You may be wondering: “How does the stock market work?” Furthermore, “What are the potential dangers of investing in stocks?” If you are worried about these things, you aren’t alone. Many people with limited financial experience are terrified of the possibility of losing their money to the stock market. Either that, or they’re unaware of the dangers that it presents. But, the reality is, investing in the market carries a lot of risk, yet can be a great way to build up your savings if approached the right way.
What a Stock is
In order to understand how stocks work, let’s delve into the actual definition:
A stock is a financial instrument that represents ownership in a company, as well as a claim on its assets and earnings. Stocks are also referred to as shares or equity. Owning a stock entails owning a section of the company equal to the number of shares held as a proportion of the company’s total outstanding shares. For example, owning 100,000 shares of a company with one million outstanding shares entails having a 10% ownership stake in it. Most companies have outstanding shares that go up into the millions or billions.
Stocks represent ownership equity in a firm. They give shareholders voting rights as well as a residual claim on corporate earnings, in the form of capital gains and dividends. Investors come together on stock exchanges to buy and sell shares in a public venue.
Share prices are set by supply and demand, as buyers and sellers place orders. Order flow and bid-ask spreads are maintained by specialists or market makers to ensure an orderly and fair market. Listing on exchanges may provide companies with liquidy, and the ability to raise capital. Although, it can also mean higher costs and increased regulation.
Advantages and Disadvantages of Stocks
Here are five advantages, plus five disadvantages, of investing in the market.
Let’s start with Advantages:
Take Advantage of the Economy
As the economy grows, so to do corporate earnings. This is because economic growth creates jobs, which generates income, which creates sales. You can use this to your advantage by investing in stocks when the economy is doing particularly well.
Stay Ahead of Inflation
Historically, stocks tend to yield generous returns over the long term. In fact, the return rate for stocks tends to be higher than the inflation rate. This means that you can use the earnings from your stock market investment to compensate for inflation. However, this does mean you need to have a longer time horizon.
Stocks are Easy to Buy
The stock market makes it easy to buy shares. You can purchase them through a broker, a financial planner, or even online. In fact, you can decide to buy stocks and then follow through with the idea in a matter of minutes. IF you own a small business, you may even be able to invest through your business.
You Don’t Need a Lot of Money to Start
Most retail brokers allow you to buy and sell stocks commission-free. Furthermore, some don’t require account minimums. And, if the stock you want to buy is too expensive, you may even be able to buy fractional shares.
The stock market allows you to sell your stocks at any time. Economists use the term “liquid” to refer to being able to turn your shares into cash quickly. And that’s an important benefit, if you should end up suddenly needing your money.
And then, the disadvantages:
If a company does poorly, investors will sell. This sends the stock prices plummeting. This could result in you losing your entire investment. If you can’t afford that risk, you should try a more secure investment, another, more secure way of saving, or some mix of these based on your specific risk tolerance.
If you’re buying stocks on your own, you should research each company to determine how profitable you think they’ll be before you invest. You should learn how to follow your company closely, as well as monitor the market itself. Even the best company’s price will fall if a market correction, market crash, or bear market occurs. Taking so much time and paying so much attention to your investment isn’t exactly ideal. It brings a lot of stress.
Stock prices rise and fall fast. In addition to keeping up with the market, watching the ups and downs of the market can also be worrisome. You may not be able to handle this. Assess your specific risk tolerance.
If you sell your stock for a loss, you may be able to get a tax break. However, if you sell it for profit, you’ll be liable to pay capital gains taxes. There are, however, ways of reducing the tax burden on your investment.
Institutional investors and professional traders have more time and knowledge to invest than the average individual does. You might have professional competition, and they might have more tools at their disposal than you do.
We Can Help
Want to learn more about how to invest in stocks smartly, assess your risk tolerance, and keep your money safe? We can offer advice. We’ll help you determine how much of your money should be in stocks based on your specific situation. Reach out to us!