This is part two of our Beginners Guide to Investing in Stocks. It’s for anyone who wants to be a stock market investor but hasn’t taken the leap. In total, the guide will cover:
- why risk investing in stocks at all,
- what can being a stock market investor do for you, and
- how does the average investor build a nest egg.
So let’s discuss what being a stock market investor can do for you.*
When you decide you want to be a stock market investor, one of your tasks is to grasp what the market actually does and what investing in stocks can do for you. Remember our tip #2 in the first article was: Building a good financial vocabulary gives you an advantage.
As we continue with more lessons so anyone can be a stock market investor, let’s get going on the basic financial words (bold) you’ll be using. When you finish reading this, you’ll be well on your way to having a good contextual understanding.
What is stock & why be an investor?
Stock is one type of investment, or asset, an investor can buy and sell. Stocks are also commonly referred to as equities or securities. A stock represents partial ownership in a company. Thousands of publicly traded companies have stockholders, or shareholders.
A stock market investor will buy the company’s stock because he/she believes the stock will grow as the company flourishes, returning some of its profits to the shareholders. A stock market investor seeks to parlay a smaller amount of money into a larger nest egg by putting the money to work via a company’s stock.
This is considered passive income, or using your money to make more money rather than you working for every dollar you have. As discussed in part 1, putting money into a stock can bring greater rewards (and risks) than putting money in a savings account. Saving is not investing.
In order to turn a profit, a stock market investor buys (then sells) shares of stock. But there is no guarantee a profit will always be the outcome. Most investors don’t get rich overnight, and some lose money. A stock market investor can be experienced or novice, young or old, wealthy or not.
You may be considered a speculator, trader or long-term investor. A speculator is characterized as an investor who willingly takes more risk (of losing money) in return for a much greater profit. A trader (like a day trader) refers to an investor with the goal to buy and sell during a time period (like during a day), making frequent but smaller profits along the way so the trading period ends in profit.
Long-term investors buy and hold stocks or investments over several years, maybe decades, and often trade less to build and maintain their nest egg.
How does a stock market investor make money?
A stock market investor can make a profit in two ways:
- The stock’s price increases, and stockholders sell shares. So…buy low, sell higher = profit. But you must sell your shares in order to get the profit. If you don’t sell, it’s merely a profit (or loss) on paper and you don’t receive any payment.
- A dividend is paid out. Dividends are to stocks, like interest is to a savings account. A company’s board of directors approves dividend payouts. Each stockholder collects the dividend for every share owned as long as the shares are owned at the end of the time period announced.
The stockholder gets a dividend check (for all shares owned) no matter if their stock shows a profit or a loss at dividend payout time. Considered a reward for those who invested in the company, dividends are usually paid on a regular time period, like quarterly or annually. A stockholder can spend the dividend check, re-invest the dividend in more company stock, or buy a different investment.
Not every stock pays a dividend, however. Young start-ups, new IPOs and companies considered to be very high-growth often won’t pay a dividend, because they want to plow profits back into growing. Consistent dividend-paying companies are usually large, established corporations that are doing well, steadily growing.
A company that offers a dividend shows a sign of strength by paying the dividend consistently for years and by increasing the amount of the dividend regularly. As a stock investor, I appreciate a good dividend.
What dividends can do for a stock market investor
Let’s take a real example of how dividends can benefit a stockholder: A father bought one share of
Coca Cola for his young son and daughter. He made the purchase in 1919, the very year Coca Cola became a publicly traded stock. He paid $40 for a share, plus the stock had a small dividend. Though the company’s beverages were popular, the father knew his kids were too young to think about their Coca Cola stock for years. So 20 years go by.
In 1938, the son’s one share of Coca Cola had grown to $3,277. Since he wanted to buy a house, the son sold and used his profit for a tidy down payment (hey, it’s 1938). The daughter did not sell her stock.
A few more years pass, and it’s 1985. While the Coca Cola company had several down years where the stock struggled, the company hung in there. The daughter, now 65, noticed that her Coca Cola dividends kept plugging along, boosting the value of her nest egg. Her stock is now worth $93,000. She doesn’t need to sell, so she leaves it alone.
