Last Updated on 18 November, 2023 by Samuelsson
Undoubtedly, the stock market stands as a pivotal pillar of the economy. Economic growth in every country worldwide is intricately tied to the health and performance of its stock market. Recognizing its central role in wealth creation, we have crafted this guide on navigating the stock market to provide you with a foundational understanding.
Since the 17th century, when stocks were initially traded in coffee shops, to the subsequent formation of exchange houses and the advent of electronic exchanges, the stock market has consistently offered individuals opportunities to accumulate wealth through the trading of company shares.
What Is the Stock Market?
The stock market refers to a collection of buyers and sellers of shares in various companies, as well as the exchanges or marketplaces where the shares are traded. A share is a unit of ownership (and possibly, voting right) in a company which can be traded on the stock exchanges.
Although the term stock exchange is sometimes used to refer to the stock market, a stock exchange is simply an organized marketplace where shares are transacted, while the stock market encompasses all the marketplaces — including the electronic exchanges — and the market participants in a country or region.
For example, the U.S. stock market consists of all the stock exchanges in the US, such as the New York Stock Exchange (NYSE), the Better Alternative Trading System (BATS), Nasdaq, and many others, as well as all the investors and traders who participate in the buying and selling of shares.
The stock market is very important in the nation’s economy because of the following reasons:
- It provides companies and businesses with a cheap way to raise capital to finance their various projects.
- It offers individual investors the opportunity to buy into the ownership of a company and grow their wealth as the company grows.
- It also provides individual investors with a ready market where they can sell their shares to raise cash for personal needs.
But how did the stock market come about?
A Brief History of the Stock Market
Even though there were semblances of the stock market in the 12th to 16th century in France, Italy, and Belgium, those markets only traded in government securities and not company stocks. The first company to sell its stock to the public was the Dutch East India Company in 1602 when it released its shares on the Amsterdam Stock Exchange.
So the Amsterdam Stock Exchange, presently known as the Euronext Amsterdam, is the oldest exchange to deal on company stocks. Following the success of the Dutch East India Company in issuing its shares to the public, other companies in the neighboring regions, including London and Paris, started selling their own shares.
Investors would meet in coffee shops to buy and sell their stocks. Later on, a marketplace for stocks was built in Paris in 1724, giving birth to the Paris Stock Exchange. This was followed by the Philadelphia Stock Exchange in 1790, the London Stock Exchange in 1801, and the New York Stock Exchange in 1817.
These marketplaces initially used the open outcry system, but with the advent of the internet, most of the exchanges now employ fully automated electronic trading systems. Furthermore, the stock market now offers other financial instruments in addition to stocks.
Common Investment Vehicles in the Stock Market
Although the market is known primarily for stocks — and bears the name ‘stock’ market, share market, or equity market — other securities can be bought or sold in the market. Some of the most commonly traded securities include:
- Exchange-traded funds
- Index funds
- Mutual funds
The stock of a company is a collection of shares of the company, and a share is the unit of ownership in the company. Often times, the terms are used interchangeably. Stocks are also known as equities. Apart from entitling the shareholder to a portion of the company’s earnings and assets (in cases of liquidation), a stock may also come with the right to vote at shareholder meetings.
Based on the voting rights attached to the stock, there are two main types of stocks:
- Common stocks
- Preferred stocks
Common stocks, also known as voting shares, equity shares, or ordinary shares, are the type of stocks that give the shareholder the right to vote during general meetings on matters of corporate policy and board membership. However, holders of common stocks receive dividends only after the preferred stockholders have been paid. And in a case of liquidation, they’re the last to receive proceeds of the company’s assets.
Preferred stocks (preferred shares) do not offer the stockholder voting rights, but the holders are paid dividends first before the ordinary shareholders. The same is true for the proceeds of liquidation. Companies can structure their preferred shares differently, but the common types include:
- Prior preferred stocks — which carry the highest priority
- Preference preferred stocks
- Convertible preferred stocks — which can be converted to a predetermined number of the company’s ordinary shares anytime the stockholder wants
- Cumulative preferred stocks — with accumulated dividends if not paid
- Non-cumulative preferred stocks — dividends can’t accumulate
- Participating preferred stocks — which may offer the holder extra dividends if the company achieves better financial results
- Putable preferred stocks — which carry a ‘put’ right
Exchange-traded funds (ETFs)
An exchange-traded fund is a collection of securities — such as stocks, bonds, commodities or a mixture — that trade on a stock exchange, just like a stock. So an investor can buy a share of an ETF the same way he can a share of an individual stock. The share price of an ETF fluctuates throughout the day as investors buy and sell the security. And the price represents the net asset value (NAV) per share.
There several types of ETFs based on the underlying assets:
- Bond ETFs: They involve government bonds, municipal bonds, and corporate bonds.
- Industry ETFs: These are funds that track a specific sector, such as financial services (XLF), biotech (BBH), energy (XLE), etc.
- Index ETFs: They track some major market indexes, such as the S&P 500 Index, Dow Jones Industrial Average, Russell 2000, Nasdaq 100, etc. For example, SPDR S&P 500 (SPY) and iShares Russell 2000.
- Commodity ETFs: These ones include commodities, such as oil (USO), natural gas (UNG) or gold.
- Currency ETFs: foreign currencies like the Euro or British pounds.
Being a basket of securities, an ETF offers an investor a diversified portfolio and are known to carry low brokerage commissions. You can buy an ETF through an online broker or a traditional broker.
