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How do stocks work? That seems like a question that one should know before investing. However, with the billions of dollars invested in employer retirement plans, many people don't have the answer to that question.
We'll do our best to give you expert-level knowledge of the ins and outs of how stocks work and why they matter to investors here, as well as a quick dive into what you need to do to find success when putting your money in them.
What Are Stocks?
A stock represents a means for companies to raise capital outside of a regular revenue stream. When companies sell shares of stock, they sell a small piece of ownership for interested investors to buy. In doing so, investors get voting rights, dividends, and any gains from increases on the stock market.
Stocks and Ipos
Companies choose how many individual stocks they want to make available during the IPO process and each stock's initial price. Also known as “going public,” the process typically takes about six months. Upon completing this initial offering, publicly traded companies list on the stock market.
Once listed on a stock exchange, a company's stock price can fluctuate depending on several particular elements.
What Determines Stock Prices?
In a sense, shares of stock are priced based on supply and demand. Companies have a finite number of shares, and any investor wanting to buy stock has to decide if the price justifies a purchase. When a stock is in the limelight, prices rise, and investors want a piece of the pie. Conversely, a lack of demand leads to too many people selling stocks and no one willing to buy.
The primary factor driving the demand for particular stocks centers around a company's ability to earn money and ultimately grow. Generally speaking, as a company's profits increase, so will share prices. Since a stock represents an ownership share of a business, most investors want to buy stocks that will increase over time.
Although often directly related to a company's success, other conditions can affect the stock price.
We'll talk about this more later, but understanding a company's potential for long-term earnings can play a role in stock prices beyond a short-term success. Successful companies that have paved the way for increased profits over time tend to look suitable for investing.
A country's economy can play a role in a stock's current market price. Unemployment rates, inflation, or gross domestic product can profoundly impact the stock market at large.
Any event that affects the entire stock market can impact the price of a stock. The S&P 500 can pull stock prices up or send them into a tailspin, depending on how the index itself does.
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Changes to import or export laws or those that significantly impact a country's economy can cause considerable shifts in prices on the stock market. Political tensions or new international deals can also play a part.
How Do You Make Money From Stocks?
There are a few basic ways to make money from investing in stocks. You can make the stock market work for you, buy and sell for quick capital gains, or grab stocks that pay dividends.
As listings gain traction on the stock exchange, prices go up. When you buy stocks at low prices and selling when prices are higher results in a capital gain, earning you the difference between the buy and sell price.
It's never quite that easy, but investors tend to choose one of a few different paths when earning money through price appreciation.
One option is growth stocks, categorized by their potential to appreciate over time. Investing in these is a long-term process and can take many years to bear a significant amount of fruit. These stocks typically generate the most money if you're willing to wait them out.
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While it's not a bad idea to keep an eye on your investment, these stocks shouldn't need any attention and will continue to grow in the long run. Think about some of the biggest companies in the world that started small and have seen incredible growth since first going public.
Investors who like to keep their hands in the stock market from bell to bell may be more inclined to perform day trading. In this instance, traders locate equities across various stock exchanges to buy and sell on the same day. Such stocks are usually low in price and susceptible to market volatility that causes a lot of change in a short amount of time.
This approach is not for the faint of heart. Investors must thoroughly research the stocks with the highest potential to grow while weighing how much risk an investment will be.
In addition to any funds earned from price appreciation, some stocks pay dividends to shareholders with an active investment.
Stock dividends represent an amount of cash per share. Companies typically pay dividends quarterly. Although dividends are only a few percent, having several shares of stock in a particular company can still result in decent gains.
Companies have no obligation to pay out dividends. Many do so to incentivize stock purchase. Dividends change based on a company's profits and ability to pay, but many companies pride themselves on paying out regularly.
Despite share prices, this approach offers a relatively stable way to invest in the stock market. Dividends likely won't make you rich, but they can provide side income to feed another investment.
