What Are Stocks and Why Should You Invest in the Stock Market?

Table of Contents

  1. What is a stock?
  2. Why do companies sell the stock and we buy the stock?
  3. What is an IPO?
  4. How does an IPO work?
  5. How is the stock price decided during the IPO?
  6. How do you decide if the stock is worth buying?
  7. How long should you hold onto your stocks?
  8. What causes stock market fluctuations? 
  9. But, what’s the difference between regular market fluctuations and a troublesome stock?
  10. What are dividends? Why do companies issue them?
  11. So, What are Nasdaq, NYSE, AMEX, and the Chicago Mercantile Exchange?
  12. Let’s decode the meaning of “stock split”?
  13. What’s a buyback?
  14. A company’s stock or bonds? Which one’s safer?
  15. How are mutual funds different from exchange-traded funds?
  16. Should you invest in funds or stocks?

Investing might seem exciting and tricky at the same time. Hundreds and thousands of acronyms, charts, technical terms, numbers, and market fluctuations can make it seem risky and daunting!

Mellody Hobson, co-CEO of Ariel Investments and the chairwoman of Starbucks Corporation, says that “The biggest risk of all is not taking one". To secure your financial future, you have to take risks and learn to manage them right. These risks can certainly be minimized with your knowledge and access to the right tools. 

When you invest, you are essentially paying for a day off from work. It could mean a laidback retirement and extra time to do what you love. Starting stock market investment is a no-brainer. Let us get into the fundamental aspects of the stock market investment.

What is a stock?

A stock is a security that is a part of the ownership of a corporation. It is also known as equity. When you own stock, you are entitled to a share of the company's assets and profits. Units of stock are called shares.

The value of your share is influenced by the well-being of the company in addition to how investors perceive the company. So, when you purchase stock, you have the chance of either earning profits or incurring a loss depending on the company’s performance and several other factors.

Why do companies sell the stock, and we buy the stock?

For investors, stocks are one of the top ways to build wealth. For companies, stocks are a way to raise funds to invest in their financial growth, expansion, products or services, and other initiatives. 

What is an IPO?

Initial Public Offering (IPO) is the process of issuing shares to the public through the stock market by a company. This is the first step taken by a company that decides to go ‘public’.

An IPO is an important step for a corporation as it offers the company access to raise plenty of funds. This gives the company a greater potential to grow and expand and improve its credibility. 

How does an IPO work?

Typically, a company to be eligible to go public has to reach a specific stage of growth.  At this stage, the companies require taking a set of steps to meet specific public share offering requirements.  with the help of an investment bank, the company gets its valuation done. The company is evaluated based on certain criteria including its historic and projected revenues, costs, market competition, and its proven profitability potential. 

Post that, the company will issue the shares to the public based on the bank’s advice and the board’s decision. To ensure the owners are in control, typically the company keeps over half of the shares.

How is the stock price decided during the IPO?

The investment bank determines the price of each share depending on the number of shares it advises for the public. However, during the valuation process, the public demand for the company’s IPO is also taken into account. The higher the demand for the company’s products or services, the higher will be the price of its stock. So,  In a way, you are partially responsible for the stock price. 

How do you decide if the stock is worth buying?

Many investors often make their purchase decision based on the recommendations given by a friend or online articles. Oklahoma-based Certified Financial Planner Shanda Sullivan says that this only leads to one making emotional decisions rather than rational ones. She instead recommends sticking with target-date funds, low-cost index funds, or Exchange-traded funds (ETFs) to mitigate your investment risks.

Also, consider evaluating a few other factors like the trend in the earnings by the company, its growth relative to its competitors, its performance history, debt-to-equity ratio, revenue, and long-term stability before making your final purchase decision.

How long should you hold onto your stocks?

This is one of the common questions that you may ask yourself as an investor. Ideally, the length of your investment depends on your investment type, your target, and your strategies.

Vid Ponnapalli, a Certified Financial Planner and founder of Holmdel, believes in going back to square one if the price of the stock you’ve held has been sinking. He recommends following the decision-making process similar to buying the stock. That is to investigate the company’s revenue, profits, and to measure the leadership effectiveness. “After your analysis, if you still believe that the fundamentals you liked when you bought the stock are the same, you don't have to sell,” he says.

However, when the stock is trading at a lower price, it might be a good opportunity to buy more stock, he suggests.

What causes stock market fluctuations? 

Sometimes it can be daunting to see the prices of your stocks constantly moving up and down. These fluctuations are quite common and you don't have to worry much about them.

Apart from the supply and demand in the market, the stock market fluctuations are influenced by a lot of factors from weather conditions to economic factors to fiscal policy, and political developments. 

But, what’s the difference between regular market fluctuations and a troublesome stock?

To predict a stock’s potential growth, compare its performance to an appropriate benchmark.  For instance, if on a particular day, there’s a drop in Standard & Poor’s 500-stock index, you can expect the price of a large-company stock you own to decline.

