Stock Market Basics: A Beginner's Guide to the Stock Market
You’re curious about the stock market – great!
Don’t be fooled by the seeming complexity of the financial reports you see on the news: the world of finance is actually not that complicated, and at its core the fundamental dynamics are very easy to relate to.
Understanding the fundamentals of the stock market will give you a great head start to being a successful investor.
My own experiences of the stock market are mixed. I’m probably what you’d call an “experienced” investor. I’ve owned stocks/shares, and traded in commodity warrants and options. Although having enjoyed short-term success with my portfolio, long-term profitability still eludes me. That’s code for “I’ve lost a lot” – and more than once. There’s some valuable lessons I’ve learnt from it all though, and if I can pass them on to anyone, then even better.
Presented here then, is a Q&A style article on everything you could need to know about the stock market as a beginner!
Note: The terms “stock” and “share” are generally interchangeable, and are just variations in terminology used in different parts of the world. They’ll be used synonymously from here on in…
Q: What is the Stock Market?
A: Put simply, the stock market is an open market that allows buyers and sellers of securities and derivatives to complete their sales.
It’s an abstract term really, and although often used interchangeably with the term “stock exchange” it differs insofar as it describes a general idea, rather than a specific place.
The stock market is a “thing.”
A stock exchange is a “place.”
Q: OK, so what is a Stock Exchange?
A: In contrast, a stock exchange is an actual place where buyers and sellers of securities can meet and complete their sales.
Most countries in the world have a stock exchange of one sort or another. Popular stock exchanges you may have heard of are the New York Stock Exchange (NYSE), or the Australian Stock Exchange (ASX).
Stock exchanges can conduct their service either physically on a trading floor (such as the colourfully vested traders you see screaming at each other on the trading floor of the NASDAQ) or through an entirely electronically co-ordinated system - such as the Australian Stock Exchange (ASX) where brokers interact with the system via a computer interface, and the matching of buyers and sellers is completed automatically by the ASX.
Q: Why do we have Stock Exchanges?
A: Because it's the most efficient method for the exchange of ownership.
That’s important because without a high level of efficiency, buyers and sellers will not get the optimum price for the securities they wish to sell.
Without the stock exchange, buyers and sellers of individual securities might have to advertise the sale of their shares, and seek for a buyer of similar volume independently. Imagine going through this process, completing a sale with someone. A day later you meet another buyer – one who would’ve paid much more for the stock you were selling – but because you had to independently find a buyer, you missed out on this opportunity.
The stock exchange rectifies this imbalance by collecting and rationalizing all of the buy and sell requests for securities in one, central location – allowing the price for each to be completely market driven, and thus as close to perfectly efficient as possible. It’s the best possible outcome for buyers and sellers.
So, although the rationale for the formation of the stock exchange is one of convenience, a happy side effect is the dramatically increased efficiency of the prices.
Q: I’m confused. What is the difference between a derivative, a stock and a security?
A: This is an easy one to mix up. Let’s go through them…
A security is – in technical terms – an instrument that represents real financial value. There are many different types of securities, and they’re divided into different categories based on where the value they represent originates.
What does that mean in real terms? Those banknotes (paper money) inside your wallet or purse? Debt securities. Banknotes are “promissory” in that they are representative of value that can be “claimed” from the promising authority (in the instance of banknotes – the government). This is what gives paper money its value. The notes themselves possess no valuable characteristics intrinsically – it is merely the value of the “promise” they hold that maintains their value. Bonds and debentures are also kinds of debt securities. Don’t know what they are? Don’t worry – it’s not that important right now.
This brings us to derivatives. Derivatives are a type of security. In contrast to banknotes, bonds and the like, derivatives are equity securities.Derivatives differ from stocks in that their value is a (shock!) derivative of an underlying security. This can be seen in Options, Contracts For Difference, Warrants, Futures and Swaps. Don’t know what they are? Don’t worry – you don’t need to right now.
A stock (or share) then, is a type of equity security, and is representative of an individual unit of ownership for a company.
Importantly, the liability that normally comes with owning a company is limited in the case of publicly traded shares. So, while a publicly traded company may commit an act of negligence leading to the injury or people, degradation of the environment or misappropriation of money, the publicly traded stock owners will not be legally liable – rather, the operational managers – directors – of the company retain that responsibility legally.
As a beginning investor, you won’t really need to know about much more than stocks. Though be aware of the existence of derivatives, and the role they can play in enhancing gains and mitigating losses in a stock portfolio. They can also be traded independently, depending on your skill, confidence and liquidity levels.
The Law of Supply: All else being equal, as the price of a good increases, the quantity supplied will increase.
The Law of Demand: All else being equal, as the price of a good increases, the quantity demanded will fall.
Q: Right. So how are the prices of securities determined?
A: This is the important bit – and you’ll be glad to know it’s much simpler than you imagine.
Prices for individual securities are set on the open market. This means that the price you pay when you purchase a stock is a function of the number of shares available, and the price at which those people who own them are willing to sell them at.
It’s important to grasp here that prices are not centrally controlled. There is no entity or body that controls the prices of securities in the stock market. They are fundamentally controlled by the market – a function of supply and demand.
You’ve probably heard the words “supply and demand” thrown around a lot, and intuitively, you’ve probably already got a good grasp on what they actually mean. It’s fairly obvious that you can only sell something for as much as someone is willing to pay for it. You already know that.