A mutual fund is a managed investment fund that collects money from many investors to invest in securities, such as stocks, bonds, money market instruments, and others. The investors can range from retail to institutional investors, and the fund is managed by a professional fund manager.
A share of a mutual fund represents a fractional investment in different asset categories the fund has in its portfolio. Unlike ETFs, mutual funds don’t actively trade on the exchanges, and an investor can only buy them after the market hours at its net asset value per share.
Depending on the asset category in a mutual fund, it can be categorized into the following:
- Stock mutual fund: This type of fund is mostly invested in common and preferred stocks of different companies.
- Index mutual fund: Also called an index fund, this type of fund tries to mirror the major stock market indexes, such as the S&P 500, in its portfolio composition.
- Bond mutual fund: This type of fund invests principally on government, corporate, or municipal bonds.
- Hybrid mutual fund: Here, the fund is invested equally in various stocks and bonds.
- Money market fund: The funds in majorly invested in money market instruments, such as treasury bills.
An index fund is a type of mutual fund or exchange-traded fund that seeks to track a particular market index. The index tracked may be a broad market index, such as the S&P 500, Dow Jones Industrial Average, Russell 2000, to mention but a few. So there are basically two types of index funds:
- Index mutual funds: Here, there’s a fund manager that picks and allocates funds to different stocks to mirror the intended index. Being a mutual fund, the fund doesn’t trade actively on an exchange during the day. It can only be bought after the market hours and can be bought directly from the fund.
- Index ETFs: These types trade actively on the exchanges, and the shares can be bought like a stock. The management fee is very small compared to the other type of index fund.
By providing a broad market exposure, an index fund is inherently diversified. Additionally, both types of index funds are cheaper than building a diversified portfolio made of individual stocks or investing in traditional mutual funds. That is, index mutual funds have lower management fees than the actively managed traditional mutual funds because a fund manager doesn’t need to research before picking stocks in index mutual funds.
Comparing the Common Types of Securities in the Stock Market
|Stocks||ETFs||Mutual Funds||Index Funds|
|Fund manager||No||No||Yes||Index mutual funds have fund managers, but index ETFs don’t.|
|Minimum initial investment||None||None||$1000||Depends on the type: $1000 for index mutual funds and no minimum investment for index ETFs|
|Risk||Riskier||Less risky||Less risky||Less risky|
|Expense||Brokerage fees||minimal||More expensive||Depends on the type|
|Where to buy||Stock exchanges||Stock exchanges||Directly from the fund||Depends on the type: Index ETFs can be bought from the exchanges.
Index mutual funds can be bought directly from the fund
|Time to buy||Market hours||Market hours||After the market hours||Depends on the type — market hours for index ETFs and after the market hours for index mutual funds|
How the Stock Market Works
The stock market provides an enabling environment for investors and companies to transact in a fair, transparent, orderly, and efficient manner. It provides a secure and regulated business atmosphere that operates under well-defined rules, which are enforced by a regulatory agency.
The stock market brings different participants together in the business of buying and selling shares and serves both as a primary market and secondary market for stocks.
Serving as a primary market means that the stock market allows companies to issue some of their common shares to the public for the first time — a process known as the initial public offering (IPO). Through the IPOs, companies can raise funds from investors to finance their different projects.
Aside from raising the initial funds from the market, listed companies also enjoy the following benefits:
- The opportunity to raise additional funds by issuing more shares in the future
- Greater visibility
- The possibility of using listed shares to pay for business deals like acquisitions
- The ability to set up employee stock options plans which can attract more talented employees
As a secondary market, the stock market provides a marketplace where the existing shareholders can sell their shares to other investors to raise cash for personal use. So in the secondary market, stocks trade without the direct involvement of the underlying companies.
The Participants in the Stock Market
There are different players in the market, with each player performing a specific role. Here are some of the players:
Corporations: These are the companies whose stocks are listed on the market. They have a duty to make important information that concerns their business activities available to the public.
Investors: They are the ones that bring the funds to buy stakes in the publicly traded companies. Investors often hold their shares for a long time.
Traders: These are short-term operators, frequently buying and selling shares to benefit from short-term changes in stock prices.
Stockbrokers: They are the middlemen between the traders or investors and the exchanges. Stockbrokers help investors/traders to buy or sell stocks.
Portfolio managers: These are professional investors who are paid by inexperienced investors to manage their portfolios.
Investment bankers: They help the corporations to list on the market or perform other business deals like mergers and acquisitions.
Custodians: These ones help in holding customers’ securities for safekeeping.
Market makers: They help to maintain liquidity in the market by posting bid and ask prices and maintain an inventory of shares.
Roles of the Stock Market
The market means different things to different participants, but generally, it performs the following roles:
Ensuring Fair Transactions
It is the role of the exchange to efficiently match the buy orders with the appropriate sell orders. So the market ensures that transactions are carried out in a fair and transparent manner by making sure that buyers and sellers have instant access to the market data that help their trading decisions.
The market matches the buyers with the sellers together, so it helps to maintain adequate liquidity. Although it’s not the role of the market to tell investors what to trade and when to trade, it has a duty to ensure that all willing investors have access to whatever they want to trade and that orders are fulfilled without delay.
Ensuring Efficient Pricing Mechanism
There’s a mechanism for ensuring the proper pricing of a financial instrument. Although several factors can affect the price, it all boils down to the demand and supply of that security. So the market allows the normal market forces to determine the price, without manipulation of any sort.
Providing an Enabling Environment for All Types of Players
The players in the stock market, such as investors, speculators, traders, scalpers, hedgers, and market makers, participate differently in the market. The market should be able to accommodate all of them, allowing them to operate seamlessly so as to ensure an efficient market.
