The big, bad stock market. Everyone’s heard the horror stories. You’ve seen movies about it. You’ve (maybe) read books about it. The first thing that comes to mind is probably either a mental picture of greedy Wall Street brokers or Warren Buffett. All you know for sure: That beginners in stock investing are prime targets to be eaten alive unmercifully.
Unless you come from a finance background, the stock market probably isn’t the most comfortable or enjoyable (or even understandable) subject for you to discuss. The same is true for many newbies to the market – although most people recognize that they should invest wisely, unfortunately few know how.
It’s not exaggerating to say that understanding the basics of how the stock market works can quite literally change the direction of your financial picture. The stock market can serve as a vehicle for increasing your net worth and reaching your future financial goals. While learning any new subject may be disheartening, it is well worth “investing” some time and energy into becoming financially literate.
We here at Financial Professional believe that investing in stocks doesn’t have to be difficult, even for beginners. (We’ll make sure of it). In this article, we’ll provide you with with an entry-level explanation of how stocks work, their benefits and risks, and how you can get started investing at any age.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not meant to be interpreted as investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.
What Is a Stock?
Simply put, stocks represent ownership in a publicly traded corporation. “Publicly traded” means you can openly buy or sell shares of the stock on an exchange like the NYSE or Nasdaq.
The prices of stocks tend to fluctuate due to supply and demand, like anything else that has an open market. As a stock becomes more desirable in the marketplace, the more likely it is that you’ll see its price rise, and vice-versa.
Every day, news about companies and economies comes out, which further impacts the market. That news affects how investors feel about different investments, which in turn, effects the market value of a stock. There are a number of ways of classifying stocks, such as by size, sector, or style.
Size and Market Capitalization
The size of a company refers to its market capitalization (or market cap). This is just a fancy term for the “market value” of the company. The term may sound complex, but the idea is very simple. Market cap can be determined by multiplying the number of shares outstanding by the stock’s current market value.
For example: if a company has 1,000,000 shares of stock outstanding and its stock is currently trading at $100, that company would have a market cap of $100,000,000.
Sector refers to the area of the economy that the company belongs to. The basic sectors can be classified as:
- Consumer Discretionary
- Consumer Staples
- Real Estate
Each sector is unique and carries its own strengths, weaknesses, and opportunities.
The Style of a Stock
Style tends to refer to growth stocks vs value stocks.
Growth stocks are companies that have seen an increase in their market value due to the expectations of future growth prospects. This may be due to technological advances, research, and development, etc. The classic example of growth stocks are aggressively growing tech companies. Growth stocks usually do not pay dividends because the company reinvests most, if not all, its profits back into the business model in order to keep growing.
Value stocks tend to be more mature companies, that do not trade at elevated levels like their growth counterparts. These companies are considered value stocks because they tend to have higher book values than market values. In other words, the firm’s real balance sheet gives them a net worth that is larger than what their stock price reflects. Many blue chip companies that aren’t growing as aggressively (like Netflix) but pay steady dividends can be classified as value companies.
That is only an introduction to the ways to divide and classify stocks. The stock market is as deep as it is wide. We recommend that you continue to learn about the different types of stocks and their classifications so you can be knowledgeable on what you own, or intend to own.
Benefits of Stock Ownership
Investing in stocks can provide beginners with many benefits in your portfolio, but the main advantage tends to be growth. While they are the riskiest of the three primary asset classes (stocks, bonds, cash), they also have historically outperformed their counterparts. This is why stocks are looked at as attractive vehicles for creating wealth.
Participate in the Process
The reason stocks are so good at building wealth is because when you own a fraction of a company, you get to participate in the growth of that company as well. The Board of Directors for firms are there to ensure that the company is operating in a way that best rewards its shareholders. Companies are always in constant competition with one another (and themselves) to increase their shareholders’ equity.
Protection Against Inflation
Because of their long-term growth potential, stocks also tend to serve as a great hedge against inflation, which eats away at your purchasing power over time. A dollar today is worth less in 5 years. It’s worth much less in 20 years. Stocks can stand as a buffer against this gradual devaluation.
Financial Wealth and Liquidity
Furthermore, stocks can also provide investors with income. This can be achieved via two main channels.
Some companies reward their shareholders by paying dividends. Dividends are essentially a return of capital back to the shareholders, which originates from the company’s net earnings. This is why more mature companies and industries with steady cash flows (utilities, telecom, financials, etc) tend to pay out dividends. Dividends can play a major role in the overall return of an investment portfolio; especially in down markets.
Stocks are also considered liquid. This means that you can convert shares to cash very easily by selling them in the stock market to other investors. This can serve as a big advantage over other illiquid asset classes, like real estate.
Risks Involved With Stock Ownership
While their growth prospects may be very attractive, stocks can also be very risky. This is one reason that beginners tend to shy away from investing in stocks, as the fear of losing your income due to a bad call is very real. However, understanding what makes a stock risky can alleviate some of the risk in your strategy.