This fact of life is embodied in the laws (and they are laws – just like that of gravity given to us by physics) of supply and demand – a fundamental economic principle.
You can see their formal descriptions to the right.
Great. But what does this mean in real terms?
Easy. We can represent both those laws on a graph. Why do we want to do that? Because then we can see the relationship between both supply and demand, and the exact influence it has on the price you’ll pay for something. Anything, actually, not just securities.
Need it explained better?
I just found a great tutorial all about supply and demand over at Investopedia.
That’s it in general terms: how the market sets prices.
The crucially important thing to take away here is that there is a two way relationship between both the price of any given security, and the quantity of it that is available. You cannot change one without it having an impact on the other.
This matters because once you have a grasp of the major influences to a given securities price (and these influences vary depending on which industry a company works in), you can anticipate variations in the price of a security by factoring in “real world” information that you see in the news - such as political or environmental events.
If this isn’t clear, try searching for supply and demand on google – there’ll probably be some hip young economist on youtube who can demonstrate this principle brilliantly.
Q: And what makes the prices of securities change so much, and so quickly?
A: That is a huge question!
Essentially it depends on a multitude of factors, depending as much on the industry your security originates from as anything else.
For instance, hurricane Katrina caused a spike in the price of crude oil in 2005, as much of the extraction and refining capacities of the Texas Gulf were. Did the companies who’s assets were in the Gulf experience an increase in the value of their stock because the price of crude oil went up? No – certainly not to the knowledge of this author. One event can have several impacts on the stock market – occasionally in completely different ways. In the instance of hurricane Katrina, the effect was to drive the price of crude oil up, while damaging the value of the companies who experienced damage at the hands of the hurricane.
Influential events can include things as random as extreme (even not-so-extreme) weather events, deaths of important people in the company or business world, gossip (yes…even more than you can imagine!) all the way through to the more regular and expected events of the financial world, such as quarterly profit reports, announcement of commodity reserves, etc.
Put simply, there’s a million things that can influence the behaviors of buyers and sellers – and thus the price – of a given stock. Don’t try to factor them all in – you’ll fail.
Instead, if you do invest, choose a portfolio of companies that are related –perhaps all being part of one industrial sector, or specific project. Then, take the time to learn all of the major influential factors that each company has to deal with. This way, you’re more likely to get an accurate grasp of the market influences, and therefore likely movements, of a given stock.
Q: Great! How do I choose successful stocks then? How do I know when to enter and leave the market?
A: Excellent question!
There’s a million different methods to analyse the stock market, but happily only two major schools of thought are really worth your attention as a beginner.
They are technical analysis and fundamental analysis.
Fundamental analysis involves analyzing
a stock as a business. That is, you look at the financial state of the company
issuing the stocks. How many orders do they have? What is their profit margin?
What is the quantity and condition of their assets? And so on. Typically,
fundamental analysis is best encapsulated by a series of ratios which act as
key indicators for the financial health of a company. If all of the ratios fit
into margins that are acceptable to you, then there’s a good chance you’ve
found a “buy.” Fundamental analysis can take enormous amounts of research to do
properly, though the payoff can be monumental - as archetypal fundamental investor Warren Buffet has demonstrated.
In contrast, technical analysis is
conducted entirely on the charts of a given stock. All the movements of a stock's price are said to account for a "perfect level" of knowledge on the part of the market - that is, if the price of a stock moves, it has done so for a reason. We don't need to know that reason using technical analysis, only that the price movements of stocks can be cyclical and pattern-like. By studying the charts using technical analysis, we can determine what the future movements of a stock's price may be. Or so the theory goes...
Fundamental analysis tends to be slower,
and involves a great deal of research. Technical analysis tends to be quicker,
involving less research, though requires a very highly tunedaility to recognise trends in data.
The most successful traders tend to blend both approaches – using fundamental analysis to gauge the long-term value of a security, while using technical analysis to precisely time their entrance and exit of the market with that stock.
How you play it is up to you – go with what works best.
Q: But I don’t have enough money to start investing.
A:There's a range of options you can try to leverage yourself into the stockmarket. You don't need vast sums of money - in fact, having vast sums of money can be to your disadvantage if you are new to the stock market, as you have more to lose.
A slow and steady incremental approach will serve you best as you start out.
With this in mind, you can try managed funds. Managed funds are a collective pool of money that is managed by a professional investment firm. Often, to participate you will only be required to contribute a small initial capital sum, and then commit to contributing regular, smaller payments to increase your fund. Over the course of a year, the earnings and dividends the fund accumulates are distributed to the members accounts.
Alternatively, if you can find a like-minded group of people to invest with, you can either start or join an investment club.This allows you to share the learning process (and tips!) and can be a great way to combine fun with the whole investing process.
You'll find many more options as you expand further into the stockmarket world, such as derivatives, and penny stocks to name a few.
Explore them at your leisure!
Practice, Practice, Practice!
Now you’re cool with the fundamentals of the stock market, why not test out your skills with some paper trading?
Paper trading is the term given to
making “practice” trades. It’s easy – all you need is a notebook, and access to
the figures for any given exchange in the world. Give yourself a practice sum
of money – as little or as much as you like – and “use” this practice money to
make informal trades - recording your buy prices and volumes on one day, and your sell prices and volumes on a subsequent day. Keep a record of your progress.
If you can successfully paper trade your way to profit, then you're ready to use real money!