Understanding the Stock Market

Welcome! This is the first in a series of guides for beginning investors: Stock Market Investing Basics.
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This is the first of several articles written to provide you with all the information you need to know about the Stock Market, Online Investing, and how to begin investing confidently in Stocks, Mutual Funds, and Index Funds. Links to the other guides are provided at the bottom. Enjoy!

History of the Stock Market
While the history of the stock market isn’t essential to our conversation, a lot of our readers requested that we include at least a couple of paragraphs.  Adding a historical intro does provide a nice backdrop to the rest of this guide so hopefully, you’ll find the information interesting.  However, if you’re not interested in history, feel free to skip to What is the stock market? 

In the late 1600s the Royal Exchange was a busy place.  It was intended to be the trading place for all physical goods that passed through the port of London.  At the time, however, a new type of trading was becoming popular that allowed traders to invest money in business ventures rather than simply buying physical goods, an idea pioneered by the first stock traded company, the Dutch East India Company.  In its first 20 years the Dutch East India Company stock rose 300% and gave a whopping 18% of its profit back to investors in the form of dividends each year.  Needless to say, the idea caught on pretty quickly.

Stock traders, an unfamiliar animal at the time, were causing so much chaos and multiplying so quickly that they were expelled from the Royal Exchange.  In 1698, John Casting got the notion to write down a list of stock and commodity prices.  He distributed this list as “The Course of Exchange and other things” and organized a group of the dispelled Royal Exchange traders in a coffee house.  By doing so, he inadvertently created the earliest record of organized stock trading and founded the first stock market, the London Stock Exchange.

Over 90 years later in 1792, a similar situation occurred in America.  A couple dozen brokers in New York decided to create a stock exchange to organize what was, at the time, a chaotic method of trading.  They drafted and signed an agreement at 68 Wall Street and later adopted the name “New York Stock and Exchange Board” when they rented space on Wall Street.  I include this detail to emphasize an important point.  Most people think of the stock market in abstract terms.  You constantly hear about what’s going on with “the stock market” but we often forget that there are several stock markets and that each one of them is also a brick and mortar location.  The New York Stock Exchange (NYSE), for example, is now a global financial market representing over $25 trillion in global market value and nearly 3,000 companies but it is still headquartered on 11 Wall Street.

More recently, in 1971, the first electronic exchange was founded, the NASDAQ.  This, more than any other event, led to online trading as we know it today.  Until the electronic exchange, most prestigious companies traded on the NYSE and you could only buy stock through your local broker, which was even more tedious, intimidating, and expensive back then than it is today.  The NASDAQ quickly took the world by storm since it had more lenient membership rules than the NYSE, offered fast and simple transactions, and provided easy access to a company’s stock via electronic trading.  By 2004 the NASDAQ surpassed the NYSE’s average trading volume for the first time.  Today, all major publicly-traded companies on all major stock market exchanges can be traded through online brokerages… the world has moved online.

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What is the stock market?
Alright, now that you know more than you probably ever wanted to about the history of the stock market, let’s get to the good stuff.  What is the stock market?  To us at Money-and-Investing.com it is many things…

Definition 1:  In layman’s terms the stock market is simply the place that investors go to buy a small share of ownership in a company that they believe in.  Companies are often willing to sell partial ownership, or “stock”, in their company because they want to grow or because they want to avoid debt.

For example, let’s say the owners of Investing Education Inc. want to open a new store because business is booming.  However, they also want to avoid any debt, and opening a new store can be very difficult if you don’t want to borrow any money.  As long as they meet the many qualifications, they can join a stock market exchange through a public offering of stock.  When they issue their stock on the exchange, the people who buy it are basically paying for Investing Education Inc.’s expansion into a new store.  These investors are providing the company a way to raise money without going into debt.

Definition 2:  The stock market is also the greatest wealth-building tool the world has ever seen.  Why? Compound interest.  While this might sound very “mathy” and boring, we want you to get excited when we talk about compound interest because it’s the closest thing to magic you’re ever going to see in real life.  Albert Einstein once declared that compound interest is “the most powerful force in the universe” and we agree because it certainly has made a lot of people rich.   It’s a simple concept and is best demonstrated through examples.

Let’s say you have $10,000 in a savings account that pays 3% annually and you don’t withdraw money for three years.

  1. After one year you will have $10,300 (10,000 X 103%)
  2. After two years you will have $10,609 (10,300 X 103%)
  3. After three years you will have $10,927 (10,609 X 103%)

See?  Simple.  Now you’re probably thinking “whoopee… I made $927 in three years, so what?”  So let’s apply this to a real life example.

Let’s say that you feel it’s time for you to start investing and you decide to use your savings to buy $10,000 worth of stock in  some  of the most popular US companies.  This sounds difficult but it’s actually very easy since there is an index that tracks the performance of the 500 most widely held companies in the US called the Standard & Poor’s 500 or S&P; 500 for short.  The S&P 500’s average annual return since 1975 is about 10%, and since it is a pretty accurate measure of overall US stock market performance it’s perfect for this example.