Another 8 years pass quickly. Coca Cola stock remains steady, and the daughter loves that dividends keep piling into her account. Her one share of stock has grown into a very sizable nest egg – over $2 million. Isn’t the magic of compounding awesome?!
Can we still be in the stock market & build such a nest egg?
But…her story doesn’t end there.
Before long, it’s 2013. The daughter is 93, lives a good life, and is ready to sell her Coca Cola stock. It had become a whopping $10 million dollars! (FYI…as the company flourished and the stock price grew, the stock split several times. So the daughter’s $10-million-dollar nest egg amounted to 9,200 shares, due to both the stock splits and reinvesting her dividends.)
Unbelievable? No.
It’s the power of compounding patiently at work for a long, long time. According to the company’s investor site, if you bought 1 share of Coca Cola in 1919 for $40 and left your dividends to accumulate in your account, it would be that much. If you spent the dividends along the way, your stock shares alone would have been worth almost $400,000. Either way, a nice nest egg!
This story is not unique to Coca Cola, and there are hundreds of good companies to invest in. But to replicate this scenario, you must find a successful, innovative company that can grow as well as increase its dividend regularly. Some don’t stay around as long as co*ke. Others don’t have Coca Cola’s robust dividend history that spans several decades.
Recall the daughter started with just one share, which multiplied with each stock split. As Coca Cola prospered and the stock climbed higher, the price was adjusted with a split so smaller investors would still buy.
What does a stock split mean to a stock investor?
When a stock splits, the shares of a stockholder increase, and the price decreases accordingly – it’s like exchanging a $20 bills for two $10 bills. For example, a 2-for-1 split means double the shares, and half the price: A stockholder having 100 shares worth $20 each (or $2,000) before the split would then own 200 shares worth $10 each (or $2,000) after the split.
Notice the stockholder’s total investment, or stock value, remained the same – $2,000. The most common stock splits are 2-for-1 or 3-for-1 and sometimes 3-for-2. But a company could use any ratio – Apple stock split 7-for-1 a few years ago, for example.
Why would a company announce a stock split anyway? A lower stock price typically increases the stock’s liquidity, or ease at which it can be bought/sold. This allows more investors to buy shares, thereby increasing trading volume.
It’s been suggested, but not proven, that a stock split also encourages a stock to keep its upward momentum toward the higher, pre-split price. But some companies never do split their stock.
What companies offer stock and have stockholders?
A company becomes publicly traded after it sells its first shares (Initial Public Offering or IPO) in order to raise money, or capital. The founders’ equity (capital) can also become shares. The U.S. government must give a company permission to sell stock, and the company then continues to file reports with the U.S. Securities and Exchange Commission.
A company must keep track of how many shares are owned and who owns them, just as banks keep track of money in everyone’s savings accounts. One share equals one vote. Stockholders vote annually on major decisions, such as selling the company or electing directors. Stockholders do not vote on everyday decisions about employees or product pricing, for example.
While a stockholder may have just one share or even a fraction of a share, most investors usually own more. Investors may own shares in one company or many.
Some might own a stock fund
Thousands of shares of stock are also bought and sold as part of funds, such as mutual funds, index funds, target date funds, or Exchange Traded Funds (ETF). A fund is not just one stock, but a group of stocks and/or bonds bought and sold by the fund manager.
Many investors will buy a fund to own as a way of owning a basket of several stocks. In this case, the investor does not own each stock individually, but can only buy and sell the basket, the fund itself. If you own a fund, you cannot break up the basket, or pick and choose when to sell one stock in the basket or add a stock to it.
With individual stocks, you and I can decide which stocks we want to own as well as how many shares we want to buy. If we change our minds about a stock, we can sell it and buy another. In years past, stockholders would receive ornate stock certificates as proof of their holdings in a company.
Today, a shareholder’s trading account keeps track of stock ownership in street name (no certificate present) via a monthly brokerage statement. Most investors do not request certificates as physical proof because it’s more complex to execute a stock sale with it. Likewise, there is no physical document that details the price of a company’s stock, because it fluctuates—changes—with supply and demand.
What exactly is the stock market?
