Questions you make have asked yourself: What are stocks, how does the stock market work, and what are the potential dangers of investing in stocks? If you’re worried about these questions, you aren’t alone. Many people with limited financial experience are terrified of the stock market. This is due to the possibility of losing the money they invested. That, or, they’re unaware of the dangers presented by the stock market. The truth is, investing in the stock market carries a lot of risk. But, if approached in the right way, it can be a great way to save up money smartly.
How Stocks Work
In order to understand how the stock market works, let’s first take a look at the definition of a stock. A stock is a financial instrument that represents ownership in a company or corporation, as well as a claim on its assets and earnings. Stocks are also referred to as shares or equity.
Owning stock entails owning part of the company, equal to the number of shares held as a proportion of the company’s total outstanding shares. For example, owning a hundred thousand shares of a company with one million outstanding shares means having a 10% ownership stake in it. Most companies have millions or even billions of outstanding shares.
Stocks give shareholders voting rights, as well as a residual claim on corporate earnings. This comes in the form of capital gains (hold that thought) and dividends. Individual and institutional investors come together on stock exchanges to buy and sell shares in a public venue.
Share prices are set by supply and demand. Order flow and bid-ask spreads are often maintained by specialists or market makers to ensure an orderly and fair market. Listing on exchanges may provide companies with liquidity, as well as the ability to raise capital. However, it can also mean higher costs and increased regulation.
Advantages of Stock Investments
Here are just five advantages of investing in the stock market:
Use it to Your Advantage When the Economy is Growing
As the economy grows, so do corporate earnings. This is because economic growth creates jobs, creating income, creating sales. The more income people have, the higher the consumer demand. This drives more revenue to companies. So, when the economy is doing well, you can take advantage of it by investing in the stock market.
Compensate For Inflation
Historically, stocks tend to yield generous returns over the long term. Such generous returns, in fact, that they’re sometimes higher than the inflation rate. This means that you can stay ahead of inflation using your earnings. However, this does mean that you must have a longer time horizon.
Stocks are Easy to Buy
The stock market makes it easy to buy shares from companies. You can purchase through a broker, or a financial planner, even online. In fact, you can decide to buy stocks and follow through with the decision in literal minutes. If you own a small business, you might even be able to invest in stocks through your business.
You Don’t Need a Lot of Money to Start
Most retail brokers allow you to buy and sell stocks commission-free. Furthermore, some don’t require account minimums. Additionally, if the stock you’re trying to buy is too expensive, you can buy fractional shares if your broker allows for this.
Liquidity
You can sell your stocks at any time. Economists use the term “liquid” to mean that you can turn your shares into cash quickly. And that’s important, should you end up needing that money suddenly.
Disadvantages
However, the stock market also comes with a lot of problems. Here are five problems with stocks as an investment:
Risks
If a company does poorly, investors will sell. This sends the stock prices plummeting. This could result in your losing your entire investment! If you can’t afford risk like this, you should try a more secure investment, like bonds. Or, you should find an even more secure way of saving money. Or, probably the most efficient, some mix of these based on your specific situation.
Lost Time
If you’re buying stocks on your own, it’s important to research each company to determine how profitable you think they’ll be. You should follow your company closely. Additionally, you should monitor the market itself. Even the best company’s price will fall in the event of a market drop. Taking so much time to keep track of your investment may not be ideal. It may lead you to a lot of stress.
Stress
Stock prices rise and fall fast. You need to keep up with the market and your company, which can be stressful. Additionally, watching the dramatic ups and downs of the market can be worrisome. As we mentioned previously, assess your risk tolerance.
Taxes
If you sell stocks for a loss, you may at least get a tax break. However, if you sell it for a profit, you’ll be liable to pay capital gains taxes. There are ways of reducing the tax burden on your investment, though.
Possible Competition
Institutional investors and professional traders have far more time, knowledge, and resources than the average person. This could make utilizing the stock market difficult for you.
We Can Help
Want to learn more about how to invest in the stock market smartly? We can offer advice. We can help you assess your situation, and risk tolerance, to create the right strategy for you.