Let’s also assume that you are going to add an additional $10,000 in savings each year.  Sound like a lot?  More than likely you will only have to come up with $5,000 per year since most companies match up to $5,000 in their 401K plans.  This amount is deducted from your paycheck so you’ll never even have to worry about having enough will power to save the money rather than spending it.  If your company doesn’t have a 401K or doesn’t match, don’t worry, we have lots of great savings, budgeting and debt management advice for you in our Personal Finance section.

So our scenario is that you have $10,000 in savings, you are going to add $10,000 in savings per year, and you will receive the S&P; 500 annual return of 10% (compound interest at 10% + $10,000 savings per year).
– After 5 years you will have $77,156
– After 10 years you will have $185,312
– After 15 years you will have $359,497
– After 20 years you will have $640,024
– After 25 years you will have $1,091,818
– After 30 years (the length of the typical career) you will have $1,819,434
Not too shabby.

Definition 3:  The stock market is an extraordinary passive income opportunity.  What is passive income?  The IRS defines it as income generated by an activity in which you do not materially participate.  Clear as mud, right?  We define it as making your money do the work for you.  Most people have a regular job that requires time and effort.  The more time and effort you put into your job, the more money you will make (hopefully).

The idea behind passive income is that while you are working, watching TV, or sleeping you are still earning money.  Sounds good right?  That’s what is happening when you invest in the stock market.  You don’t have to do any extra work, your money makes money for you as the value of your investments increases, and it doesn’t require anything on your part other than choosing investments wisely.  Investing foolishly can create a passive expense but just keep reading, it’s easy to invest wisely if you have a good teacher like Money-and-Investing.com.

Definition 4:  The stock market is a temperamental animal.  I’m sure you’ve heard the terms “Bear Market” and “Bull Market”.  Trust us when we tell you that you’re going to learn to love Bulls and hate Bears regardless of your current animal fetish.  Bears are by nature grumpy, dangerous and best avoided.  Bear markets are the same although they’re much more difficult to avoid than a bear in the woods.  A “Bearish” market means that the majority of stocks on the market are currently decreasing in value.

It’s a little harder to think of an analogy for a Bull Market since real bulls are known to gore people but trust us when we say you are going to love when the market is “Bullish”.  This means that the majority of stocks on the market are currently increasing in value.  Most stocks tend to increase over time, which means that historically the market is usually bullish and your stocks will usually increase in value (hence the 10% average return for the S&P; 500).

While the market does tend to go up more over time than down and bullish periods tend to be longer, the bearish declines are often steep and fast which causes a lot of chaos.  Investor psychology plays a huge role in short-term market activity and this is another reason the market can seem like an animal or spoiled child when it is bearish.  This is why most people refer to market activity as market “behavior” instead.  While the market’s behavior is difficult to predict and even more tricky to time, generally when consumer confidence is high and there are no major negative economic or political headlines, the market rises slow and strong.  When consumer confidence gets shaky because there is a lot of bad news such as a sub-prime mortgage crisis, the stock market swings wildly back and forth and drops can be swift and steep.

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Dispelling Beginner Illusions
We thought it will be fun to conclude this article by discussing what the stock market is NOT so we can dispel your pipe dreams if you happen to have any.

The stock market is not a casino!!! There is a big difference between gambling and investing.  Gambling means the odds are in the house’s favor and history has proven that the odds are overwhelmingly in your favor on the stock market.  It’s difficult to lose money if you invest wisely for the long term.  So why does it seem that so many people associate investing with gambling?  Probably as a result of their method of investing.  If we chose stocks by throwing darts, day traded, bought stocks based on anonymous email recommendations, or bought based on advice we got after work at a happy hour we could see how it would seem like gambling.  But… if you learn from people that have decades of investing experience, do your homework before you buy, and hold your investments for at least a year or more then you can consider yourself an investor and investors aren’t gamblers.

The stock market is not a way to get rich quick!!!  We’ve all heard the stories about the stocks that would have made us millions and some of those stories are even true (Microsoft and Google come to mind).  But the truth of investing is that you’re better off betting on the rule than on the exception.  Whenever you invest you should always be thinking in terms of the risk and the reward of your decisions.  When you’re constantly trying to pick the next Google, you might as well be throwing darts and your money will be gone very quickly.  If instead you choose high quality stocks or funds based on great advice and sound analysis, you will build wealth quickly… but not overnight.

The stock market doesn’t care how you feel or what you want!!!  So many people get emotionally involved in the stock market and this is a huge mistake.  The most common mistake people make is falling in love with an investment and holding onto it come hell or high water.  Be objective with your investments.  You’ll pick losers now and then but they won’t hurt you as long as you replace them as soon as you realize your error.  Don’t hold onto an investment after it tanks for six months because you “can feel that it’s about to take off”.  The second most common mistake is losing interest when things don’t go your way.  When you make a poor investment or when the market is beating you up a bit, this is the time to pay the most attention because you can learn so much more from your mistakes than from your successes.  Investing is all about risk management which is a fancy way of saying you need to have enough experience to avoid stupid mistakes and make good decisions based on imperfect information.  When you make a bad investment, learn from it or you’re destined to repeat your mistakes over and over again.

Now that you know some Stock Market Investing Basics and even some history, it’s time to dive into the next guide, Stock Investing Basics.  If you prefer, feel free to skip around to the other guides in the series, there’s no reason that you have to read them in the order that they were written.

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