I cringe when I hear news commentators talk about “the market.” They often describe a mythical beast that can’t be tamed. It’s up, it’s down, it’s a bull, no it’s a bear!
Because of this coverage, stock market investing is often very misunderstood. Many Americans equate the stock market to “Wall-Street”, or insider trading, or rocket science that can’t be understood. These misconceptions often result in a costly mistake – failing to invest in equity markets altogether.
But none of that is true.
The market is usually just slang for the stock market. And when you hear people reference either, they are usually commenting on whether the market is up or down. If someone says that the market is up, they mean that the stocks that make up the market have increased in value for the day. So to better understand the stock market, let’s look at it’s composition.
What’s a Stock?
Stock represents ownership of a company. If you own stock in a company, you actually own a portion of that company. Because of that fact, you have the right (but not obligation) to attend the shareholder’s meetings, vote on important company decisions (like the board of directors), and you have a right to collect a share of any future company earnings. Most people choose to own stock for the last reason alone.
Company earnings can be retained for growth, or paid to shareholders. Typically, smaller firms and high-growth firms choose (with the permission shareholders) to reinvest the dividends to help the company grow faster. That usually leads to increased stock prices, and the possibility of greater dividends in the future. Other companies choose to consistently pay dividends each year to shareholders.
The driving force behind all stock ownership is the right to claim a portion of the earnings produced by a profitable company. Strong earnings lead to more investor interest, which leads to higher stock prices.
Stocks are bought and sold through exchanges – with the major players being the the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotation System (NASDAQ). Each of these exchanges has its own rules and regulations that govern which companies can be listed on the exchange.
None if that really matters because don’t have to know which stock is listed on what exchange. If you invest in ETFs or index mutual funds through a fantastic company like Wealthfront, or use a discount online broker such as Optionshouse, it’s all done for you.
Individual stocks are grouped together to form an index. The index is then tracked and often used as a general reference for overall stock prices.
For example, The Dow Jones Industrial Average (The DJIA or The Dow), The Standard & Poor’s 500 (The S&P 500), and the NASDAQ Composite Index (The NASDAQ) are all famous indexes that are often times quoted as a reflection of (you guessed it!) – “The Market.”
They are nothing more than a bundle of underlying stocks.
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks in the U.S.
The S&P 500 is a stock market index composed of the 500 largest and most important companies publicly traded in the U.S. stock market.
The NASDAQ is both an index and an exchange. The stock market index is composed of the common stocks and similar securities listed on the NASDAQ exchange, and has over 3,000 components. It is highly followed in the U.S. as an indicator of the performance of stocks of technology companies and growth companies.
These indexes and many others are useful beyond market tracking. They form the basis of sound passive investing. Research shows that “index investing” outperforms active stock trading over the long haul. Index investing literally means buying shares of an ETF or mutual fund that is tied a specific index. So the investor owns a portion of each company inside that index. I’ll write more on index investing in an upcoming article.
Stock prices fluctuate each day based on trading. Temporary pricing is pretty basic supply and demand. If stock owners begin selling a stock, and other’s aren’t willing to purchase, it’s price will go down until it reaches a point when buyer demand increases to meet seller supply. If potential investors all want to purchase a stock, and none of the current stock owners are selling, the price will be driven up.
The important thing to remember here is that day to day stock pricing is volatile (difficult to predict and wild). The stock market moves up and down like a yo-yo. This should make you scared of trading, not investing. There is a huge difference. Trading involves temporary guesswork, it’s nothing but a gamble. Investing is a long term process that involves purchasing ownership in companies with the intent to hold for long periods of time. Research shows that investing is much more profitable than trading.
Investing is inherently tied to the true value of a company. Value is often determine by profits, growth, and other technical information. Well guess what, businesses can’t predict their future earnings or growth, which creates room for lots of speculation and volatility in the stock market.
If a company reports lower than expected quarterly profits or a temporary production setback, traders get scared and sell. If a company reports spectacular growth, traders want to buy, pushing prices higher.
This is how the market also behaves on the whole. If the economy reports slow growth or high unemployment, traders get uneasy and sell. This causes the entire stock market to drop. It doesn’t have anything to do with a specific company, it’s just knee jerk reactions by millions of people who are far too worried about trying to pick stocks and day trade. A habit which, according to research, results in huge trading costs and much lower overall returns than those who just buy and hold for the long run.
This is why a long term approach is crucial. There is no need to worry about temporary swings because the value of stocks have always increased as the earnings of the underlying companies have gone up. Earnings have historically grown pretty steadily here in the U.S, as have the dividends paid by successful companies. In fact, stock market returns have averaged more than 10% per year over the last century.
In summary, be an investor, not a trader. Long term investing is profitable. You don’t need to try to pick winning stocks or time the stock market. Simply choose a few good index funds and let your investments to grow. It works, and it’s easy enough.
I hope that understanding how the stock market works is no longer a mystery to you. Share your thoughts with a comment!