The Royal Exchange Manchester - Last day of trading

An Introduction to Investing in the Stock Market

The best and most feasible way of increasing your financial freedom is by putting your money to work on your behalf, and putting money in the stock market is a core component of a well-constructed investment portfolio. Everyone who has read our primer on improving your personal finances, The Basic Principles of Personal Finance, are well aware. However, if we look at the number of people who invest in the market, it is clear that there are far too many individuals who are still cautious, and don’t realise what they are missing out on by not investing in the market.

Too Many People Are Not Investing

A report by Gallup from April of 2016 showed that the percentage of Americans who own stocks was at a record low, with just 52% stating that they invest in stocks. This number has more or less been shrinking since 2007 when it peaked at 65%, which means that an increasing part of the American population has been missing out on significant returns over that period. We can illustrate this by plotting the development of the percentage of Americans invested in the stock market against the growth of the US market, as represented by the S&P 500:

Chart Americans Invested vs S&P 500 2007 - 2016
Percentage of Americans with investments in the stock market versus development of the S&P 500 from 2007 to 2016. Data sources: Gallup and Yahoo! Finance.

Sure, those that got out throughout 2007 and 2008 escaped a significant value drop. But they also missed out on a fantastic growth period in the years that followed. In fact, had they held firm through the dip of 2007-2009 and until 2016, they would have seen their money double, despite the significant decline at the start of the period. If we look at the number of young people who invest in the market, the numbers are even worse. A Bankrate Money Pulse survey from July of 2016 uncovered that less than a third of millennials (ages 18-35) have investments in the stock market.

The poll also asked the subjects on why they stayed on the outside of the financial markets, and 34% of all millennials picked “don’t know about stocks” as their reason for not investing. Knowing that time in the market matters, and that getting in early increases your chances of seeing significant returns, these numbers are worrying. It is clear that a large part of the population doesn’t know enough about investing in stocks, and as a result are too scared to invest. The reasoning is sound because as Warren Buffet once advised, you should only invest in what you understand. The problem is not having a basic understanding of the financial markets, and that is what I want to address with the series of articles, of which this post is the first. My hope is that anyone who takes the time to read through these articles will finish feeling comfortable enough with their knowledge of stocks and the market to start investing.

What Is Investing, Anyways?

In this first article, we will start at the very beginning, and look at what means to invest in the stock market. To understand that, we need to start with the fundamentals. Every single adult in the western world has an intuitive understanding of the concept of a company, so we will use that as our starting point. Everyone doing business are, with few exceptions, representing a company. The place you buy your coffee? That’s a company, and if you are part of the majority that company is Starbucks. Your local barber shop? That’s also a company, but probably not one that is as big as Starbucks.

Every company has a unique vision, mission and goals, but in a capitalistic society, all of them aspire to make money. The why will differ from company to company, but all of them need to make money or inevitably face insolvency, and in turn, bankruptcy.

Pencil pointing at the word investing
What does investing in stocks mean, anyways? Photo by CafeCredit (Flickr).

If a company succeeds and makes money, who is it that ultimately profits from the good fortunes of the company? Employees may have performance related compensation agreements, but those rarely form the entirety of a company’s profits. No, the real benefactors of a company’s success are the owners of the company. They are the ones who ultimately control the company by setting the strategy, hiring and firing the management, and deciding how to handle the company’s assets. If the company earns a profit, the owners can choose to reward themselves by returning money to themselves in the form of dividends, or they can keep the money in the company with the aim of generating even higher yields.

In addition to dividends, owners of a company can also make money from selling the company, either their entire holding or parts of what they own. If someone is willing to buy it for more than they first paid for the part they own, they will have made a return on their investment.

Where Can You Buy A Company?

Imagine a big mall where you can go shopping. However, instead of shopping for clothes and gadgets, it is different companies that are on display and available for you to purchase. That big mall is an actual thing, and it is called a stock exchange! A stock exchange is simply a marketplace where you can buy and sell shares of stock of the listed companies. Examples of stock exchanges are NYSE (New York Stock Exchange) and NASDAQ.

When someone refers to “the market” or some other variation of the term, they are in reality referring to all the different companies listed on all the various stock exchanges, either in a geographic area such as the US (the US market) or the entire world (the global market). If you start looking, you will find that not every company you know of is listed on an exchange. We differentiate between listed and unlisted companies by referring to them as public and private companies, respectively. The next article in the series will look at why some companies are private, and some are public, but for now knowing the distinction will suffice.

In years gone by, buying a share company stock could be a bit of hassle. You had to have a broker, with whom you placed your order over the phone. After that, it was waiting, hoping that your bid got accepted before your broker came back to you with the verdict. These days, anyone can buy easily through online brokerages, which means that the bar for getting started with investing in stocks is no higher than opening up another bank account.

The More You Know, The Better You Can Invest

When you break it down, the general principle of the stock market isn’t very complicated. As long as you understand what I have laid out in this article, you have a basic understanding of what the stock market is. You know that there are, at the most basic level, two ways to make money from investing in shares of stock of a particular company, and that is either by receiving dividends distributed to shareholders or by selling at a higher price than you bought.

There are, naturally, layers upon layers of complexity that form together to determine how the markets function. No single person can claim to have an all-encompassing knowledge of every aspect of it, but as a starting point, just knowing the basics will serve just fine. The next post of this series looks at the company. How is a company born, which factors determine whether or not it is successful, and how does it evolve from being an operation out of your parents garage to the most valuable business in the world.

An understanding of such fundamentals will help you make more informed investing decisions. To make sure that you never miss a post from Abovare, be sure to sign up for our mailing list. Alternatively, you can follow us on Twitter or Facebook, or subscribe to our RSS feed.

4 thoughts to “An Introduction to Investing in the Stock Market”

    1. Thanks Erik. My current investment strategy is very much a lazy one, with the majority of my portfolio currently placed in index funds. In terms of your question, the answer then would be both, as dividend yielding stocks are obviously well represented in a global index fund, but all dividends are reinvested. I also have some “play money” I use to purchase shares in individual companies, and some of these pay out dividends. But in terms of income it is minuscule.

      Principally, I believe in a (more or less) rational market, meaning that I believe the market price adjust according to whether the company keeps cash on hand or distributes it back to its shareholders. But I absolutely see the appeal in dividend investing to create a reliable cash flow, as opposed to selling of regularly.

  1. I am super lazy and also have most of my funds in passive index funds. I figure why try to buy individual companies at the mall when I can buy the whole thing and hope that it goes up over time 🙂 Great overview and I really enjoyed reading it.

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