A Guide to Buying Stocks on the Stock Market
The stock market has held a peculiar place within the American mind for generations. Whereas the British tend to place bets on sports, Americans place bets on stocks. Full-scale speculative manias have gripped the United States at multiple times in its history. The most infamous of these manias is the one preceding the stock market crash of 1929 which led to the Great Depression. The most recent speculative mania is the housing bubble that led to both a real estate crash in 2007 and a stock market crash in 2008. The previous decade has seen two stock market crashes: One in 2008 and in 2001, after the speculative mania surrounding the dot com bust.
How Stocks Make Investors Money
Despite these unfortunate catastrophes, investors are still attracted to stocks for the simple reason of growth. This is a result of how stocks work. Stocks are traded as individual shares on an exchange. These shares represent ownership in the company that issues them. An investor who buys shares in a company can benefit in two ways. The company can elect to pass some of its earnings onto investors in the form of dividend payments. These dividends are expressed as a certain amount of money per share. The more shares an investor owns, the bigger the dividend he receives.
Alternatively, if the company posts strong earnings, the stock price may rise as a greater number of investors bid for the same number of shares. This is basic supply and demand. It applies to the stock market as well as the broader economy. Through price growth and dividend payments, a stock investor can reap fairly large returns on his initial investment if he invests wisely and at the right time.
Stock shares represent claims on assets as well as on earnings. If a company goes bankrupt and cannot get short terms loans, stock investors will receive whatever is left over after all of the company's creditors have been paid. Importantly, being a stock owner does not mean the investor is liable for the company's debts. The investor's loss is limited to the amount of his investment in the company.
Why Are Stocks Risky?
Stocks, also known as equities, have been subjected to a blistering array of mathematical techniques and analysis over the past fifty years. Modern portfolio theory, diversification, correlation and the "random walk" theory provide investors with a seemingly bulletproof quantitative foundation for identifying or eliminating risk. The crash of 2008 largely put an end to that sort of thinking. As investors discovered during that frantic time, there is no mathematical expression for the vagaries of the human psyche. Greed turned to fear, and the great selloff began in earnest.
Investors can lose every cent they put into a stock or group of stocks, receiving nothing for their efforts. While this is really the only risk that an investor faces with stocks, he does not and cannot adequately discern when that event is likely to occur. The stock market is now viewed as an important economic indicator. A healthy and rising stock market is considered to signal a healthy and growing economy. Moreover, the equity market has been strongly influenced by the decisions of the Federal Reserve. The indication of a second round of quantitative easing in August 2010 was enough to send stocks on a strong rally.
Participants in the stock market have to be careful when making their decisions. The market does not seem to pay attention to the actual fundamentals of a stock-issuing company. Euphoria seems to be triggered by nothing more than the vague hope of the much-heralded but yet to be seen economic recovery.
How Equities Are Traded
The stock market, at its core, is a much more sophisticated version of the local farmer's market for buyers and sellers of stocks. A stock exchange is the place where buyers and sellers meet to participate in the process of price discovery. The most well-known stock exchange in the world is the New York Stock Exchange (NYSE), where the crashes of 1929, 2001 and 2008 largely played out. The stock market is actually split into the primary and secondary markets. The primary market is where companies issue their first shares in an initial public offering (IPO).
The secondary market is where investors purchase shares from each other instead of from the companies themselves. When financial market participants, commentators and journalists refer to the stock market, they usually mean the secondary market. The secondary market can consist of living, breathing traders executing orders on the floor of the exchange, which is what occurs at the NYSE. Alternatively, computer systems execute trades electronically, which happens at the Nasdaq exchange, the second most popular exchange in the United States. Investors at brokerage firms send their requests to their brokers, who get in touch with the exchange and place the trade.
The price discovery method is like an auction. Current prices are the highest amount at which anyone is willing to buy and the lowest amount at which anyone is willing to sell. Once the trade is made, the exchange notifies the brokerage firm which sends the information on to the investor. This method can be quite complex and bewildering as investors constantly change their expectations based on earnings, speculation and expectations of future growth. Stocks are volatile instruments, capable of undergoing extremely rapid changes in price.
How To Buy Stocks
Investors have two options when it comes to buying stocks. The most common method is opening an account at a brokerage firm, depositing the money they have to invest and contacting their assigned broker to start making trades. Brokerage firms, in turn, come in two sizes: full-service and discount. A full-service broker features retirement planning, tax advice and other financial services in addition to their securities offerings. The commissions charged are also higher. Discount brokers feature lower commissions without the additional financial services. Discount brokers have become more popular with do-it-yourself retail investors.
The alternative is the dividend reinvestment plan (DRIP). A company allows an investor to purchase a portion of its stock. The dividends the investor receives go towards purchasing more stock, growing his investment little by little. The advantages of a DRIP are no commissions because the investor deals directly with the company, and the reinvestment is not limited to whole shares. Fractional shares allow the investor to reap the benefits of dividend investing without as much cost. DRIPs are still subject to income and capital gains taxes. DRIPs are designed for long-term investing strategies, giving investors the security they desire while their wealth slowly builds in the background away from the hustle and bustle of the market.