You’ve likely heard since your first job that saving for retirement is crucial. Investing in the stock market is often recommended as a primary method to achieve this goal. While headlines about market volatility might seem daunting, understanding the stock market can empower you to build a secure financial future.
Even though stock prices fluctuate daily, historically, the overall market trend is upward. Stocks generally outperform investments like bonds and savings accounts over the long term. This makes them a viable option for those with a longer investment timeline before retirement.
The stock market and its terminology can be overwhelming. This guide provides the essential information you need to understand the stock market, enabling you to confidently begin investing and build your retirement nest egg.
What is the Stock Market?
The stock market is where companies sell shares of their stock – representing a piece of ownership in the business – to investors. This process allows companies to raise capital without incurring debt.
Company stocks are traded on exchanges. The New York Stock Exchange (NYSE) is the largest, listing corporations like Citigroup, Nike, and Walt Disney. NASDAQ is the second largest, primarily featuring technology companies, including Apple and Facebook.
When you hear news about the market “going up” or “down,” it usually refers to a market index. A market index tracks the performance of a select group of stocks. Two major indexes are the Dow Jones Industrial Average, which tracks 30 large U.S. companies, and the S&P 500, which follows 500 companies. Investors use these indexes to gauge the overall health and performance of different market segments. Many investments use an index as a benchmark against which to measure their own performance.
The New York Stock Exchange (NYSE) is the world’s largest stock exchange by market capitalization.
What is a Share?
A share represents a single unit of ownership in a company. If you invest $500 in a stock trading at $10 per share, you own 50 shares of that company.
As a shareholder, you have the right to vote on important company issues, such as electing directors to the board. Typically, each share equals one vote, although some companies have multiple share classes with differing voting rights.
How Does the Stock Market Work?
When you place an order to buy or sell stock through a broker or online trading platform, you’re generally buying or selling from other investors. If a stock is traded on the New York Stock Exchange, your order is routed to the trading floor. However, a significant and growing portion of trading is now conducted electronically. Intermediaries match “bid” and “ask” prices: the bid is the highest price a buyer is willing to pay, and the ask is the lowest price a seller is willing to accept. Once a match occurs, the transaction is completed.
What Factors Affect Stock Prices?
The principle of supply and demand is the primary driver. High demand for a stock drives up its price, incentivizing current shareholders to sell for a profit. Conversely, if many investors want to sell a stock and buyers are scarce, the price will decline.
Numerous factors can influence demand. Positive news, such as better-than-expected earnings reports or increased favor for the company’s industry, can attract buyers. Negative news, such as significant losses or an economic downturn, can prompt sellers to divest their shares. Sometimes, investors simply choose to realize their profits.
Stock prices are affected by supply and demand, news, economic factors, and investor sentiment.
How Does Investing Work?
Investing in strong companies can lead to increased stock value over time. When you sell your shares, the difference between your original purchase price and the selling price represents your gain (or loss). Remember that you may be subject to capital gains tax on any profits.
Another way to generate income from stocks is through dividends. Established companies often distribute a portion of their earnings to shareholders as dividends. For instance, if a company pays an annual dividend of $3 per share and you own 50 shares, you would receive $150 in dividends for the year.
Dividend income is also taxable. Most dividends are considered “qualified” and are taxed at capital gains rates, which are typically lower than regular income tax rates, depending on your income bracket. Other dividends, known as “ordinary” or “unqualified,” are taxed at the same rate as your earned income.
What is a Mutual Fund?
Many individual investors lack the resources to invest in a wide variety of companies. Mutual funds provide an accessible solution.
A mutual fund pools money from multiple investors to purchase stocks, bonds, or other securities. A fund manager makes decisions about which securities to buy and sell within the fund. Diversification is a key advantage of mutual funds. If some stocks within the fund decline in value, these losses may be offset by gains from other holdings.
Mutual funds are not traded on exchanges and can only be bought or sold once per day after the market closes.
What are Index Funds?
Index funds are a type of mutual fund designed to mirror the performance of a specific market index by holding securities similar to those in the index. Funds exist to track various indexes, such as the S&P 500 for large companies or the Russell 2000 for small companies.