Ensuring the Validity of Transactions
The market makes sure that all market participants are verified and play by the established rules and regulations to ensure accountability and prevent cheating. Fraudulent practices, such as insider trading, should never be allowed — all entities must be made to adhere to the rules of the game.
Regulating the Listed Companies
The market and its regulators have a way of monitoring the activities of the companies listed on the exchanges. The listed companies are mandated to report their quarterly earnings timely and also supply the market with other information pertaining to their business activities, such as acquisitions, change of directors, etc. This way, the investors will have all the necessary information for making their investment decisions.
Why Stocks Move: The Effect of Supply and Demand
The price of a stock is affected by the imbalance in the demand and supply of that stock. There must be a willing seller and a willing buyer for a transaction to take place. So if there are more willing buyers than sellers, the stock’s price will go up. On the other hand, if there are more sellers than buyers, the price will go down.
Let’s break this down.
Some buyers place orders at certain prices they’re willing to buy the stock at. Similarly, some sellers place orders at prices they’re willing to sell. A stock’s current price is represented by the bid and ask prices — which are the highest of any of those buy orders and the lowest of any of the sell orders respectively.
A transaction happens when a seller accepts the bid price or a buyer accepts the ask price. If there are more buyers than sellers (more demand), there will be buyers who are willing to accept the ask price, and by taking out all the orders at the current ask price, the price will go up to meet more sell orders at a higher ask price. This way, the demand is driving the price up.
Conversely, when there are more sellers than buyers (more supply), some sellers will be willing to accept the current bid price, and by doing that, move the price down to the next buy orders which are bidding at a lower price. So the price effectively trends down.
Factors That Affect the Demand and Supply of a Stock
Fine, demand and supply affect stock prices, but what are the factors that affect the demand and supply of a stock?
There many factors that can affect the demand of a stock. Some of them include:
- any news about the company
- the company’s financial reports, such as earnings, revenues, and sales
- the general state of the economy
- changes in interest rates
On the other, the supply of a stock will be affected if:
- the company buys back its stocks
- the company issues new shares
- there’s a spinoff
- negative information is released about the company
How is the stock market regulated?
Every country has a financial body tasked with the job of regulating the country’s stock market. In the US, the stock market is regulated by the Securities and Exchange Commission (SEC).
The SEC is an independent federal agency whose mission is to protect the investors, maintain a fair, orderly, and efficient market, and facilitate capital formation. It enforces the rules in the market to ensure that the investors are treated fairly.
The Differences Between Penny Stocks and Normal stocks
Penny stocks are quite popular among new trades, since they trade at low prices and often experience wild swings, both to the upside and to the downside.
To understand how they differ from normal stocks, it’s important to explain what a penny stock is.
A penny stock is a stock that trades at less than $5 per share. Although in the past, penny stocks were considered stocks that traded for less than $1 per share, the SEC has recently modified the definition to include all stocks that trade below $5 per share.
Unlike the normal, well-capitalized stocks which trade on the popular exchanges, such as the NYSE, Nasdaq, and others, most penny stocks trade via electronic over-the-counter (OTC) marketplaces, such as OTC Bulletin Boards (OTCBB) or privately owned Pink Sheets. These are not regulated exchanges, and bear higher levels of risk.
Furthermore, penny stocks differ from normal stocks in the following ways:
Penny stocks, generally, don’t have adequate liquidity. They trade only a few thousand (or less) shares each day, and that is why institutional investors don’t invest in them — there will be no one to take the other side of their trades when they want to sell.
On the other hand, normal stocks that trade on the big exchanges trade large volumes each day, so the issue of liquidity does not often arise. Both retail and institutional traders can buy and sell the stocks with relative ease.
Closely related to liquidity is volatility. Because of the lack of liquidity, penny stocks are highly volatile. With a relatively small volume, the price can jump up or down depending on the direction of the trade. So the stocks usually show outrageous price swings on the chat, making technical analysis more difficult and less accurate.
Normal stocks, on the other hand, have normal volatility because more traders are involved and the volume is high enough to prevent wild price spikes most of the time. The charts of normal stocks therefore might be easier to analyze with technical analysis methods.
Because there are fewer traders involved in penny stocks, the bid-ask spread can get extremely wide, worsening the excessive volatility in the stocks. Additionally, the widened spread increases the cost of transaction as a percentage of the stock price.
In normal stocks, the spread is usually not that high, and more importantly, it is quite stable. Because normal stocks trade at higher prices, the cost of transaction as a percentage of the stock price is very small.
The majority of penny stocks don’t trade on well-known exchanges like the NYSE — which are tightly regulated by the SEC — so they don’t get the attention of the stock market regulators. The OTC marketplaces where they trade have little or no listing criteria or minimum standards. Nobody demands financial reports or quarterly earnings.
Conversely, normal stocks must meet certain criteria before they are allowed to be listed on the standard exchanges. Listed companies are required to release their financial reports and quarterly earnings. In addition, they must make available to the public other important information concerning their day-to-day business activities. Failure to adequately inform the public is met with suspension from the market.
Many of the companies behind the penny stocks are new and relatively unknown. Generally, these companies don’t have a good track record, and some may not even have any track record at all —some are even close to bankruptcy. This lack of historical fundamental data — like earnings, revenue, and sales — makes it difficult to fundamentally analyze the stocks.
The opposite is the case for normal stocks. Because of tight regulation, there’s a wealth of information about normal stocks. Just go to the companies’ websites; you will have more than you need for your analysis.