Ponnapalli says “When you start investing, you are not investing for daily movements.” He advises one to opt for long-term investments rather than short-term.

Remember that the regular market fluctuations are also influenced by news related to political elections, international or national affairs that affect the public substantially.

What are dividends? Why do companies issue them?

Some companies offer their earnings to the shareholders in the form of dividends. They are typically paid in various forms like cash or stocks. A company’s board of directors decides all the components of the dividends including how much you should get and when you should get.

Most big and stable companies issue dividends, indicating that they are capable of generating wealth and spreading funds. So, if a company has a steady history of offering dividends it could be considered as a financially fit and potential company, thus attracting more investors.

Having stated that, it doesn't mean that the companies who don't issue regular dividends are not financially thriving. You might see that many startups or other organizations do not pay dividends. That could be because they might focus on investing their earnings to further grow and expand their businesses.

So, What are Nasdaq, NYSE, AMEX, and the Chicago Mercantile Exchange?

There are two main US stock exchanges and they are Nasdaq (National Association of Securities Dealers) and the New York Stock Exchange or the NYSE. Unlike other stock exchanges, Nasdaq does not operate on the floor. The trading happens online. On the other hand, the NYSE operates on a physical floor with registered traders. It is considered to be the largest American stock exchange by volume.

The AMEX (American Stock Exchange)  is a smaller stock exchange when compared to the NYSE. It mostly attracts the smaller companies that cannot conform to the NYSE’s listing and reporting requirements. 

The Chicago Mercantile Exchange is considered the largest American stock exchange for trading futures and options.  Futures and options are contracts to buy (or sell) an asset or a commodity at a specified price and a future date. Unlike the futures, the Options give you ‘the right’, but not ‘the obligation’, to buy (or sell) an asset at a fixed price and date. 

Let’s decode the meaning of stock split

A stock split is a process in which the companies split the outstanding shares thereby increasing the number of outstanding shares. During the stock split, although the price of each share decreases the market value of the company remains the same. For example, if a company whose stock value is $200 a share executes a 2-for-1 stock split,  the outstanding shares available are doubled and the value of the stock drops to $100 per share. 

Essentially a company does a stock split to make it affordable and accessible for more people to invest in its stock. And, if more people buy the stock at a lower price, the value of the stock would further increase.

What’s a buyback?

A buyback is a process in which a company buys back its stock from the shareholders, usually at a price higher than the prevailing price of the stock in the market. Companies typically buy back the shares to invest in their growth and expansion. During the buyback, the number of shares available in the market dips enabling the companies to hold a greater proportion of the stock. The company might also choose to buy back its stock to raise its value whenever it feels that it is undervalued in the market. But it could also be a strategy exerted by the company to appear more worthy than the current market value.

A company’s stock or bonds? Which is safer?

A company’s stock price could either soar significantly or drop depending on various factors. But when you invest in a company’s bonds, it’s more like a loan you offer the company for which it promises to pay you back with a fixed interest. As long as the company doesn't go bankrupt, bonds are a relatively safer investment.

Check out the risk ratings and assessment tool on Moody’s and Standard & Poor’s to evaluate a company’s bonds before you invest.  

How are mutual funds different from exchange-traded funds?

Most ETFs track indexes, and are mostly managed passively. Mutual funds, on the other hand, are usually managed actively. The ETFs typically levy lower fees than mutual funds. 

EFTs are traded like regular stock at different prices throughout the day. The prices of Mutual funds are calculated based on their net asset value (NAV) and can be bought only at the end of the trading day. NAV is calculated by dividing the sum of the values of all the securities in the fund ( the price at the end of the trading day) minus any debts or obligations the fund has - by the number of outstanding shares.

Should you invest in funds or stocks?

Ponnapalli quotes “Single-stock investing is risky and does not provide diversification”. That’s because when you bet all your money on one stock you take a great risk of losing your money if the value of that stock drops and doesn't recover at the time you want to sell. A well-diversified portfolio helps you earn profits efficiently, but it would require you to work hard! 

The mutual funds and EFTs are managed by the fund managers who make investing easier for you. They do most of the hard work for you by putting together a portfolio of hundreds of different stocks for you to have a diversified portfolio with just one investment. 

Target-date funds, also known as age-based funds, are designed to offer you a simple and diversified investment solution. They are a combination of various types of stocks, bonds, and other investments where you choose the year you expect to reach your target earnings (typically your retirement year). Then the fund managers build a suitable portfolio for you, making adjustments when necessary as the deadline approaches. 

They are an easier approach to investment where all you need to do is just choose the right risk tolerance.

Remember you pay the taxes on your stocks only if you sell them but not if you are holding them. The tax is levied only on the profit you make by selling the stocks and this tax is called ‘the capital gains tax’.