Trading a company’s stock does not directly involve that company. Rather, the price of shares is determined in an open marketplace where brokers buy and sell for investors – the stock market. What we know as the U.S. stock market today is actually comprised of several markets, or stock exchanges.
The largest and most well known is the NYSE, (New York Stock Exchange). An exchange can be a physical building with a trading floor, like the NYSE, or purely an electronic network of computers, like the NASDAQ. A stock exchange does not own the stocks, bonds or funds traded there. It is merely where trades are executed.
When an individual stock market investor wants to buy or sell shares, you typically go through a market like NYSE, using a brokerage account you’ve set up with a financial institution such as Charles Schwab, E-Trade, Merrill Lynch, or several others. You don’t call the NYSE directly, and you do not contact an individual who already owns shares and want to sell them.
A stock market investor can place an order to trade anytime by going through an online brokerage portal linked to their account. Some brokerage firms will still take an order by phone and place it for an investor. Either way, a broker is the go-between for you, the investor, and the stock exchange.
Looking for ways to teach kids about the stock market? Check out our book!
What happens as you buy a stock?
To initiate a trade, an investor provides the stock’s symbol, whether it’s a buy or sell order, and how many shares are desired. Then the investor also decides whether the trade is executed as a market order (current price) or a limit order (name a price you will pay). A stock’s price is not fixed, but goes up and down throughout a trading day as buyers and sellers agree on a price.
Because stock exchanges operate at a very hectic pace, a short-cut (think fewer keystrokes) uses stock symbols instead of official company names. This practice goes back to the ticker tape days used by stock markets in the late 1800s and it still works well today.
You likely can recognize some of these stock symbols: DIS = Disney, MCD = McDonalds, PEP = Pepsi, AAPL = Apple, PG = Procter & Gamble, JNJ=Johnson & Johnson, V = Visa, T = AT&T. Companies listed on the NYSE use symbols with three letters or less, while companies that started on the NASDAQ exchange use four or more letters.
When the stock market is open, orders flow efficiently through a process where buyers are matched with sellers. I learned how finely tuned the markets operate and saw how quickly things happen when I visited the NYSE floor a few years ago. The trading process can start and finish within a matter of seconds: A buyer bids, a seller asks, and a market specialist makes the match at the NYSE.
After a price is agreed upon, the trade is confirmed, details are sent back to the brokerage firm, and a confirmation is sent to the individual investor. This happens all day long for thousands of stocks, hundreds of trades an hour, and thousands of investors everyday the market is open.
What does The Dow have to do with the stock market?
When a trading day is over, each stock will record its closing price, or where it settles after the last trade of the day. This is the price that becomes part of the stock’s historical record.
As financial reporters keep us updated about the trading day, you might hear reports that cite The Dow — when the stock market opens/closes, as prices change during a trading day, when the market makes big swings up/down. A lot of news relates to The Dow. So you might assume The Dow = the stock market.It does not.
In actuality, The Dow is a set basket of stocks designed to represent the thousands of publicly traded companies comprising the U.S. stock market. The Dow is the industry nickname given to this market basket. It’s formally called The Dow Jones Industrial Average (DJIA), and it’s also referred to as a market “index.”
Devised by Charles Dow in the late 1800s,The Doworiginally began as a simple benchmark to help investors gauge the stock market’s performance and make sense of stock price fluctuations – a thermometer of sorts.You wouldn’t recognize the companies Mr. Dow first selected since the DJIA now looks far different.
The blue chip stocks that comprise The Dow 30 today rank among the world’s most widely held, powerhouse companies with great track records. (Currently, all 30 stocks are also dividend payers.) The index still marks the average price of stocks selected (subjectively) by editors atThe Wall Street Journal.
While The Dow is still the most widely known and reported stock market benchmark, you may have heard of two others – the NASDAQ Composite and the Standard & Poor’s 500.
What’s Wall Street have to do with the market?
Like The Dow, Wall Street should not be confused with the stock market either. Today, Wall Street in New York City is several blocks long and is the financial hub of the U.S. Wall Street has actually been a road at the tip of Manhattan Island since Dutch settlers built a wall of brush and mud along a path.