Penny stocks often have less actual value than they’re made to appear when you see them on the news for one reason or the other. Most of the time, their prospects are exaggerated. The promoters know what they’re doing; they have their interest.
Normal stocks, on the other hand, have less need for exaggerated promotions, as you can get the necessary fundamental information online to calculate their real value. Moreover, many analysts follow these stocks and usually discuss those things.
Penny stocks exist mostly for speculative purpose, as the companies behind them have little or no available information about their operations, resources, revenues, and management. The companies may not even have proven products.
Although there’s speculation, normal stocks are relatively less speculative. They are genuine companies that do genuine business and gradually grow their revenues and earnings. The share prices often reflect growth in the underlying companies, so the changes in the stock prices are rarely excessive.
Manipulations and scams
Because of the lack of liquidity, the resultant high price volatility, and lack of regulatory oversight, penny stocks are highly prone to manipulations and scams. One popular strategy the fraudsters employ is the pump and dump scheme — the scammers would acquire large long positions in a penny stock and then promote (pump) the stock to lure investors; once investors rush to buy the stock, they sell (dump) their shares and move on.
Normal stocks are relatively liquid and less volatile so they are less liable to this type of scam. Moreover, they’re highly regulated.
Some brokers don’t allow their client to trade penny stocks. The brokers that permit penny stocks often charge higher commissions for such trades.
There are no brokers’ issues when it comes to normal stocks.
The Benefits of Trading Penny Stocks
As you can see, the differences we discussed showed penny stocks in the negative light. But there may be a few benefits of trading penny stocks, and here are some of them:
- Potential winners of tomorrow: Not all stocks trading below $5 per share are hopeless; there are many good companies with good management, consistent earnings growth, and excellent products that are trading below the $5 benchmark.
- High return potential: Because they’re trading at such low prices, the upside potential for good companies are very high when they’re eventually discovered. And a lucky investor who spots a good company can make great returns from small investments.
- Fast moves: Sometimes, the moves in penny stocks occur very fast — within hours or a few days — so money can be made in a relatively short time.
Different Ways to Play the Stock Market
There are many different ways to play the stock market, but they can be broadly grouped into two main categories:
Active trading is the act of buying and selling stocks to profit from the frequent up and down swings in price movements. Active traders can trade in either direction — long or short. They believe that they can time the market and capture the various trends in the market, making significant profits in the process. In other words, the aim of active trading is to beat the market.
Traders often analyze the price charts to identify potential trading opportunities. Although some of them may also study the stock’s fundamentals, they often tend to rely heavily on technical analysis of the price and volume charts.
Depending on how long they’re willing to hold their positions and the type of price trends they try to capture, active trading can be categorized into:
In addition to these categories, you could divide all traders into two more categories regardless of trading style:
- Algorithmic Traders
- Discretionary Traders
Algorithmic traders execute their systems with the help of a computer, and may do other things while their computer trades for them. The laborious task of finding strategies to trade can be done anytime, which means a lot of freedom for the trader!
At The Robust Trader, we believe algorithmic trading is superior to discretionary trading irrespective of that trading form you’re into. We recommend that you read our guide to algorithmic trading to find out more!
Now, let’s cover the different types of trading styles!
Scalping is the quickest styles an active trader can adopt. It involves exploiting the various price changes that occur throughout the day. Each trade usually lasts from a few seconds to a few hours.
A trader who uses this style is called a scalper. Scalpers monitor price movements in the shortest possible timeframes, such as the 1-minute to 10-minute timeframes and even the tick charts. Most scalpers base their trading on technical analysis alone.
However, some scalpers may try to profit from the higher price volatility that occurs when important news — such as earnings — is released. When trading based on technical analysis, scalpers may use oscillator indicators, such as stochastic and relative strength index (RSI), which closely follow price swings.
Because they try to capture little price movements, scalpers often use the four-to-one leverage available to intraday traders to maximize profits. While profits can quickly compound if a scalper uses an effective exit strategy to minimize losses, overtrading and over-leveraging associated with this style of trading makes it extremely risky.
In addition, scalping incurs heavy commissions because of the huge number of transactions.
This is a style of trading where a trader buys and sells (or shorts and covers the short) a stock within a single trading day. In other words, the position must be closed before the market closes for the trading day. A day trader often tries to profit from the predominant price trend of the day.
So if the trader thinks that the stock will trend up for the day, he goes long, and if his analysis indicates a downtrend, he goes short. Most of the time, a day trader relies on technical analysis but may also be mindful of important news releases to avoid price gapping against his position.
Day traders’ favorite timeframes for analyzing a stock are lower timeframes like the 15- and 10-minute charts. Some may also use a higher timeframe, like 4-hour bars and daily bars, to ascertain the direction of the predominant trend.
Most day traders use margin leverage: brokers often allow 2:1 leverage, but some may permit up to a maximum of 4:1 leverage. Although leverage can enhance profitability, it increases the risk of huge losses.
Because of the number of transactions involved, commissions can easily add up.
Swing trading is a type of trading style where the trader tries to profit from short-term price swings. This type of traders normally holds their trades from a few days to a few weeks, as they try to milk the short-term trends. For most swing traders, spotting price patterns and using technical indicators to find trading opportunities is how to play the stock market.
However, they may also make use of fundamental analysis to select the stocks to trade and then use technical analysis to determine when to make a trade and the direction of the trade. Their aim is to identify price reversals early enough and ride the next price swing.
