Over the years, stock investment has remained one of the most popular types of investments. If a financial analyst mentions five investment opportunities to you, stocks are most likely to be one of them.
Investing in stocks allows you to take advantage of the stock’s future price appreciation. However, you will need to understand how the stock market works before investing in stocks.
So, we’ll take a good look at how investing in the stock market works.
What Is a Stock?
A stock refers to a type of financial instrument representing ownership in a company and a proportional claim of its assets and earnings. In other words, a stock shows that an investor owns a part of a company.
Furthermore, it entitles the investor to the company’s assets, such as what the company owns and its profit. You can also refer to stocks as shares or a company’s equity.
In stock ownership, you own a part of a company equal to the number of shares you purchase based on the company’s total outstanding shares. For example, if the company owns 100,000 outstanding shares and you buy 10,000 shares, you own 10% of the company.
The fundamental reason that investors own stock is for a return on investment (ROI), and this generally comes in two ways:
1. Stock’s Price Appreciation
As the stock’s price appreciates (increases), you can sell the stock for a profit.
Most stocks pay dividends – a share of the company’s revenue that it pays to its shareholders. Generally, companies pay dividends quarterly.
Now that we have established a basic understanding of what stocks are, let’s explore the available types.
Types of Stocks or Shares
There are two major types of stock, common and preferred stock. Let’s explore each one of them.
1. Common Stocks
As a common stockholder, you profit from the company’s capital gains and dividends they offer to investors. Common stocks have higher earning potential and higher risk because prices can make a big move either to the upside or downside.
In addition, a common stockholder has the legal right to vote on the representatives of the company’s board of directors. Common stockholders also have the right to approve or decline major corporate decisions such as mergers or acquisitions.
The most attractive aspect of common stocks is that the value can dramatically increase over time as the company becomes more successful.
On the flip side, common stockholders have a lower priority to get their money back when things go south for the company.
2. Preferred Stocks
Preferred stocks share similarities with bonds. A preferred shareholder receives a fixed amount of income via a recurring dividend. Furthermore, interest rates affect the value of preferred stocks – when interest rates go up, the value of preferred shares declines and vice versa.
Preferred shareholders receive dividends first before common shareholders.
If the company fails and its assets must be distributed to its investors, preferred stockholders get a fixed amount before any common stockholder.
Why Do Companies Issue Shares?
Companies have different reasons for issuing sticks to shareholders and the general public. Here are two major reasons;
1. To Raise Capital
The growth and expansion of a company will typically rely on the amount of cash they invest into it. Money is a key factor in translating a unique business idea into an actual company.
But, that’s only the fundamental aspect of a business. The company will probably need to expand its operations beyond its startup capacity with time. And this requires capital.
One of the ways a company can raise such capital, aside from borrowing (debt financing), is by selling shares (equity financing). And, this option may not just be one out of many for a startup, but the best option.
It is the best option because, at this point, the company barely has enough assets to use as collateral for a loan. Plus, interest rates on loans can contribute to a major financial burden. They may not be making sufficient profit yet to meet with proper loan repayment.
2. Listing Shares
When a company lists its shares, it makes these shares available for the public to buy through a process called Initial Public Offering (IPO). At this point, the company is most likely established and has access to much more significant amounts of capital, aside from its operating capital.
Trading a company’s shares publicly changes the company’s status from a private firm to a publicly-traded company. This implies that it’s no longer only a few shareholders that can hold the company’s shares, rather several public members. This is the process that allows you to invest in or buy stocks.
Notably, once a company lists its shares on a stock exchange, and people start trading (buying and selling them), these shares’ price begins to fluctuate. This is a result of investors’ and traders’ assessment of the stock’s intrinsic value.
How Does Investing in Stocks Work?
To invest in stocks, you must know how the process works. Let’s explore the flow of how stocks work.
#1. The Company Lists its Shares on the Stock Exchange
When a company decides to go public, it lists its shares on an exchange. An exchange is a platform that connects sellers of shares with buyers. It is a secondary market that facilitates stock transactions.
So, when you generally buy shares on a stock exchange or the stock market, it is not the company itself that sells the shares. As a shareholder, if you decide to sell your shares for profit, you trade them on the exchange, and other investors buy from you.
#2. Prices are Set
The investors and stockholders determine the current market value of the stock. They set the prices of these stocks in several ways, such as;
>> Ask and Bid
The ask and bid is the most common way buyers, and sellers determine share price. It is an auction process where buyers declare the price they are willing to buy – “bid,” and sellers also declare the price they are willing to sell – “ask.”
When there is an agreement between “ask” and “bid,” trade occurs. This means either a seller takes the bid price or a buyer accepts the asking price.
Before buying stocks, buyers want to thoroughly examine these stocks using different analytical tools, metrics, and ratios such as the P/E ratio, P/B ratio, etc.
The price-earnings (P/E) ratio is a major stock valuation metric that shows the relationship between the price of a stock and its earnings. The goal is to tell whether a stock is undervalued or overvalued.
>> Stock Market Supply and Demand
The immutable law of demand and supply applies in every market, including the stock market. For a transaction to occur, there needs to be a buyer and a seller. And, the law of demand and supply plays out in a way that when there are more buyers than sellers for a stock, its price goes up. On the flip side, when there are more sellers than buyers, the stock price falls.
If buyers are more than sellers, they may be willing to raise their bids to perhaps convince the available seller to sell to them. Sellers will most likely ask for higher prices for their stocks. If sellers are more, they may be willing to lower their prices, while buyers will also lower their bids.
#3. Matching Buyers to Sellers
Nowadays, technology has made matching buyers and sellers of stocks very easy with the introduction of computerized trading systems that most exchanges provide.
These trading systems are highly efficient in matching buyers and sellers and still offer significant benefits such as rapid trade execution and lower trading costs.
Four Steps to Invest in the Stock Market
Now that you understand how investing in stocks works, here’s a quick guide to the steps you should consider before investing in any stock.
Step 1: Decide and Research
Decide on a stock(s) you want to buy, that is, companies that you want to buy their shares. Before you reach this decision, conduct thorough research to know its profitability.
Step 2: Find a Stock Broker
Find a stockbroker and open a brokerage account that lets you perform stock transactions – to buy shares. Finding a broker is becoming increasingly accessible as there are now many online brokers.
Step 3: Fund Your Account
Fund your account and invest or buy shares. The number of shares you’ll buy depends on how much you invest, so before you start investing, you should have a clear budget of how much you want to invest.
Step 4: Manage Your Stock Portfolio
This entails making trading decisions and executing trades. If you think managing your portfolio will be a hassle, you could get a Robo-advisor or a human advisor to do it for you. A Robo-advisor uses a computer algorithm to manage your portfolio.
Investing in the stock market is now easy. With the information you have now, you can start taking advantage of this investment to build your financial life.