Understanding how the stock market works
Author: Tom Drake
Never in history has stock market investing been more accessible to the average investor. But if you're new to buying and selling stocks, it can seem like a steep learning curve. In this article, I'll guide you through the basics of how the stock market works, and how you can get started investing in the markets today.
What Is the stock market?
The stock market is a group of markets and exchanges located around the globe, that allow for the buying and selling of shares of publicly traded companies, as well as a number of other security-related activities.
Where are the major stock markets located?
Around the world, there are 60 major stock exchanges. Canada's largest exchange is the Toronto Stock Exchange (TSX), but at less than $2 Trillion in total stock market capitalization, it is tiny when compared to the world's largest stock exchanges. For example, the largest stock market in the world is the New York Stock Exchange, with a total market cap of almost $30 Trillion.
Rounding out the top 5 are the NASDAQ ($11 Trillion), the Tokyo Stock Exchange in Japan ($5 Trillion), and the two largest Chinese markets, the Shanghai Stock Exchange, and the Hong Kong Exchange, at just under $5 Trillion each. Overall market value refers to the total market capitalization of all of the stocks listed on the exchange.
What is a stock?
Before we dive deeper into how stock markets work, we should probably look at individual stocks first. This will be helpful for anyone new to stock market investing.
Stocks, also known as shares, represent partial ownership in a corporation. When you purchase shares, it means that you own a small slice of that company. That ownership stake, no matter how tiny, grants the shareholder certain rights, like voting rights, and a claim on company assets and earnings.
Keep in mind that large corporations, TD Bank or Apple, for example, issue millions of shares. So, when you purchase 10 or 20 shares, it really is a drop in the bucket from an ownership standpoint. What's more important is that even 20 shares in a world-class corporation is a valuable thing, and chances are you'll be rewarded for it in the long run.
Common and preferred shares
There are many different classes of stock, but the two main types are common and preferred. As the name suggests, common stock is by far the more heavily traded of the two. One thing that is unique to common shares is that they come with voting rights. In other words, shareholders have the right to vote to appoint directors to the company board at annual general meetings, and on other items of vital importance.
Preferred shareholders don't have voting rights, but what they do have is a priority claim on dividends and company assets, if the corporation were to ever become insolvent. Unlike common shares, preferred shares pay a fixed dividend, at a higher average yield than common shares.
Why do companies issue shares?
Companies sell shares as a way of raising large amounts of capital to fund their expansion. While many of the world's largest corporations may have begun as an idea in the mind of a single entrepreneur, at some point, massive amounts of capital are required to grow the business into a multinational organization.
Large companies can also borrow to fund their growth. This is referred to as debt financing. The challenge with debt financing is that the company must have fixed assets available to back the loans, which isn't always possible.
Bull market vs. bear market
You may have heard the stock market referred to as a 'bull market' and a 'bear market', and wondered what that meant. A bull market occurs when prices rise or are predicted to rise across a broad section of the financial market.
The most recent example of a bull market began after the great recession of 2008. In the 11 years that followed, US stock prices rose consistently. This was a particularly long bull market run, as they are usually less than 5 years in duration.
The 2008 recession, as mentioned above, is a prime example of a bear market. Prices are falling or expected to fall across the financial markets. That's exactly what occurred following the US financial crisis, which was largely caused by deregulation in the financial markets.
How risky is stock market investing?
People who are wary of stock market investing often point out the risks involved. This can lead others to believe that the stock market is something that should be avoided. Nothing could be further from the truth.
No stock, mutual fund or ETF, is guaranteed. And in the short term, any individual investment can drop in value, some stocks are highly volatile, in fact. But if you're investing in the stock market for the short term, you're doing it all wrong.
Short-term savings, i.e. money you plan to spend in the next 1-3 years, should only be invested in low-risk vehicles, such as savings accounts, money market, GICs, and other safety class investments.
If you're investing for the long term (10+ years), you have time to ride out the short-term fluctuations the occur in the market, and history suggests that you will always end up ahead by investing in high-quality equity investments, versus low-risk accounts like savings or GIC.
But you can't just throw money at a stock or investment fund and expect to get rich either. Our money is connected to our emotions, and humans often make poor investment decisions based purely on how they are feeling at any given moment. This is why it's important to seek professional advice before making any stock market investment and maintain a long-term mindset.
How do you invest in the stock market?
There is more than one way to participate in the stock market. You have the option of buying individual stocks, or you can purchase a basket of stocks inside a pooled investment, like a mutual fund or Exchange Traded Fund (ETF). Mutual funds allow investors to own a well-diversified portfolio of stocks (and bonds) without requiring large sums of money. Many financial institutions let you start a mutual fund with a contribution of $25/month.
In recent years, investors have begun to turn to ETFs as an alternative to mutual funds. ETFs offer many of the same benefits, easy access to the markets, diversification, and rebalancing, but they can be available at a lower cost.
Final thoughts on stock investing
If you want to buy and sell stocks, there's no better time to get started than right now.
If you are thinking of trading stocks or ETFs, consider consulting with an investment professional before getting started. They can advise you on how to choose the correct asset allocation, how to properly diversify, and ensure that your investment objectives align with your account holdings.
Consider ETF portfolios as an alternative to stocks
If diving into the stock market seems overwhelming, consider an all-in-one ETF. These funds are also known as ‘one-ticket’, ‘asset-allocation’ or ‘balanced’ ETFs. They offer investors access to a mix of stocks and bonds that work as a complete investment portfolio. Learn how you can start investing with Fidelity All-in-One ETFs.