Most swing traders analyze their charts on the daily timeframe to find trading setups and then some choose to go to the 1-hour timeframe to select the best entry. They may also check the weekly timeframe to gauge the state of the long-term trend.
Although swing traders don’t trade as frequently as day traders or scalpers, their volume of transaction is still high when compared to position traders or investors, so they incur higher trading costs. Furthermore, the fact that their trades can last for several days may expose them to the risk of overnight price gaps.
Position trading is the kind of trading that tries to benefit from the long-term trend rather than short-term price movements. This style of trading is suited for the very patient and long-sighted traders. Position traders are trend followers, and they usually keep their trades from several weeks to months and, sometimes, years.
Some position traders predominantly use technical analysis in making their trading decisions while others use more fundamental analysis. But most of them use the combination of both. Their technical analysis is usually done on the weekly timeframe but can come down to the daily timeframe to select better entry levels.
This style of trading saves the trader a lot of time, as there’s less need to analyze the market often. Once the stock is bought or sold and a stop loss set, the position trader will only have to wait until the targeted profit level is reached. Because there’s less trading, the cost of transaction is less.
The major risks associated with this style of trading is overnight price gaps beyond the stop-loss levels. Another disadvantage is that the capital is tied down for a long time, so there’s the issue of opportunity cost.
Investing is the act of buying an asset (stock) with the expectation of a future return. The return may be in the form of income (dividends) or price appreciation. Investing, more or less, is all about ‘buying’. For the most part, investing doesn’t require as much effort and time as active trading, but there may be a need to search for the right stock to buy.
Investors mostly select their stock through fundamental analysis. There are different strategies investors employ in playing the stock market, and these are some of the most popular ones:
- Value investing
- Growth investing
- Buy and hold
- Income investing
- Dollar-cost averaging
This is an investment strategy that involves searching for stocks that seem to be trading for less than the intrinsic value. The intrinsic value of a stock is the calculated value of the stock, based on the current economic data that is available.
Value investors are always on the lookout for stocks the market has unfairly undervalued. They believe the market can be irrational on the short-term and excessively reacts to temporary bad news that may not affect the long-term profitability of the company.
The tendency of the market to overreact often provides good stocks that trade significantly below their real value. The aim of value investors is to find such stocks and buy them at a discount, with the expectation that the market would eventually catch up with the real value in the long term.
However, determining the real value of a stock is not that simple. There are different metrics value investors use to calculate the real value of a stock and they are derived from fundamental analysis. These are some of them:
- Price-to-book ratio (P/B), which compares the stock’s price to the value of the company’s assets
- Price-to-earnings (P/E), which measures the ratio of the stock’s price to the earnings per share
- Free cash flow, which is the cash left after operational and capital expenditures
Some of the most notable value investors include Warren Buffet, Benjamin Graham (Buffet’s mentor), and Christopher Browne.
Growth investing, also known as capital growth, is an investment style that focuses on companies whose potential for growth in sales, revenue, and earnings is greater than their industry sector or the overall market. These type of companies are called growth companies, and they are usually small, young companies with new technologies, products, or services and may have just started trading publicly.
Growth investors study the underlying business, the quality of the management, and the rate at which the business is growing before deciding whether to buy the stock or not. They also check the prospect of the industry in which the stock belongs and how widely accepted the company’s products or services are.
For a company to be considered a growth company, the company must have a trend of strong earnings and must be reinvesting a great percentage of its earnings to expand and grow. As the company grows, it is expected that the price of its stock will appreciate. Facebook, in 2012, was a growth company, same as Microsoft in 1986 or Apple in 1981.
Some of the champions of the idea of growth investing include Thomas Rowe Price, the founder of T. Rowe Price investment firm, and Phil Fisher who wrote the popular stock book, “Common Stocks and Uncommon Profit”.
Also known as dividend investing, this strategy primarily focuses on picking stocks that consistently pay high dividends. The strategy offers the opportunity to have a constant stream of income in addition to whatever capital appreciation that may come. But the primary target is the dividend income — not capital growth.
Dividend investors look for well-established companies with a track record of not only paying regular dividends but also increasing the amount paid. Stocks with higher dividend yield are the stocks of choice.
The dividend yield is dividend expressed as a percentage of the share price. The higher the dividend returns, the faster your income can compound to large sums.
For a company to consistently pay a dividend, it must be making good profits. It is safer to buy stocks of companies that pay no more than 60% of their earnings in dividends. This way, if there’s a fall in profit in the future, there will be funds for the management to cushion the effects.
Buy and hold
Buy and hold is a passive investment strategy in which an investor purchases a stock, an ETF, or an index fund and holds it for a long time (several years) without minding what is happening in the market. An investor who employs this strategy doesn’t care if the market is in a bullish or bearish phase of the market cycle.
This strategy is based on the belief that the market will always advance in the long run and a good stock will definitely appreciate in value no matter what happens.
But to benefit from this strategy, the investor must be good at picking the right stocks. The investor may use growth or value investing methods or a combination of both to choose good stocks. Once the stocks are selected, the investor purchases them and forgets about them for many years. The strategy has tax advantages because taxes on capital gains can be deferred for a long time.
As we’ve touched on earlier, one of the best ways to profit from the market in a passive way, is to buy a low-cost index fund!
Dollar-Cost Averaging (DCA)
Dollar-cost averaging is an investment strategy in which the investor keeps buying stocks at regular intervals until the total budgeted sum has been invested. This strategy can be combined with any of the other strategies; the investor is simply buying the selected stocks at regular intervals without having to time the market.
