Investing may seem like a hassle at first, but understanding the basics of the stock market for dummies can help you get around it. Understanding some concepts will help you grasp the whole of the stock market easily, like the workings of the stock market, the difference between long-term investing and stock trading, and why it is important that you diversify your portfolio.
This guide to stock markets for dummies aims to explain all the basic stock market concepts and give you a solid investing foundation to build upon. The first thing you need is a licensed brokerage that will make trades on your behalf.
Not understanding the stock market basics can make all the stock trading seem gibberish. “Earning moves” and “intraday highs” are jargon with not much importance to an average investor. If you aim to go along with your investments, then there is no need to know them or worry about the red or green flashes on the TV screen.
But if you want to learn to trade stocks, you will have to learn about the stock market and also the basics of how it works.
The Stock market
The stock market is a mixture of a swap meet, auction houses, and shopping malls.
The stock market in terms of a flea market:
It comprises individual and institutional investors such as hedge funds, pension plans, and investment banks, buying and selling items like the public companies listed on stock exchanges. The prominent stock exchanges are New York Stock Exchange (NYSE), Nasdaq Exchange, and OTC Markets. Every exchange has different listing requirements for companies looking to use their services to raise capital from investors.
The stock market, in terms of an auction house.
The auction-like pricing system of the stock market makes it appear like an auction house. There is no set price for each item; the prices frequently change with buyers and sellers trying to reach a market price for a company’s stock. In addition, various factors impact stock prices; it can be internal, like the company’s earnings and growth prospects, and external, like upcoming elections.
The stock market in terms of a shopping mall:
The stock market is a one-stop-shop. It is a place for all publicly listed companies, where all the investors buy and sell any publicly traded stock they wish to. Stock market exchanges act as primary and secondary markets for a company’s stock. In addition, they enable companies to sell shares directly through the initial public offerings (IPO) to raise funds and expand businesses.
Companies can carry out numerous secondary offerings of their stock when looking to raise additional funding if investors are willing to buy. In the meantime, exchanges provide investors liquidity since they can sell shares among themselves.
The stock market concepts
The stock market moves higher over time but not in a straight line, and so there are various terms coined to describe the big swings in stock markets:
Bull markets
When the market index gains more than 20% from a recent bear market, it is a bull market. These markets are often multi-year events driven by economic expansion.
Bear markets
A bear market is when there is a drop of more than 20%.
Corrections
A stock market correction is when there is a 10% to 20% decline in a major market index like the S&P 500.
Crashes
A sharp drop in the major market indexes over a short period is a stock market crash.
Volatility
Stock market prices fluctuating sharply is stock market volatility. Usually, the stock prices grow gradually as companies expand operations and earnings with economic growth, making the underlying businesses more valuable. The average stock market return has increased more than 10% each year as measured by the S&P 500 Index (a collection of the 500 largest US-listed publicly traded stocks. But it is not less down periods.
The 1929 stock market crash was the worst market crash on record at the onset of the Great Depression. Economic recession can lead to stock market sell-offs, although that is not the sole factor that can lead to a big market slump.
Stock market corrections are often challenging for beginners, but they are usually short-lived. Most stock market corrections of the last 50 years did not last more than three months.
Long-term investing vs. Stock trading
Some stocks deliver significant gains in shorter periods; these are outliers and not the norm. Beginners should hence not get involved in stock trading or actively buying and selling stocks, mostly day trading, and put their energy and money on long-term buy-and-hold investing.
Buy and Hold
An investor should conventionally buy stocks and hold them for three to five years at the very least.
With long-term investing, there is,
- A higher probability of positive returns
- A lesser chance of missing out on bigger gains
- Benefit from compound interest
- Saving on taxes
Holding stocks for the long term generally yields the best returns; it is also critical to understand when to sell. One of the reasons is when the reason you bought no longer applies. Others can be that the company is acquiring, you are thinking of rebalancing your portfolio, or you require the cash to make a big purchase.
Portfolio Diversification
Understanding the benefits of a diversified portfolio will help you minimize your losses. Diversifying means buying a diverse group of stocks across different stock market sectors. You cut your risk of a permanent loss and the portfolio’s overall volatility by diversifying. But keep in mind that the returns from a diversified portfolio are usually lower than what an investor earns upon picking a single winning stock.
Why Diversify?
A diversified portfolio of stocks cushions the blow during a correction or bear market, so investors do not suffer from irreversible loss of capital. But over-diversifying can prove to be a problem for an active investor since holding too many stocks reduces returns with minimal incremental benefit from a reduction in losses or volatility. Moreover, when a portfolio has more than 100 stocks, it is hard to manage. Furthermore, it would also produce returns that match an index fund.
You can make significant wealth with the stock market
Stock market trading can seem complicated, but the basics can help you get around it. The market is a chaotic amalgamation of a flea market and an auction house where prices move wildly. It is a free market system where a company can raise equity capital from investors who are free to buy and sell those shares.
The price fluctuates wildly here, suggesting that investors take a long-term strategy with a diversified portfolio of stocks. Embracing the basics of stock trading for dummies enriches the experience with the investors benefiting from the stock market’s ability to yield high returns that compound with time.