Many new investors have the same question in the beginning: how do stocks work and how to invest in them? This is the question most are asking, especially considering the recent surge in GameStop’s stock price.
Because of this, many of the younger generations have gotten a glimpse into the opportunities and the risks of investing in the stock market. The power of the stock market to make your money work for you cannot be understated. Although, it is extremely important to learn the in’s and outs of stocks at a basic level before investing.
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The best time to start investing was yesterday, the second-best time is today.
The Importance of Learning How Stocks Work and How to Invest in Them
Until apps like Robinhood came into public eye and accessibility, the stock market seemed like an unattainable and unneeded means of making money. Although, now younger generations are using these commission free stock trading apps to dip their toes into the stock market world. Since there is zero commission on these stock trades, it opens the doors to an entire market of potential investors.
It is important to learn how the stock market works before investing your hard-earned money into it. Since success stories in the stock market are written about more than the failures, it is also important to know that investing poorly can cause you to lose a lot of money. For instance, selling your shares at the first sign of a small share price drop is not a good practice (depending on the stock). Learn the in’s and out’s of the stock market and how stocks work below.
How Do Stocks Work
To understand how stocks work, we must understand the companies behind the stocks. When a company “goes public” it means that they are now a publicly traded company. When they go public, they will have an initial public offering which is the process of offering shares of a private corporation to the public. So why do companies go public? Going public helps companies raise capital that they can use to invest in future operations and grow the company.
When people buy stock, they are giving the company money in exchange for a share in the company’s profits or losses. This is often called common stock. To summarize, purchasing shares of a company gives the buyer a very small amount of ownership equity in the company.
1. How Does the Stock Market Work?
The stock market today works entirely different than it did 20 years ago. I am sure you have seen the movies where frantic businessmen are running around the stock market floor on Wall Street yelling and waving papers. Well, those times are almost all but gone. Of course, there is still Wall Street, and of course people still work there. Although, it has changed drastically. With the progression and adoption of technology, most of these trades are performed online.
So how does the Stock Market work today? The majority of stock transactions are all done digitally. Services like Fidelity and Robinhood are examples of this. When thinking about how the stock market works, think of it as a network of exchanges. When companies list shares on an exchange, investors then purchase those shares, buying and selling them among one another. This constant buying and selling is one of many driving forces affecting the price of the stock.
2. How Do You Make Money from Stocks?
Now let’s discuss how you make money from stocks. This is the reason to get into the stock market after-all isn’t it! Luckily, this area is not too complex and is more of an “oh that’s obvious”. There are two ways that you can make money from stocks. One is through the appreciation in value, and the other is through dividends.
Make Money with Stocks
When you purchase a stock, you buy it at a certain price. Overtime, that share price will go up in value or it will go down. For this case, let’s say it goes up. The stock price appreciates in value since you purchased it, thus it is worth more than when you first bought it. Because of this, you can sell the stocks you purchased at the new higher share price for a net profit. For example, let’s say you bought 5 shares of a stock at $60 a share. If you are using Robinhood then there is 0% commission. Over time, the share price rises to $72 a share and you decide you want to sell all 5 shares. If you sold all 5 at the new share price of $72, then you would make $60 in profit, a 20% ROI (Return on Investment). If you would like to perform your own calculation, you can use this stock calculator.
Make Money with Dividends
Making money from dividends is different. A dividend is when a company that owns the stock issues a payout to their shareholders. You actually do not need to sell your stocks in order to make money. So you must be thinking, well that’s a win win isn’t it? Unfortunately, unless you have a very considerable amount of money/shares in that company, then the dividend payout will be rather small. These payouts are also infrequent.
Companies usually issue dividends quarterly, every three months. Banking on dividends as a means of income is not recommended as companies can halt dividend payouts at any time. Although, if you have a considerable number of shares in a company like Target with a dividend yield of 1.6% then you may be in a position to score some extra income.
3. Deciding Which Stocks to Buy
Everyone including myself wants to know what the best stocks to buy now are. Unfortunately, no one has a crystal ball. If we did then millions of people would have bought Amazon stock as soon as they went public. This is the reason why the stock market has risk, mitigating that risk and assessing your risk tolerance is essential when determining which stocks to buy. There are two methods of investing that have opportunity. Investing in individual stocks like Tesla, Apple, etc. Or investing in Index Funds. Of course, you can do both or just stick to one.
Investing in individual stocks takes more research then investing in index funds. I say this because there is much higher risk to it. When investing in a company, you need to research the company’s financials, stock price trends, as well as the business sector they are in.
If a company is in the videotape and CD production industry, then you definitely do not want to invest in them as they are in a dying industry. That is an extreme example, but the point is there. On the flip side of this, if a company is leading the charge with Electric Vehicles or sustainable projects with a high growth trend, then that may be a company you look into.
Index funds are a type of mutual fund that typically track a market index. They contain a wide variety of stocks from various companies in that particular market index. Index funds give the investor a wide variety of stocks, increased diversification, and much lower risk.
For example, an index fund that matches the S&P 500 has been well regarded as one of the best investments for long term growth. The fund simply follows the path of the market meaning you will get the markets return. The S&P 500 index has an average yearly return of 10%. This is by no means a get rich quick game plan, but it is a less riskier and more sustainable method of growing your money through compound interest in the long run.
4. How to Invest in Stocks
The barrier to entry for investing has never been lower. In fact, it is extremely easy to start investing. With apps like Robinhood and Acorn, there has never been an easier time. There are also free services like Fidelity which has much more information regarding investing than I have seen on Robinhood.
Furthermore, Fidelity has a strong reputation for a extensive and diverse amount of index funds for investors to choose from. Investing with Fidelity means that there are fund managers ensuring that the index fund is growing properly and that there are no issues.
5. Short-Term vs. Long-Term View: Managing Expectations
Managing expectations and impulse is essential to ensuring investment success. Part of the downfalls of Robinhood is that it is easily accessible. Confusingly enough, this is also a plus side to the service. I say it is a downside because people are checking on their stocks very often.
This means that there is a much higher chance that investors will sell at the first sight of a downward trend line (decrease in price). Learning how and why markets fluctuate allows investors to realize that these occasional downward trends is just part of the market. You do not actually lose or make any money until you sell your stocks. Unless the company goes under.
Another expectation to manage is get rich quick schemes. Many on social media praise day trading as a means of making a ton of money fast. This is not the case. Stocks and especially index funds should be thought of in the long term. If you would not want this stock in 10 years, why have it now? Ensuring a long-term growth of your portfolio allows compound interest to take control. That is interest on your interest, thus having your money for you. See how compound interest and investing are crucial to your financial success.
Check out the below articles if you would like to learn more about investing and the stock market. More to come soon.
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