Friday, March 14, 2008

Stock Market For Beginners

An introduction to investing in the stock market for beginners.

In this article I will explain the basics of the stock market. Those first starting out in investing need to grasp the basics of what it is and how it works. Who are the participants and how does an ordinary investor fit into the picture? The first thing we need to do is understand some of the basic concepts.

What Is A Stock?

A stock or share represents part ownership in a company or corporation. When you buy a stock you become part owner of a business - it may only be a small fraction of the business, but it's still important to consider yourself an owner. Ownership of the stock entitles you to all of the rights and responsibilities a business owner normally enjoys. You're entitled to share in any profits the company makes. You'll receive the benefits of any success the company has. This could be through share price appreciation, stock dividends, capital returns and so on.

When you buy stock, it's important to understand that you are buying a piece of the business, not just lending the company some money. If you lend a company money (by buying a bond or debenture) you're entitled to receive regular interest payments and a specified rate. Anything the company earns in excess of that amount becomes the property of shareholders. This means that as an owner you can receive potentially unlimited benefits if the company does well.

However, if the company does poorly and doesn't make much money, the creditors (people who decided to lend money to the company) will normally be paid their interest payments before shareholders receive any dividends. And in the worst case, where a company goes out of business and gets wound up, the shareholders stand last in line. Everybody else must be paid in full before shareholders receive a cent. This means employees, other secured and unsecured creditors, the government - everybody gets paid before stock holders. Only if there are excess funds after paying all of these other people and institutions do the owners of the company's stock receive anything.

What Is The Stock Market?

The stock market is an institution which facilitates the buying and selling of shares. It provides a mechanism for owners of listed companies to sell their stock to those interested in buying. The price of a stock at any given time is a basically what someone is willing to pay for it. This is an important concept to grasp and I will explain it more fully in a future post. But for now you just need to understand that price and value are 2 different things. The underlying value of a stock may be vastly different to the price at which it trades.

Where was I? That's right, the stock market is a place where people can buy and sell shares. When (and if) you decide to invest in shares, the stock market is the institution which will facilitate this. Whether you're investing on the NYSE, the NASDAQ, the LSE (London Stock Exchange) or the Bombay Stock Exchange (Indian market), the principles are the same.

What About The Dow, S&P 500 and the FTSE?

When you hear commentators saying things like "...the market was up by 25 points today..." what are they talking about? Normally they're talking about stock market indices. A stock market index is kind of like an average representation of a particular market (or segment). The stock prices of a group of companies is averaged out (it's actually more complex than a simple average but that will do for now) and presented as a single number. That number is then used to give an indication of the direction the market moved on a particular day - ie. up or down - and its relative level over time.

The most well known market index is probably the DJIA (Dow Jones Industrial Average) often just called The Dow. The DJIA is comprised of the 30 largest and most widely held companies in the United States. The index is currently comprised of companies like IBM, Microsoft and General Electric. I say currently because the composition of the index changes from time to time. As companies grow and shrink, or merge with other companies, the top 30 companies can change so the index is altered to reflect this.

Other stock market indices include the following:

  • S&P 500 - The S&P 500 is made up up 500 large capitalization corporations in the US. It's maintained by Standard and Poors and is a broader based index than The Dow. This means it should give a better indication of the broader activity of the market.
  • FTSE 100 - The FTSE 100 idex is comprised of the largest 100 companies listed on the London Stock Exchange.
  • SENSEX - The top 30 on the Bombay Stock Exchange.
  • Hang Seng - 40 largest companies listed on the Hong Kong Stock Exchange.
  • DAX - 30 large cap companies listed on the Frankfurt Stock Exchange.
  • Nikkei - An index of stocks on the Tokyo Stock Exchange.
  • CAC 40 - 40 of the top 100 stocks on the French Stock Exchange.
Why Invest In The Stock Market?

So why would you want to invest in stocks? The fundamental reason is to generate wealth (or put more bluntly, to make money). But this can be accomplished in two main ways.

The first method could be called stock market trading (others may call it speculation). This normally entails buying a stock to take advantage of short term price movements. The underlying value of a company is sometimes of secondary importance. The buyer is normally more interested in whether the price of a company's stock will go up in the short term. People engaged in this sort of activity may only hold the stock for a matter of days (sometimes even hours).

The second method can more properly be called investing. It entails buying stock in a company because you believe in the long term prospects of the company and because the stock can be bought at a reasonable price. Determining a fair price to pay is another article (or articles) in itself, but you can do worse than starting with fundamentals like price to earnings ratios and dividend yield for investing. Having bought the stock you would normally hold onto to it, bank the dividends when they arrive and only sell it when it becomes overvalued or a better opportunity arises.

How To Buy Shares On The Stock Market.

An ordinary investor normally can't participate directly in the stock market. You will need to engage a stockbroker to do your buying or selling for you, for which you will be charged a fee or commission. The stockbroker holds a license to buy and sell shares on your behalf. I wont go into the mechanics of it here, but you basically call your broker and ask him to buy or sell stock on your behalf. Most stockbrokers now have only share trading facilities which allow you to buy and sell over the internet, normally for much lower fees.

There is obviously a lot more to investing than I've been able to cover in one article. However, in a nutshell, this is the stock market for beginners.

14 comments:

Amit said...

Well, only one thing is certain and that is change. Changes are always certain, so does the experienced stock world.It has moved on to cyber space from the clattered, clumsy stock markets, which looks nonetheless fish markets. The evolution of Internet is the reason for the revolution in stock markets as well as other trading. It got the easy access feature along with the comfort of operating stocks from one’s office or home. The speedy technology acted as a catalyst to break the norms of stock market. It is no more an alien world for people. Rather, it got unearthed and the mysteriousness of this trading place just vanished. Now, people are comfortable trading online and the investors and their investments have increased three-fold. The bulls and bears are no more only confined to the creams rather it has skimmed to the commons.

stock-in-sin said...

thanks for sharing such good article... will looking for more

Stock Market Club said...

This does look like a great place for beginners to start.

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