- UK stock market: home to all the companies in the UK
Stock exchanges are venues where stocks and other investment securities are traded. They provide the infrastructure that facilitates the buying and selling of asset securities and ensures fair pricing (you can see exactly what a company is being bought and sold for).
Some examples of stock exchanges include:
- New York Stock Exchange (NYSE): the largest in the world
- London Stock Exchange (LSE): one of the oldest in the world
How The Stock Market Works
The stock market works according to a simple law: supply and demand. Stock prices change as supply (the volume of shares being sold) and demand (the volume of shares being bought) change.
Stock prices rise when there are more buyers than sellers (more demand than supply). The scarcity of available shares for purchase forces prices higher as sellers require a higher price to justify selling their ‘prized possessions’.
On the contrary, stock prices fall when supply exceeds demand. Because buyers have a choice now, they can wait for a stock to get cheap enough to warrant a buy.
On another note, when you buy shares in a company, in most cases, 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.
Another Type of Investment Security
We all know that stocks are traded on stock exchanges – it’s in the name. But if you’re unfamiliar with the stock market, you may not know about this second security available for purchase.
Exchange-Traded Funds
Exchange-traded funds (ETFs) are passively managed funds (pools of stocks) that trade on stock exchanges, hence their name. They typically track indices like the S&P 500 and FTSE 100 and sectors like information technology.
The weightings of companies in an ETF are set based on their weighting in the index that the ETF tracks. So, if Amazon accounts for 10% of the S&P 500 index, it will account for 10% of an S&P 500 ETF.
ETFs are reviewed and adjusted regularly to reflect all changes in the index or sector they track.
The Risks And The Rewards
There are pros and cons, benefits and tradeoffs, risks and rewards with all things, and investing is no different. This is not an exhaustive list of all the risks and rewards of investing, but a summary.
The Risks
Risk of Loss
The most obvious and often experienced risk. This can arise from selling an investment during a market downturn or company-specific issues. Making investment decisions based on emotions, not facts, is also a contributing factor.
Market Volatility
Stock prices fluctuate daily, which may result in sudden gains or losses. Volatility to the downside can have you second-guessing yourself, potentially leading to decisions you wouldn’t otherwise make.
The Potential Rewards
Capital Appreciation
- Unrealised – profit on paper because shares haven’t been sold.
- Realised – the actual profit after shares have been sold.
Compounding Growth
Over time, stocks generally increase in value, allowing investors to sell at a profit. These investment gains can be:
Reinvesting dividends can lead to exponential wealth growth over time, as compounding generates interest on the principal (your original investment) and your reinvested dividends.
Rounding It All Up!
Stock market investing can be a powerful wealth-building tool if approached with knowledge and discipline. Understanding the basics, the risks, and the potential rewards will help you manoeuvre the investing landscape confidently.
The key is continuous learning – investing is a journey, not a race. Taking the time to build a solid foundation will pay off in the long run.
