Education

Common Questions About The Stock Market Answered

Are You Wondering what the stock market is or how it works?

Have you ever seen images of people screaming into three phones in front of a screen filled with numbers and wondered what they were doing?

The good news is that you can increase your financial awareness about what the stock market is.

#1: What is the stock market?

The term stock market  is used across old and new media and often  conjures up the image of a type of financial casino. But the stock market is much more than that. It’s a powerful tool for low risk wealth creation.

By thinking about the stock market as a place for wealth creation you can focus on investment strategies that will make this a reality.

The stock market is a collective term for stock exchanges around the world.

For example, in the United States, there is the BSE (Bombay Stock Exchange) and the NSE ( National Stock Exchange). In the United Kingdom, there is the London Stock Exchange. In United States , there is the New York Stock Exchange.

Each of these are stock markets and they are sometimes referred to as ‘financial markets’.

You can buy and sell shares from a range of different stock markets around the world and use financial websites to gain access to free stock market information.

#2: What is a stock exchange?

Think of a supermarket when you go shopping for your groceries; under one roof you can buy pretty much anything.

A stock exchange is a supermarket for the buying and selling of stocks and shares.

For example:

  • Are there any companies listed on your home exchange that you can find on financial websites?
  • Banks and supermarkets are the most recognisable companies listed on stock exchanges
  • Were your experiences good or bad when you dealt with these companies?

#3: What is a share?

In the US shares are referred to as stocks. A share is a single unit of ownership of a company.

When a company ‘lists’ themselves on an exchange they issue a vast number of shares for people to exchange (buy or sell). One of these shares is a single unit of ownership.

The challenge for value investors is to buy shares of companies that are undervalued. Most company shares, most of the time are valued fairly or are overvalued. But not always.

For example if a company has $100 million in assets and $50 in total liabilities, thats $50 million of value. If the same company has issued a total of 50 million shares, that’s $1 of value per share:

$50million of value divided by 50 million shares = $1 of value per share

If the current market price for each share is 75 cents, then its shares are undervalued.

#4: Why do companies issue shares?

Stock exchanges allow companies issue shares to the public in exchange for cash.

The amount of cash each company gets from issuing shares depends upon how many shares they issue and how much each of their shares are worth.

For example a company may already have bank loans and due to their business plan or terms of their existing loans, may be unable to raise cash from further loans.

Issuing shares is one way around this.

If companies are successful at growing their businesses, they can always buy back some or all of their shares. They may also issue more shares in the future when they need more cash.

#5: Why do people buy shares?

To make money.

Money can be made in three ways from the purchase of shares:

  1. By receiving dividends
  2. By the value of the shares increasing from the price at which they were first purchased. Then they can be sold at a higher price back to the stock market.
  3. Or both.
Use virtual portfolios (investing without using real money) on financial websites like to practice buying and selling shares.

#6: How do you buy and sell shares?

Are you ready to buy shares but don’t know where to do this?

Nowadays, the vast majority of individual investors buy and sell their shares online.

Years ago you would have needed to telephone a broker to buy and sell shares for you. Most brokers are now online and you can buy and sell shares anywhere with a computer and an internet connection.

Always read the terms and conditions carefully of any online stockbroker you would like to invest with.

A good online stockbroker should have:

  • a reputation for good customer service
  • a good introduction or guide to investing with them
  • clear information about your rights as an investor
  • an uncomplicated and reasonable fee structure
  • a good range of different countries that you can invest shares in
  • a straightforward website (platform) from which you actually place orders for stocks
  • a demo account for you to practice placing buy and sell orders without risking any money

I wouldn’t worry too much about freebies such as stock tips, live market prices or a news feed since you would want to have a separate service between who you invest shares with and who you get your live stock market prices from.

#7: What are dividends?

Dividends are nice.

They are  payments made to shareholders out of the money a company makes. For example, if you have 100 shares in Glaxosmithkline and they pay a yearly dividend of £1.00, you would receive £100.00 a year from Glaxosmithkline in dividends (100 shares x £1.00 dividend).

Not all managements will agree to pay its shareholders dividends. Apple for example only started paying their shareholders a dividend in 2012. Some companies never pay a dividend.

Dividends can also form part of an investment strategy if you would like to create an income from your investments. 

Whether a company pays a dividend or not  is something you will need to assess and make part of your investing strategy before you purchase your first shares.

Here are a few suggestions:

  • What is your reason for investing? If you would like to receive income whilst you invest  then you need stocks that pay a dividend. If you pursue a purer value oriented strategy then dividends are not so important. In some cases a lack of dividend may actually alert you to a value investing opportunity.
  • Check the numbers. A company’s ability to pay a dividend is dependant on its ability to continue making a profit. But because the future is unknown, check the dividend payment history of a company going back as far as records go. If you can’t be bothered with that, check at least 10 years’ worth of dividend payment history.
  • Review the company’s financial position. Dividends can only be paid when a company is in good financial shape and management are willing to pay a dividend. Use screeners to check whether a company pays a dividend whilst taking account of the health of their finances.

Even though dividends can increase your wealth, shares should not be purchased just because the company pays a dividend; research the company thoroughly.

#8: Does a shareholder own the company?

Kind of.

Being a shareholder is about having a vested interest in a company, its prospects, its financial position and the way it is run by management and how they treat shareholders.

One share of stock is one part ownership of a company.

For example Apple Inc. at the time of writing, have 937 million shares of which any number of people or pension funds, banks or hedge funds could own.

As part owners of a company, shareholders are entitled to dividends, although some companies choose not to pay their shareholders dividends and instead use the cash to grow the business.

The most important thing to bear in mind is that management are there to serve shareholders and not to run the company for the benefit of themselves by paying themselves as much as possible with stock options and annual salaries.

You should follow the opinions of other shareholders as you read the financial press. They will often share new insights that could affect your valuation of the company.

As part owner of a company, it is your duty to ensure that management’s conduct is conducive to you as a shareholder and to the company as a whole.

#9: Can I become a millionaire if I invest in the stock market?

Yep.

You can also lose you house if you’re not careful.

Becoming a millionaire from the stock market requires a dedication that most are not willing to commit to.

Here are some things to consider:

  • Most people who involve themselves in the stock market lose money
  • If your starting capital is $50,000 and you make 20% a year, it will take 16 years to get it to £1 million.
  • If your starting capital is $100,000 at 20% a year it will take you 12 years.
  • The long term average rate of return for a UK pension is about 7%
  • You will sometimes lose money on your investments.
  • If you have not formulated, tested, written down and can explain to a child your investing strategy, you are gambling.

It is the last two points that prevent individual investors from stock market success. Either because they cannot bear to see the value of their shares go down for extended periods of time or they have not properly researched their investing strategy.

If you look at the track record of revered investors, you will see that they occasionally lost money.