Stock Market’s Simple Underlying Business Principles

Written by: CashAdvice Staff

The stock market is similar to an auction house. People buy and sell shares of stock because they believe the company’s overall value will eventually increase. If the company is successful, then demand for shares should increase. This increases the overall cost of the shares. Major stock markets utilize a specialist who facilitates stock transactions. The specialist reduces volatility by making sure the stock prices remain stable. 

Stocks generally represent ownership of a company. Let’s say there are 100 shares of Microsoft. If you own 10 shares, then you own 10 percent of Microsoft’s total value. Businesses also issue dividends. These are cash payments that represent a portion of the company’s profits. Some companies choose not to issue dividends. They prefer to retain the cash and use it to invest in things like additional plant assets and equipment. 

Many people remember the stock market crash during the 2008 recession. This crash occurred because of systematic risk. Systematic risk cannot be reduced through diversification. This crash happened because the underlying financial system malfunctioned. Unsystematic risk can be controlled. An example would be the dot-com bubble. People who owned a portfolio comprised entirely of technology stocks would’ve lost a ton of money after the bubble burst. If technology stocks represented a small amount of your total portfolio, then the damage would’ve been reduced. You might have even made a profit at the end of the year. 

Building a strong portfolio is extremely important if you plan on investing money by buying shares on a stock market. Analysts do a lot of the work for investors. Some people prefer to buy stocks they like. Others read stock tips to decide on winning investment choices. The main reason many people get rich owning stocks is because of compounding. $100,000 invested at a 10 percent annual return will net you $10,000 a year in additional net value. 

Many of the greatest investors claim that emotional investing is a bad idea. Investors often panic when stocks decline. The efficient market hypothesis is a popular theory among investors. Supporters of the theory believe that markets are inherently rational, and price changes are based on shareholder reactions to new information. An example would be a company’s quarterly earnings report. If the business performed very well, then demand for the stock may skyrocket. People will buy more shares, and the market value of the stock will increase as a result. A public scandal can simultaneously cause a company’s stock to decline. 

Most companies start out as private entities. A company files paperwork with the Securities and Exchange Commission to sell stocks to the general public. Public shares in the stock market can be bought and sold by anyone. Publicly traded stocks are typically considered liquid assets. You can sell them immediately to convert them to cash. This differs from investments in assets like real estate. It may take years to sell a piece of property, and the transaction involves significant closing fees. The only potential fees on the stock market are broker commissions and taxes. The capital gains tax is relatively low, and you don’t pay any taxes on stocks that depreciate when you sell them. 

Potential investors need to understand that there is some inherent risk in stock market investments. Most financial experts would agree that it’s impossible to know the correct time to invest to ensure a profit. Some investors used dollar cost averaging to ensure that investing at the wrong time doesn’t destroy their portfolio. The investor buys an equal amount of stock every month to ensure the risk is spread out as time progresses. 

Online Trading

It’s a lot easier to buy stocks these days because online trading platforms automate broker transactions. You can buy $1,000 worth of shares with just a few clicks. You should consider broker commissions when conducting online trades. If the broker is charging $7 per trade, then it’s going to cost you at least $14 to buy and sell the stock for a profit. Some online trading companies let the user buy and sell stocks for free. If you choose to trade using a managed fund, then fees are usually pretty low. 

Day Trading

Day traders try to take advantage of daily market fluctuations to make a profit. This is often very difficult because market timing is impossible, but some day traders use advanced statistical calculations to make educated guesses about future stock performance. Some traders make a profit through options trading. If a buyer selects an options contract, then he’s not obligated to buy the stock when the contract expires. Options are part of the derivatives market. 

Long-term Investing 

If you’re looking for greater returns, then there is usually greater risk involved. If you can hold onto a diverse portfolio of stocks for 20 years, then the risk typically decreases over time. Some investment firms offer exchange-traded funds. These are comprised of a diverse mix of different stocks. They’ll typically cover multiple industries, but some may focus on a specific one. ETFs are a great option for people who don’t want to manage individual stocks. The diversification is automated, so the risk is decreased. This also means that potential returns on ETFs aren’t as great as some individual stocks. This should be irrelevant for the amateur investor because it’s extremely difficult to beat market averages. Most who do beat the market’s average typically only do it by a few percentage points. 

Stock Market Volatility

Many people are familiar with market crashes. Markets tend to become volatile in times of economic uncertainty. The market will also shift depending on fiscal decisions made by the Federal Reserve. If the Federal Reserve increases interest rates, then markets will dip. This is because companies can’t receive loans needed to fund projects that spur business growth. It’s also possible to measure the volatility of a stock by looking at its beta. Beta measures the volatility of a stock in comparison to the overall market. You should ultimately choose a stock market investment strategy that suits your specific needs. If you are close to retirement, then you’ll likely want to select stocks with low volatility.


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