No Guarantee on Return
The main reason stocks are risky is because you have no guarantees when it comes to your investment. Some investments, like bonds, are a contract to pay you back, sometimes with interest. Stocks, on the other hand, do not provide you with that luxury. If a company goes bankrupt, there is no guarantee that you’ll get your initial investment back. In fact, if you’re a common stockholder, you may be among the last to get paid back, if at all.
Volatility in the market is another reason that stocks are high-risk investments. This is especially true during periods of economic instability.
During the worst part of the Great Recession, the market was down about 40%. To put that into perspective, if you had $100,000 invested entirely in the S&P 500, your portfolio would’ve been worth about $60,000. You can do all of the research in the world about a specific stock, but all it can take is one piece of bad news to show you how volatile stocks can be (coronavirus, anyone?).
Just take a peek at CNBC on any given day to see how a piece of bad news has caused a stock to lose 10% of its value in the matter of a couple of hours.
How Much Exposure Should Beginners Have to Stock Market Investing?
Considering the risks and potential rewards, it’s natural to wonder how much exposure you should have to the stock market. However, there’s not one “size fits all” answer to the question.
Everyone’s circumstances are different. Everyone has a different level of risk tolerance and different financial goals that they are focused on. When creating your asset allocation, you should always consider what is relevant to your situation before anything else.
That said, the primary variable in the equation, especially for beginners, is time.
Generally speaking, the more time you have on your side, the more aggressive you can afford to be with your investment mix. This is because you have time to recover from serious drops in the market. In fact, if you have the long-term in mind, those drops can serve as fantastic entry points to purchase stocks at steep discounts.
A real example of this comes from the year after the 40% drop in the S&P 500, where stocks rebounded, returning 37.2%. Since then, stocks have continued to have a historic run. No matter how much exposure you have to stocks in your portfolio, it is always important to know what you own and why you own it. This means understanding the risks inherent with the stocks you own and the role they play in your portfolio.
Where Can I Trade Stocks?
Buying and selling stocks in today’s world is much easier than it was a couple of decades ago. As long as you’re 18 you can open an investment account just about anywhere. If you are under 18, you can have a parent or guardian assist you in opening a custodial account.
There are plenty of options available for investing in the stock market for all ages of beginners. It is worth taking some time to do your research on the different providers to make sure you are comfortable with what is available to you. Different platforms provide different levels of services, tools, resources, customer service, etc.
Furthermore, when selecting an investment account, go with the account that will help you best meet your goal.
For example, if you’re looking to invest for the long haul, and are comfortable with investing for when you are older in life, retirement accounts like 401Ks or IRAs may be a great fit. Conversely, if you don’t want to be subject to early withdrawal penalties or contribution limits, a regular taxable (brokerage) account will do the trick.
Give some careful consideration to what account you go with, as it can make a big difference, along with your investment selection. If you don’t want to be in charge of your own investment selection, you can always consider working with a robo-advisor or a traditional financial advisor or planner.
What are My Options?
You essentially have three ways of getting access to stocks when you open up your investment account:
- Mutual funds
- ETFs (Exchange Traded Funds)
- Individual stocks
Each option has its pros and cons. You can be successful using one, or all three of these options. The same rules apply: know what you own, and why you own it.
Where Can I Learn More?
You should always be making an effort to learn how you can improve your financial situation. While this article covers all of the basics, it’s by no means a comprehensive look at the market. The best thing you can do is find a medium that you are comfortable with and helps you retain the information best (such as FinancialProfessional.com, wink wink).
There are plenty of professionals on the internet and social media sharing their experience and knowledge as well. Books can also be a timeless resource. Here are a few that can help you get a grasp on things:
- The Intelligent Investor
- A Random Walk Down Wall Street
- One Up on Wall Street
- The Little Book of Common Sense Investing
- Stocks For The Long Run
Investing in the Stock Market for Beginners: Recap
While the stock market may get painted in some interesting lights at times, if you can look at it objectively as a tool, it can provide you with the ability to grow your net worth by an incredible margin over the long run. As long as capitalism continues to provide incentive for competition, companies will continue to stretch to add as much value as much to their shareholders as possible.
One the other hand, while the prospects of becoming wealthy through the stock market may be exciting, it’s also important to understand the risks involved with the stock market.
You should be very mindful of your risk tolerance and take risks responsibly. The risks involved with investing are very real and often underestimated.
That being said, it’s a great time to be an everyday investor. Technology has removed barriers to entry that used to make it very difficult to access the market unless you worked directly with a stock broker. There are plenty of brokerage solutions available in today’s world.
Just be sure to do your due diligence and go with what meets your needs best. On your journey as an investor, you should make an effort to continue to learn as much as you can in order to be an intelligent and educated investor. You don’t have to be Howard Marks or Charlie Munger to be successful. You just have to be committed to learning and very clear on what you are trying to accomplish.