In early 1792 this is where merchants formed a central auction at 22 Wall Street, so brokers could buy and sell for customers. These brokers first met outside under a buttonwood tree, but moved indoors and formed the New York Stock Exchange by 1863. So when today’s investors refer to Wall Street, they usually mean the market and not the street.
When I first walked around 22 Wall Street on a business day, I was amazed at how quiet and compact the area seemed even though the buildings were several stories high. The narrow streets, absence of blinking lights, few consumers and fewer cars were in stark contrast to the NYSE trading floor inside.
The NYSE was buzzing with people moving quickly in all directions, flashing digital boards everywhere, and the iconic jangling bell. (Of course, the rest of New York was the expected 24/7 hustle-bustle, sidewalks packed with people, cabbie horns, and traffic-clogged streets.)
It’s always interesting to be in the midst of the financial action, with everyone talking stocks. But you don’t have to be on Wall Street to hear plenty of financial talk these days. You might have heard peers or financial advisors talking about a bear market lately.
What Is a Bear Market?
The definition of a true bear market is when declines in stock prices hit 20% or more and stretch over several months or even years. Bear markets often happen when the economy stalls or is sluggish too long. Recession, investor fear, pessimism, or catastrophic events can also cause a bear market. These types of down markets got this nickname because a bear knocks down its victims and attacks with a downward stroke of its claws.
To date, we do not yet see all the conditions to truly call March 2020 the start of a bear market – the 20%+ declines haven’t lasted long. But investors are skittish plus the Covid-19 pandemic is a catastrophic event, so some financial pundits jumped to that conclusion. While we could call them bearish, we shouldn’t yet label March 2020 a traditional bear market. Spring 2020 could be a market correction instead, which is a downturn of 10% or more typically lasting less than two months but can extend longer. Hindsight will show us.
It’s so difficult to predict the start of a negative market now because the 10% indicating a correction or 20% slide for a bear market were arbitrary percentages that were set years ago. These have been reliable predictors, fear, drama, opinions and panic selling that take center stage. But as the Dow grows and the up/down swings get larger and more frequent, maybe those percentages need some adjustment to better reflect today’s situations.
Bear Markets vs. Bull Markets
The opposite of a bear market is a bull market. In bull market territory, stock prices charge up like an agitated bull thrusts up his horns in attack. In these times, we say investors and financial analysts are bullish –confident and optimistic about our economy’s strength and stocks’ profits. (While a bull market explains the stock market in general, it can also refer to a small group of stocks or asset classes that are doing well. For example, the tech sector itself can be in a bull market.)
The recent bull market that began March 2009 is the longest bull market on record (to date). We certainly experienced some corrections—declines of 10% or more—throughout that bull market. But overall, whether we are experiencing a bull market or bear market is typically determined when it’s over and the real numbers can be analyzed. It’s difficult to tell when a bull or bear market actually begins, yet it makes for good drama.
What’s the cost to buy or sell a stock?
Something else a stock market investor is usually interested in is whether the prices of particular stocks are moving higher or lower. You can probably recall news about the stock of some companies and industries and the devastating effect of the virus pandemic. This makes for lively conversation, but a stock’s price is a moving target.
Prices are only relevant when you can compare what you paid when buying the stock to what you got when you sold it. In addition to paying for the price of the stock shares, an investor also might pay a commission to have a trade executed.
It used to cost a lot more to buy a stock, and buying in 100-share increments was a common trade. Over the last 30 years or so, the price to buy 100 shares has gone from $50- $70 down to $5-10. By the end of 2019, firms like Schwab and E-Trade charged $0 for a stock trade.
Before we can talk more about costs, we should discuss the “hows” of the market – how to find a stock or investment you want, how to decide how much to buy, how to make the purchase. Buying a stock can be as easy (or hard) as buying a computer or car.
In our next article, we’ll discuss how you buy shares of stock and build a nest egg.
*This content is presented as strictly educational in nature, with the understanding that the publisher and author are not providing legal, investment or other professional services and are not liable for any loss, damage or injury. Investors should seek the assistance of competent professionals.
Did you enjoy this article? You might check out part #1 and part #3 of the series.