How to Invest in Stocks
There are two avenues investors can pursue when looking at stocks: direct ownership and indirect ownership.
The most common way to invest, direct ownership, revolves around stock investing straight from stock markets themselves. Through this means, investors buy shares (or sometimes fractions of shares) of a particular stock to hold or turn around and sell.
With indirect ownership, investors acquire stocks through a slightly different means. The most common forms of doing so are mutual funds and exchange-traded funds (ETFs).
A mutual fund offers a means for several investors to collectively pool funds to place in stocks, bonds, and more. These collective investments become a portfolio that rises and falls depending on the assets within the fund. A money manager decides what to buy and sell as the need arises.
Everyone investing in a mutual fund can see what's inside and what it's doing but cannot change the portfolio. Thankfully, this diverse set of investments goes a long way toward minimizing risk. These particular funds are only traded once per day.
ETFs are a collection of different stocks or bonds that usually fall within a specific category. For instance, it's possible to find ETFs specific to energy, gold, or even cybersecurity.
Some of these stocks may be expensive on their own. An ETF provides the opportunity to get a piece of said stock at a lower rate. Although traders own a portion of the ETF, they do not own any assets within.
ETFs offer as much flexibility as stock, and they trade any time the market is open.
Making the investment
Once you're ready to start your journey on the stock market, you'll need the means to do so. One of the easiest ways to get into stock trading is setting up a brokerage account.
Brokerage services act as a medium you can use to buy and sell shares of stock in a snap. An online broker like Robinhood makes the process as simple as a few clicks. Best of all, online brokers make investing possible from anywhere with a computer or mobile device.
What to Look for When Picking Out Stocks
When analyzing stock investment options, investors study some figures to determine whether to buy or sell shares. Shares of stock listed for a set dollar amount can be spot on or over or undervalued.
Price-to-earnings (P/E) Ratio
A company's stock has a price-to-earnings ratio that reflects its value on the stock market over time. The value comes from a simple calculation of stock price divided by earnings per share. There's no definitive number or numbers that indicate when to buy and sell stock; However, there are guidelines to consider.
Many investors use the P/E ratio for the S&P 500 as a baseline for the value of a stock, with ratios on either side considered high or low.
A low P/E ratio represents a value company with a predictable strategy. These companies trade below their worth but could provide a significant return in short order.
On the other hand, high P/E ratios point to growth companies that can outperform the stock market in the long run. These companies focus on rising to the top of a particular industry before focusing on profits.
Market capitalization, or market cap, represents the total value of a company's stock shares. You can obtain this number by multiplying the share price by the number of shares outstanding.
This information, in many ways, provides a company's size to help determine its financial position.
Large-cap companies have a market cap of over $2 billion. Many view these companies as being more stable. These businesses may not grow as fast but are less risky than a venture with a lower market cap. Consequently, medium and small-cap companies are more volatile and can grow.
When investing, don't rule out a company's past performance on the market. Even if currently in a downward trend, some businesses have shown by experience that they can overcome and rise again.
Are Stocks a Good Investment?
Stocks offer incredible investing potential and can lead to massive profits if done correctly. While admittedly rare, individuals have achieved their financial goals from investing in the stock market.
Playing the stock market can be a risky business, and there is also the possibility of losing money. Before making any investment, you should always do extensive research and due diligence to ensure you're walking into a good deal and not a bad one.
If you're not sure where to start, consider seeking investment advice from a financial advisor.
How Do Stocks Work: Final Words
Thanks to modern technology, investing in the stock market is more accessible than ever. Everything you need to make an educated decision about a stock is no more than a click away. With this article, you should have all you need to start making a name for yourself in the world of stocks.
This article originally appeared on Wealth of Geeks.
Noah is an American copywriter on a mission to help clarify the nuances of the financial world. With a background in tech design, Noah is no stranger to numbers and financial data. He now uses these powers for good by writing reviews for The Stock Dork. When he’s not working, you’ll likely find Noah out running or traveling.