With this method, an investor who wishes to invest $5000 in the stock market may divide the amount into 10 and be buying $500 worth of the selected stocks every month until the total amount is invested. This way, the investor acquires the stocks at different prices, thereby reduces the risk of buying on a market high, potentially lowering the average cost per share.
To effectively practice this strategy, you will need to determine these four parameters beforehand:
- The stocks to buy
- The total amount to be invested
- How long it will take you to invest all the budget amount
- How often you will be buying the stocks
Once you have decided on these factors, you can calculate the amount to invest each time and simply stick to your plan.
How to Analyze the Stocks to Buy
Stock analysis is very important for someone that wants to play the stock market. There are different ways investors and traders analyze stocks to find potentially profitable ones. While some use technical analysis, others use fundamental analysis. A good number of them use some combinations of the two.
The method you use is a matter of preference, but first, you need to understand the two methods of analyzing stocks so as to know the one that fits your objectives.
Technical analysis is a method of evaluating stocks by analyzing historical price movements and changes in volume. It is mostly used by traders to assess changes in the supply and demand of a stock, as reflected in the trends and patterns of price movements and volume indicators.
Followers of technical analysis believe that all you need to analyze where the price of a stock is headed is on the chart — the price and volume data. There are two approaches to technical analysis:
- Price action analysis
- Indicator analysis
In price action analysis, a technical analyst tries to analyze the price chart directly without the help of indicators. So the analyst uses candlestick patterns (engulfing, tweezers, hammer, etc) and price structures (triangles, double tops, etc), to predict the direction the price will take in the future. In addition, the trader might use the sequence of previous price swing highs and lows to identify the trend — higher highs and lows indicate uptrend, while lower lows and highs indicate a downtrend.
Indicator analysis, on the other hand, involves using certain indicators to interpret the price movements. Some of the common indicators used are moving averages, moving average convergence/divergence, stochastic, and relative strength index.
Technical analysis is a great way to analyze the markets, that really has a lot of profit potential.
Fundamental analysis focuses on the businesses behind the stock. It is the process of examining the financial and economic factors that can affect the value of the stock, from the macro to the micro-level. This method tries to get an idea of what a stock is actually worth and the general state of the economy.
With fundamental analysis, an analyst will be looking at things like interest rate changes at the macroeconomic level and the effectiveness of the company’s management at the micro-level. The analyst will then go deeper to examine the attractiveness of the company’s products and services, as well as the robustness of its industry sector.
A fundamental analyst will ultimately go on to examine the company’s growth potentials by studying its earnings, sales, and revenues and how these key indicators have been growing from quarter to quarter and year to year. At this point, the analyst will study the company’s key financial ratios and how they compare with other companies in the industry sector.
Some of the important financial ratios include:
- Earnings per share (EPS): The amount of a company’s profit assigned to each share of the stock. It is calculated by dividing the total earnings (net profit less the dividends on preferred shares) with the total number of outstanding shares.
- Price to earnings ratio (P/E): The ratio of the stock’s price to its EPS.
- Projected earnings growth (PEG): The expected one-year earnings growth.
- Price to sales ratio (P/S): This compares the stock price to the company’s revenue.
The Difference Between Technical and Fundamental Analysis
Here is a table that will help to sort out the main differences!
|Focuses on the stock’s historical price and volume data||Focuses on the prevailing economic environment and the intrinsic value of the stock|
|Everything needed for the analysis — price and volume data — is on the chart||The analyst will need to search for the necessary information online — the company’s website, financial websites, and the websites of government agencies|
|Involves price action and indicator analysis||Focuses on the company’s management, earnings, and financial ratios|
How to Invest in Stocks
Although you know that investing in stocks is a great way to grow wealth, do you know how to go about it?
Follow these steps to learn how to play the stock market:
1. Know the Type of Investor You Want to Be
Depending on how actively involved in picking stocks you are, there are two approaches to stock investing. So you need to determine the type of investor you want to be:
- An active investor — the type of investor who wants to be actively involved in selecting the stocks to invest in
- A passive investor — the type of investor who just wants to provide the money while someone else handles the process for you: If this is who you’re, you may want to check out robo-advisor — a low-cost investment management service offered by many brokerage firms. Here, the broker simply invests your money based on your investment objectives. However, index funds still are great options for passive investments, and should not be ignored!
After you have decided how you want to invest, you will need to open an account:
2. Open an Investment Account
To invest in stocks, you’ll need to open an investment account. If you’re the active type, you’ll need a brokerage account. But if you prefer the passive approach, you’ll have to create a robo-advisor account. Continue reading to find out more.
For American, it may interest you to know that a 401(k) is an investment account, and if you’re into it, you may have been investing in stocks — probably stock mutual funds. But with a 401(k) you don’t have access to individual stocks, and you may have limited choices with mutual funds.
However, despite the limited investment options, employer contribution makes 401(k) a worthy investment to make. However, in addition to your 401(k), you may need to invest through other accounts.
The active Investing Approach: How to Open a Brokerage Account
It is easy and cheap to open an online brokerage account, which gives you access to any stock, funds, or other securities of choice. You can choose to open an individual retirement account (IRA) — which is tax-free. But if you’re already saving enough for retirement, you may want to open a taxable brokerage account.
To choose the right broker for your investment account, you will need to check several of them and evaluate them based on certain parameters:
- Security options: choose the one that has several options, including commission-free ETFs if you prefer funds
- Cost: compare their account fees and trading commissions
- Educational resources and tools: for training and research
The Passive Investing Approach
As mentioned, there are two major ways that you can invest passively in the stock market:
This type of account offers you the benefits of investing in stocks without having to do the tough work of researching the stocks to buy. You only to explain your investment objectives, and the service provider will build a portfolio that satisfies those objectives.
