The Basics of Stock Market Investing

Considering investing in the stock market? With some basic information and helpful tips and tricks, you will be a stock market pro in no time.

Stocks are a type of investment that represents ownership in a company. In other words, when you own a stock issued by a particular company, you own a portion-or a share-of that company. That's why stocks are often referred to as shares, and why owners of stocks are often referred to as shareholders.

How much ownership do you have? Let's say a company has issued 1,000,000 stocks. If you were to buy 100,000 stocks of that company, you would own 10% of the company. But if you only bought one stock, you would only own 1/1-millionth of that company. Generally speaking, people who invest in stocks are interested in trying to increase the value of their investment as aggressively as possible or to accumulate a significant amount of money for a long-term goal.

Stocks can also be used to take control of a company, either through a buyout or a hostile takeover. In this situation, another company attempts to purchase 50.1% of the available stocks of a company to gain a majority voting position on the company's board of directors. These events make great headlines, but unless you're very wealthy or the CEO of a Fortune 500 company, chances are you're using stocks to build wealth for the future.

Characteristics of stocks
One of the basics of stock market investing is that greater short-term risk has the potential for greater long-term rewards. For example, money markets are typically associated with the least potential for investment risk, or the chance that price swings will cause your investment to lose value. As a result, money markets are also likely to provide the lowest long-term returns.

Stocks are on the opposite end of the risk/return spectrum. Stocks generally pose the greatest risk of short-term price volatility and loss, yet stocks have historically provided the highest long-term average annual returns. Bonds are in the middle: They're typically less risky than stocks and generate lower returns than stocks, but bonds are riskier and more likely to generate better returns than money markets.

Stocks are often the investment of choice for two types of investors: Those willing to take a big risk in return for a potentially big short-term return, and those willing to tolerate short-term price swings while they pursue important investment goals that are still many years away.

Types of stocks
Just as there are many different types of companies, there are many different types of stocks. Stocks are often categorized according to the following descriptions:

  • Growth stocks and value stocks. Growth stocks are the stocks of companies that have generally performed well in the past and which are expected to continue producing strong earnings and investment returns in the future. Value stocks are the stocks of companies that may be underpriced by the market, such as companies that have not yet been discovered or those recovering from past problems.
  • Small-, mid-, and large-cap stocks. The size of a company is determined by its overall stock market value. Another term for overall stock market value is market capitalization, or market cap for short. Stocks issued by relatively small companies are called small-cap stocks. Mid-cap stocks are those issued by medium-sized companies, and large-cap stocks represent ownership in the stock market's biggest companies.

As a general rule, investments in large-cap and growth stocks tend to be less risky, while investments in small-cap and value stocks typically carry more risk. This is because a large, diversified company with a solid track record is more likely to weather rough economic times than a small company that is struggling to generate profits.

Investing in stocks
There are two ways to invest in stocks: by purchasing individual shares on your own or by investing in mutual funds that invest in stocks. If you're thinking about assembling an asset allocation of individual stocks, consider working with a financial professional who can help you make well-informed decisions.

Mutual funds, on the other hand, make it possible for individuals to invest in a well-diversified mix of stocks with just a single investment. Technically speaking, when you invest in a stock mutual fund, you own shares of the mutual fund itself, not shares of company stocks. The fund is the owner of the company stocks. Each mutual fund's managers pool the combined assets of the fund investors and use that money to assemble a portfolio of stocks. The value of your investment in the fund is determined by the performance of the stocks owned by the fund. If the stocks in the fund generally increase in value, then the value of the fund-and your shares in the fund-can be expected to increase.

You'll find mutual funds targeted to the different types of stocks available. Some funds invest exclusively in large-cap growth stocks, while others focus on small- or mid-cap stocks with an eye toward higher annual returns. Risk varies among stock mutual funds, so it's important to read the prospectus for any fund you're considering so that you're comfortable with the potential risks and returns.

One of the easiest ways to invest in stocks is to choose an index fund. These mutual funds buy stocks that are listed on a major index, such as the Dow Jones Industrial Average or the S&P 500. The goal of stock index funds is to mirror the annual returns of the index it invests in.

Stocks in a diversified portfolio
Choosing investments among stocks, bonds and money markets for your portfolio isn't an all-or-nothing proposition. Not only is it possible to simultaneously own a mix of stocks, bonds and money markets, it may even be a good idea, because owning a mix of different investments can be an effective strategy for managing overall investment risk in your portfolio.

For example, owning stocks and bonds simultaneously could help to limit your losses if either market experienced a downturn. Theoretically, gains in the other market could offset those negative returns.

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