What is the stock market? What are stocks? How do stocks fit into your big-picture financial plan? Here are some answers.
What is a stock? What is a public company?
In broad terms, companies are defined by who owns them. Your local independent pizzeria is privately owned, probably by the folks who started it.
Contrast this with Domino’s Pizza, which is one of thousands of publicly-traded companies. What that means is that members of the public can buy stock in Domino’s.
Buying stock means you’re actually buying a piece of that company. Rather than saying, “you own 0.001% of this company,” companies will sell shares of stock.
Benefits of buying shares
- You can vote on certain company issues, such as the members of the Board of Directors and executive compensation
- If the company is profitable, you share in the profits as the stock value rises
- If the company returns some of its profit to shareholders, also known as dividend payments, you’ll receive a pay out as a percentage of your ownership stake
Sadly, you won’t get free pizza. But in the last five years the value of Domino’s stock has more than tripled. That will buy a lot of pizza.
Why do companies go public?
Companies generally go from private to public for two reasons: going public and selling shares is a way to raise a lot of money (or “capital”) quickly, and it gives the founders (and sometimes early employees) an opportunity to “cash out” on their hard work.
Companies must achieve a certain size and meet specific financial and other requirements to go public, which is why your neighborhood pizzeria is just, well, your neighborhood pizzeria and not Domino’s.
How does the stock market work?
The stock market, which began in Philadelphia in 1790, brings buyers and sellers together.
Before computers, sales and purchases were made in person in one of several stock exchanges (e.g., the New York Stock Exchange NYSE), where buyers and sellers “exchanged” money for shares.
Today, that happens electronically. Stock traders buy stocks and sell stocks: they trade their money for shares of stock, or vice versa. Similar marketplaces exist for bonds and other assets.
What makes stocks rise and fall?
Supply and demand
At its core, the stock market is simply a reflection of supply and demand.
When there are more buyers than sellers, the demand for a stock increases, driving its price up. Conversely, when there are more sellers than buyers, the supply of a stock increases, driving its price down.
Investor sentiment
Stock prices are also based on future expectations. If individual investors expect a company to be more profitable in the future, its price is likely to rise. It's also based on supply and demand
That doesn’t mean that the price of a stock will rise every day. In the short term, the market will react to many factors and the stock price will rise or fall.
A hot new product, the loss of a key contract, or some other incident can cause a sudden rise or drop.
Those short-term fluctuations aren’t where investors should focus. Instead, take the longer view, building a risk-appropriate investment portfolio aligned with long-term financial goals and your overall plan.
The difference between a bear market and a bull market
For many investors, the terms "bear" and "bull" are often thrown around in conversations.
While both types of markets can present opportunities to make profits, understanding the difference between the two can help you make informed decisions and stay calm during market fluctuations.
Bear market
Characterized by a general downward trend in the stock market, with a decline of 20% or more.
In bear markets, investors tend to be pessimistic and more likely to sell off their stocks, causing a further decline.
Bull market
Characterized by a general upward trend in the stock market, with a rise of 20% or more. In a bullish market, investors are more optimistic and tend to buy more stocks, causing the market to continue to rise.
While the terms may seem simple, it is important to remember that stock markets are always changing, and it can be difficult to predict when these trends will occur.
However, having a solid understanding of bear and bull stock markets can help you make informed decisions and remain level-headed during both good times and bad.
Tracking the market
The general direction of the stock market is usually judged by one of two indexes. Indexes use a combination of stocks to measure the market.
The Standard & Poor's 500 Index
Referred to as the S&P 500, is the value of the 500 (actually 505) largest stocks in the stock market. The largest are Apple, Microsoft, and Amazon.
The Dow Jones Industrial Average
Often referred to as the Dow Jones or the Dow. The Dow is based on the prices of 30 companies, which change from time to time. Apple is also in the Dow, along with Microsoft, Visa, JP Morgan Chase, and 26 others.
Learn more: Mutual funds: Common types, fees, and practical considerations
Smart investing is boring
Stock investing may seem like a game or a gamble. To smart investors, it’s neither. Here are things to keep in mind to invest the right way:
The stock market is best used for long-term investments, such as saving for retirement.
It's not a good idea to invest money in the market you'll need to access soon. In the short run, stocks can experience market volatility, rising or falling dramatically.
Instead, park that money in a savings account and earmark it for emergency funds.
In the long term, the overall market (as measured by the S&P 500) has averaged about a 10% annual gain. Invest for the long term in a diversified portfolio and the law of averages will work in your favor.
Many investors get nervous when the market drops or excited when it rises. That’s natural. But when those emotions cause investors to try to time the market, results suffer.
Studies show that market timers average about a 4% annual gain. Investing in the S&P 500 for 30 years may not give you an exciting story to tell, but an average gain of 10% a year will help you get to some exciting places.
When it comes to individual stocks, buying and holding for the long-term is also often a good strategy.
Had you purchased $1,000 worth of Apple stock on the day the first iPhone was announced in 2007, your investment would have gained $300 that day, and would be worth over $30,000 today.
Most importantly, have a financial plan for every aspect of your life, including the role stocks will play in that plan.
To learn how a CFP® professional at Facet can create a customized investment strategy that aligns with your goals, get in touch today.