The most interesting thing about the robo-advisor services is that the management fees are usually cheaper than those of human portfolio managers. Most robo-advisors charge about 0.25% to 0.50% of the asset under management.
Still, index funds remain solid alternatives to the services that are offered by robo-advisors, so don’t rule them out! Index funds with low fees repeatedly manage to outperform most actively managed funds, and are excellent options for passive investor!
3. Choose Between Individual Stocks and Exchange-Traded Funds
If you’re taking the active approach, you need to choose between individual stocks and exchange-traded funds.
Individual stocks: You can buy the shares of one or more companies you think have the potentials to appreciate in price or that pay reasonable dividends if that’s what you desire. It is better to build a diversified portfolio of stock to minimize risks, but you will have to spend a significant amount to do that. When building your portfolio, avoid buying stocks of companies in the same industry sector to avoid correlation which would defeat your diversification aim.
Exchange-traded funds (ETFs): A great way to get a diversified portfolio of stocks is by investing in exchange-traded funds. These are baskets of stocks in one or several industries that are trading as a single unit. When the ETF is mirroring a stock index like the S&P 500 index, it is called an index fund. So ETFs and index funds are inherently diversified and, therefore, less risky. Although they may not perform as great as some individual stocks, they have always performed better than most fund managers.
4. Have a Budget for Your Investment in Stocks
As a new investor, you may be wondering what it will take to start investing and how to allocate your funds to various asset categories. You are not alone. In fact, most new investors have these two questions:
1. How much do I need to start investing in the stock market?
There’s no fixed amount to start investing in the stock market; you can start with what you have. Some brokers offer zero-minimum-deposit accounts provided you commit to saving a certain amount every month. Stocks trade at different prices, so what you spend buying an individual stock depend on how much the stock is trading at.
On the other hand, most mutual funds require a $1, 000 or more minimum deposit. So if you want a diversified portfolio but have a small budget, it’s better to buy an ETF because it trades like a stock. You can buy a few shares of an ETF for a couple of dollars.
2. How do I allocate my money to different asset classes?
This depends on your age, your risk appetite, and your investment objectives. Let’s say you’re 28 years old, and you’re investing for retirement, you can allocate 80% of your funds to stocks (ETFs preferably) and invest the remaining 20% in some fixed-income assets. But if you’re 70 years old and want a stable income, you can do the reverse — 80% in fixed-income securities and 20% in stocks.
5. Begin to Invest
After getting all you need to invest, you just have to save the money and start investing. If you want, you can commit to saving a certain amount every month and putting it in your investment account. Although investing might appear difficult, it’s very simple if you stick to the basics. Simply buying a low-cost S&P 500 index fund and holding it for a long time might be one of the best investment decisions of your life.
Stock Market Tips for Traders and Investors
Playing the stock market as a trader or an investor can be highly rewarding if you know the rules of the game and play by them. The market can also be highly unforgiving to the reckless ones.
Here are some tips that will make your trading or investing journey a successful one:
1. Learn the Common Market Jargons
You must have noticed that the stock market has a lot of unique terms and acronyms, such as bulls, bears, EPS, P/E, and others. It is very important you get familiar with those market jargons so that you can flow with the market news and analysis.
Have a look at our financial glossary, where we give explanations to the most common words and expressions!
2. Start with Paper Trading
To succeed in the stock market as an active player, you need to practice a lot to master your analysis skills. Paper trading is a great way to practice your analysis, trading, and portfolio management skills, without investing your own money.
Paper trading entails making trades in a simulated environment, so you can practice your investing or trading strategies without risking real money. It gives you the opportunity to prove to yourself that you can actually do it before going to do it on a live account. It’s advisable to practice for more at least six months before going live.
3. Create a Watchlist
As you horn your skills with paper trading, you will make a list of the stocks that meet your trading criteria. Whether your style is active trading or long-term investing, you need to research stocks and make a list of the one that fit your strategy.
Some people’s strategy might require trading stock with higher volatility, while some others would be less volatile stocks. Know yours and create a list of about 30 to 40 stocks to pick from.
4. Get the Right Broker
The broker you open your account with can determine how successful your stock market adventure is going to be. The account fees and trading commissions have a way of affecting profitability, especially for a small account.
Online brokers may offer cheaper services, but there are many of them out there. You will have to do a lot of comparisons to pick the one that suits you best.
5. Start Small and Grow
When you’re about to transition from paper trading to investing real money, it’s advisable you test the waters with a small amount first. Buy a couple of shares with a few hundred bucks and see how it feels. See if you can implement the strategies you have practiced in paper trading without making mistakes. When you get used to the emotions, you can increase your account size.
6. Don’t Be in a Haste to Make Money
Don’t mind what they tell you and the flashy ads you see on the screen; the truth is, it takes time to make money in the stock market. The desire for quick returns and instant gratification has cost some people their investment capital and pushed them out of the game.
7. Protect Your Capital
Warren Buffet once said, “The first rule of investing in the stock market is to protect your capital, and the second rule is never to forget the first.” These two rules must always be at the back of your mind when playing the game of trading because if you lose your capital, you will be out of the game.
Just know this: A fifty percent loss in your capital would require a hundred percent profit to breakeven!
