Stock trading basics need to be understood if you want to invest in the stock market.
The stock market can be intimidating, but a little information can help ease your fears. Let’s start with some basic definitions.
A share of stock is literally a share in the ownership of a company. When you buy a share of stock, you’re entitled to a small fraction of the assets and earnings of that company. Assets include everything the company owns (buildings, equipment, trademarks), and earnings are all of the money the company brings in from selling its products and services. The investor exchanges his funds for shares which earn the right to participate in important company decisions as a shareholder. The shareholder gets a vote for each share owned. He also participates in any profits that the company earns in the form of dividends. This refers to common shares, which are the typical term referred to by “shares”. Other terms relevant to this discussion are defined in the glossary.
Why would a company want to share its assets and earnings with the general public? Because it needs the money, of course.
Companies only have two ways to raise money to cover start-up costs or expand the business: either borrow money (a process known as debt financing) or sell stock (also known as equity financing).The disadvantage of borrowing money is that the company has to pay back the loan with interest. By selling stock, however, the company gets money with fewer strings attached. There is no interest to pay and no requirement to even pay the money back at all. Even better, equity financing distributes the risk of doing business among a large pool of investors (stockholders). If the company fails, the founders don’t lose all of their money; they lose several thousand smaller chunks of other people’s money.
Shares you invest in will be listed on a market exchange, such as the Toronto Stock Exchange or the New York Stock Exchange, which impose certain reporting and other requirements on companies in order for their shares to be listed on their exchanges. Modern stock exchanges make buying and selling easy. You don’t have to actually travel to New York to visit the New York Stock Exchange or Toronto to visit the Toronto Stock Exchange. You can buy and sell stocks online for a small fee (see choosing an online broker).
Stock prices aren’t fixed. From the second a stock is sold to the public, its price will rise and fall based on free market forces. It is these ever-shifting market forces that make short-term movements of the stock market so difficult to predict. And that is precisely the reason why short-term stock market investing is so risky. The value of the shares will go up or down depending on the performance of the company. If the company has good financial performance, the value of the shares may go up and the opposite happens if the company does poorly. As such, the shareholder can profit by selling his shares at a higher price than he had bought them.
Be sure to read more about how to invest in the stock market now that you understand the basics of stock trading. Ultimately, it’s the change in a stock’s price over time that determines its ultimate value to shareholders. The key to investing is “buy low, sell high.” You want to buy a stock at $2 a share and then sell it when it’s $20 a share. The safest way to buy low and sell high is to invest in a broadly diversified portfolio. This allows your portfolio to weather short-term fluctuations, but average steady growth over time. A much riskier investment strategy is to try to pick the “next big thing” and cash out quickly after the stock price skyrockets (see penny stocks).