Index funds charge an annual fee, known as an expense ratio, to cover management and operational costs. Because index funds passively track an index, meaning there’s no active research and stock picking by a fund manager, their expense ratios are typically low.
What is a Target-Date Fund?
Target-date funds, common in workplace retirement plans, are designed for investors who prefer a hands-off approach to investing.
You simply select a fund with a target year that aligns with your expected retirement date (e.g., Retirement 2050 or 2060). The fund manager will invest your money more aggressively when you are younger and gradually transition to a more conservative portfolio as you approach retirement.
What is an Exchange-Traded Fund?
Exchange-Traded Funds (ETFs) combine characteristics of index funds and individual stocks. Like index funds, they typically invest in a basket of securities designed to mirror an index. However, like individual stocks, they are listed on an exchange and can be traded throughout the day.
ETFs often have lower annual fees than other mutual funds, including index funds. However, you may incur a commission each time you trade an ETF.
What are Bonds?
Bonds are essentially IOUs. You lend money to a company or government, and in return, you receive your original investment plus interest when the bond matures at a predetermined future date.
The risk associated with bonds varies. Higher-risk bonds offer higher interest rates to compensate investors for the increased possibility of default. Rating agencies assess the creditworthiness of bond issuers to guide investors.
Investing in a bond fund differs from buying individual bonds. Bond funds may hold bonds from hundreds of issuers and sell them before their maturity dates. Unlike individual bonds held to maturity, bond funds do not guarantee the return of your original investment.
Why Should I Invest in the Stock Market?
If you’re investing for the long term, such as for retirement decades away, stocks are a suitable choice. Historically, stocks have outperformed other traditional investments. The average annual return of the stock market, as measured by the S&P 500 index, is around 10%. This exceeds the returns on bonds and interest-bearing bank accounts.
However, stocks are inherently riskier and subject to short-term price volatility. This makes them best suited for younger investors with ample time to recover from market fluctuations. As investors approach retirement, it’s generally recommended to shift some assets from stocks to more stable investments. However, even retirees typically maintain some stock holdings to hedge against inflation.
How Do I Get Started in the Stock Market?
The simplest way to begin investing is through workplace retirement plans, such as a 401(k). These plans typically offer a variety of stock and bond mutual funds.
If you want to buy individual stocks or mutual funds outside of a retirement plan, you’ll need to open a brokerage account. This can be done online. (Compare fees, as some online firms offer no account minimums or trading commissions.) Once you’ve funded your account, you can begin investing. It’s important to understand the tax implications of regular brokerage accounts versus tax-deferred retirement plans. Consult a tax advisor to determine the best strategy for your individual financial situation.
Researching and understanding companies is key to making informed investment decisions.
How Do I Find Good Companies to Invest In?
Before investing in any company, conduct thorough research. Start by identifying publicly traded companies whose products or services you admire. A loyal customer base often indicates a strong company. Look for companies with a competitive advantage and a history of consistent earnings growth.
Review information on the company’s website, as well as news coverage in the financial press. You can also access a public company’s annual report (known as a 10-K) on SEC.gov. Brokerage firms often provide analysts’ reports on stocks. You can research the performance of mutual funds on Morningstar.com.
Be cautious of “hot” stock tips that seem too good to be true.
Ensure your overall stock portfolio is well-diversified across various companies in different sectors. Over-concentration in a single stock or sector can expose your portfolio to significant risk if that stock or sector declines.
Consider consulting a financial advisor who can recommend suitable stocks or mutual funds based on your individual needs and risk tolerance.
Where Can I Find More Information About Investing?
Numerous online resources can help new investors. This includes resources with information about the right mix of stocks and bonds based on your age, and how to manage your portfolio and investment options.
Starting to invest in the stock market can seem challenging, but with the right knowledge and approach, it can be a powerful tool for building long-term financial security. Remember to do your research, diversify your investments, and seek professional advice when needed.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. Consult with a qualified financial advisor before making any investment decisions. Everyone’s financial situation is different.