8. Avoid Using Leverage
Leverage is a double-edged sword. While it can help you increase profits, it can also magnify your losses. In fact, using leverage is one of the fastest ways to rundown your investment capital. And it doesn’t end there, you may even end up owing your broker. Nobody likes to get that call from the broker!
Don’t use leverage at the beginning of your trading career! You will make a lot of mistakes, and it is best if those don’t cost you too much money!
9. Know Your Risk Tolerance and Develop Mental Toughness
We all have different risk appetites. It’s necessary that you know what you can and can’t handle.
Make sure your trading/investing strategy is in accordance with your risk tolerance — your stop loss level, for example. This way, it becomes easy to develop mental toughness, and you will be able to execute your trades without fear or greed.
10. Don’t Get Emotionally Attached to a Stock
Remember why you came to the stock market — to make money. So you should put your feelings out of the way. Don’t buy a stock because you like the company or use their product, instead, buy a stock because it meets your investing criteria, and your analysis shows that it’s going to appreciate.
11. Think Long Term
Building wealth through the stock market is a journey, so you need to be on the right path for as long as it takes. It pays to have a long-term outlook. There will be bull markets and bear markets, and your investment accounts will fluctuate at times.
This doesn’t mean you aren’t making progress. Once you’re effectively implementing your strategies, just be patient, wealth will come with time.
12. Diversify Your Portfolio
There’s an old adage that says, “Never put all your eggs in one basket.”
This is very much true in the stock market: you must create a diversified portfolio to reduce your risk exposure. The easiest way to have a diversified portfolio is by buying index funds or ETFs.
13. Treat It Like a Business
It is very necessary you treat investing or trading like a business because there’s money involved — your money is on the line.
Put in the effort, get the right training, and develop a good business plan for your investment. What is your plan for your dividends — reinvest it? What happens when you sell a stock?
14. Keep a Journal
It is important you keep a trading journal where you record all your trades. From time to time, go through the journal to study your previous trades and see where you made mistakes. Studying those mistakes and learning how to avoid them in the future is the key to succeeding in this game.
15. Don’t Ever Stop Learning
In the stock market game, you need to always be up to date with the latest news and trends in the market. A reading culture is a must. You can make it easier by subscribing to an online financial service that will promptly send you newsletters about the latest happenings in the market.
People who became rich by playing the stock market
Let’s round off this article with a few examples of people who have actually made money from stocks!
Many people in different parts of the world have made fortunes investing in stocks. Here are examples of people who learned how to play the stock market and became rich through it:
Klaus Hommels is a Swiss investor and the founder of Lakestar, a Zurich-based firm with offices in London, New York, Hong Kong, and Berlin. The company invests in young internet companies in different parts of the world, especially Europe, America, and Asia.
He started his career at Bertelsmann and later moved to AOL Germany, where he worked as a managing director in business development from 1995 to 1999. From there, he moved to Apax Partners in Munich, where he worked till 2000 before starting out as a private investor. Klaus obtained a Master of Science in Business Administration from the University of Fribourg, Switzerland. He also got a Ph.D. in Finance from the same university.
During the dotcom bubble burst, Klaus went solo and took interest in the stock market, investing for himself for the next six years. His investment interest was mostly on internet companies. After six years as a private investor, he worked briefly with Balderton Capital (then Benchmark Capital) in London as a venture partner before setting up his first firm, Hommels Holding.
Hommels likes to spot and invest in young internet companies early, and he has found amazing success with Skype, Xing, and Adjug. He is also heavily invested in the likes of Facebook, Spotify, King, Woo Media, Stardoll, and Klarna. In 2012, he founded Lakestar, a venture capital firm with interest in tech entrepreneurs.
In 2006, he was declared Europe’s most successful entrepreneurial private investor by leading European business schools INSEAD, the University of St. Gallen, and IESE. He was ranked as one of the top European venture capital investors in the global Midas List for 2013, 2014, and 2015. He’s also seen as one of the best European investors at the moment.
Paul Glandorf is a retired businessman who took an interest in the stock market in his early sixties. He was a pipe fitter by profession and created a successful construction business in Cincinnati, Ohio. So he never had time to learn about stocks.
But as he got closer to retirement, he became more interested in how his retirement funds were being managed. At a time, he believed he could do better than most of those managing his money. After turning 60, he took over the management of his funds and started trading his personal account in 2001.
According to the man, he combines fundamental and technical analysis in picking the stocks to invest in and when to buy or sell the stocks. He loves aggressive growth stocks. He would normally select a portfolio of about 75 to 80 stocks and invests about $10,000 in each stock. On many occasions, he was making up to 50% annual returns.
Generally, 80% of his stock picks make money while about 20% lose money, except in 2007 when he stayed out of the market. But even that year, Glandorf made about 50% return from his initial short positions.
In 2013, he took part in an investing competition where you buy five stocks in on January 1 and hold them till the end of the year. Four of his picks (LinkedIn, Fidelity National, Valeant Pharmaceuticals, and 3D Systems) did very well, but one, Lululemon, lost money. His portfolio made a staggering 71% return by the end of the year, and he finished second in the competition.
He started a stock club in the early years of his investing adventure, and they were meeting at the pipe fitters’ training school in Cincinnati. They call the club the Stock Wizards, and they now meet at Sycamore Senior Center.
As you can see, it’s possible to learn how to play the stock market, but you must put in some effort.
We hope you’ve learned the basics about investing in the stock market and from this guide.
If you are interested in trading and in particular automated trading, why not have a look around our site? For example, have a look at our edge page where we have gathered edges and strategies for various markets!