How Does the Stock Market Work?
Curious about stock market investing? Read on to find out everything you need to know.
The stock market is an open market for equity. In business terms, equity is partial or complete ownership of a company. If you own stock in a successful company, the stock will increase in value or pay you regular portions of profits called dividends.
The pieces of equity in the stock market for sale are called shares. The key to success in the stock market is to buy low and sell high. The key to making a profit in the stock market is to purchase shares when they are inexpensive and sell them when they are worth more money.
General Trends and the Economy
The companies up for sale in the public stock market are called public companies. These are generally the largest employers in the national economy, and the overall prices in the stock market are a reflection of the economy.
The Stock Market and the Economy
As the financial capital of the world, the US stock market includes many international businesses and reflects the overall health of the global economy.
In times of good economic health, the economy will grow and stock prices will rise. This is called a bull market and it’s a great time to own shares and invest. When a bull attacks an opponent, it will thrust its horns up into the air and try to throw them upwards. This is how investors looking to profit from upward price movements got their name, and they are generally buying.
In times of poor economic health, the economy will shrink or stagnate, reflecting similar trends in the market. This is called a bear market, as a bear will swipe downwards at its opponent. A bear is also someone who tries to profit from downwards movements, and they will be selling and trying to push stock prices down.
The overall direction of the stock market is called the general trend. It’s wise to invest according to the general trend as each company and their shares will follow this trend.
Recessions and Corrections
Economic growth is not perfectly linear, it moves in cycles according to the business cycle.
If you’ve ever seen or experienced an economic recession, you may have read about a market crash. The economy is designed to experience regular crises, and this cycle occurs through the steps of expansion, recession, depression, and recovery.
It’s important to understand this cycle if you want to invest in the stock market. A recession or market crash is a great time to invest in crisis and buy cheap stocks and shares, but they won’t yield great profits until the recovery and expansion that follows.
As the market moves in natural cycles, sometimes it will move against the trend briefly in what is called a correction. These corrections occur at every scale, and some stock market investors refer to it as a dip. Even bull markets experience corrections, and this is also a good time to purchase inexpensive shares.
Doing Market Research
The key to making good investments is information. Being informed will give you a clear picture of the market and allow you to make wise investment decisions. This information is found by doing research, and there are many ways to research investments.
The most important information about a company is its fundamentals. These metrics reflect the general financial health of a company, and they can be deduced from public documents like earnings reports and legally required financial disclosures.
One of the most important fundamentals to calculate is the price-to-earnings ratio or PE ratio. This is the ratio between the stock price and its total earnings. If the ratio is high, the company shares may be overpriced or overvalued. If the ratio is low, the shares may be undervalued.
The share price will correct itself according to this ratio. Buying undervalued shares will give you a discount on stocks that are likely to move upwards. Inversely, selling overvalued shares will allow you to collect a profit on stocks that are likely to move downwards.
Another important metric is the price-to-book ratio or PB ratio. This is similar to the PE ratio, but it compares the total value of all shares, also known as market capitalization, to the total value of the company. The company value is calculated by subtracting the total assets from the total liabilities. These numbers can be found in legally required SEC reports.
Some other important fundamentals are the debt-to-equity ratio or DE ratio, which reflects the proportion of borrowed debt to public equity that the company uses to finance itself. There is also Free Cash Flow or FCF, which is the total cash a company takes in after paying debts and expenses.
These are the core fundamentals to look for when investing, and this approach is called value investing. It may seem intimidating at first, but these can be easily calculated from financial reports or even found pre-calculated on stock information websites such as 4 traders stock analysis. These are important in case you also consider doing investing in futures contracts.
Volume and Trends
The market is always moving, and there is much more to a stock price than fundamentals. The activity on the stock market itself has a strong effect on stock prices. We’ve discussed the general trend, but each individual stock undergoes its own trends.
One very important metric that drives stock prices is volume. This is the total amount of money that is flowing through the stock market or an individual stock. High volume leads to large price movements or volatility. Low volume typically means the stock price will remain stable.
The biggest investors in the stock market are large financial institutions and public corporations. These investors will make very large purchases every day, and they can provide enough volume to make large swings in the market in the short-term and long term.
Investing in growing companies with lots of volumes or following similar trends is called trend investing. This means looking at long-term trends, and it also means buying and selling more frequently than value investors.
Investing is not day trading, it involves long-term purchases in stocks. This is called a buy-and-hold approach, and the average investor does not need to be constantly involved in watching the market. Good investing is careful and informed investing.
Understanding the general trend, researching fundamentals, and buying at the right time are all you need to make successful investments. Many are eager to simply jump in, but it’s not wise to buy equity without first doing proper research. This research is also called due diligence.
A good analogy for successful equity investing is growing a tree. When you first plant a tree, you put a lot of care and effort into ensuring that it will successfully grow and survive. If you can accomplish this, then your investment will become sturdier and give you steady returns.
Features Image: Twenty20