5 Steps to Understanding the Stock Market

In today’s high tech connected world, it’s now easier than ever to invest.

The digital revolution of the past 20 years allows the intrepid individual to take risks in the stock market with the potential for a big payout. The point of this guide is to give some basic knowledge and tips to newbie investors without all the technical Wall Street jargon that makes the stock market seem impenetrable to the average person. The basic overview of this guide is as follows:

  1. Why Invest?
  2. How the Stock Market Works
  3. Deciding What To Invest In
  4. Funding Your Investments
  5. Continuing Your Investments

Learning how to invest properly can be compared to an art, it takes a lot of practice and some people have a natural talent for it.

1.Why Invest?

Consider a life without investing first. You go to your 9-5 for about 40 years, buy a house, new car, and maybe have a few kids. As you get older and become more unattractive for hiring, since you did not invest, you subsist on a paltry social security fund for the rest of your life. Even though you made decent money while younger, you don’t really have anything to show for it in older age.

Imagine again that you did save money for retirement, but it was not invested. Say you were extremely diligent and able to save £2,000 a month for 30 years. That comes out to a total of just over £700,000 to live on. With a £70k a year lifestyle, you would only last about 10 years before you ran out of money. Even if you have been a great saver all your life, you can still go broke easily.

Let’s see what happens when we put some investment in the situation. Say you saved £2000 a month but you continuously invested this money into stock markets. Imagine further that you only got a 7% return on these investments per year (that’s the worst-case scenario, the average annual return is 10%). At this rate, you would accrue over £16 million over 30 years.

Now that you have a huge lump sum of money and assuming a lower 3% return on your investments, you can rake in almost £100k a year without taking any out of your savings!

The name of the game here is compound interest. Compound interest is what allows you to accrue and maintain wealth over time. Compound interest allows your investment income to grow exponentially, by increasing the amount that is invested every fiscal year and reaping the dividends. As the amount you invest increases each year, the percentage return on those ever-growing investments gets ever larger.

The “Magic” Of Compound Interest.

The best part is that compound interest is not some extra complicated concept or a get rich quick scheme; it is a relatively simple and time-tested concept with a very simple mathematical equation.

Compound interest is the way that some of the world’s richest people (Warren Buffett, Bill Gates) achieved their vast fortunes. There is a reason that, when asked what force in the universe is the strongest, Albert Einstein replied: “compound interest” (Note: Einstein probably didn’t actually say this, but it’s good financial advice nonetheless!).

So if compound interest is the reason to invest, let’s talk a bit more about how investing and the stock market works.

2. How the stock market works

To be frank, Hollywood has painted a very inaccurate picture of how the stock market works. The common perception is that stock markets are full of Jordan Belfort types (from The Wolf of Wall Street) with a giant Scrooge McDuck pile of riches to swim in. The market is depicted as the ultimate theme park ride and entire fortunes are made and lost in singular instants.

Sure, there are ups and downs in the market, and you can lose a lot of money if you make a seriously wrong call, but most investors take long-term boring and safe strategies for investing. They take these investments because they understand how stock markets actually work.

Let’s start with the basics. A stock market is a place where people buy and sell investments, most often in the form of stocks—shares of ownership in a public company. There are several different stock markets around the world, the Standard & Poor 500 (S&P 500) and the Dow Jones being the most well known, and each of which index the performance of a certain section of the stock market.

What Is A ‘Stock’?

The basic concept behind stocks is pretty simple. Stock markets allow you to buy shares of a company. Investors buy these shares, which raises money for the company to grow the business to make a profit. As the value of the company grows, the value of individual stocks grows as well. Investors can then buy and sell the shares they have based on market performance. The goal is to buy and sell stocks to make a profit.

Here is a simple example. Say company A is initially selling stock at £10 per share. As more people buy shares, the company gets more money, which they put towards increased performance. After a year, the company’s total value may have grown and each share is now worth £15. If you bought 100 shares at £10 each (£1000 total) after a year your total investment would be worth £1,500, a profit of £500.

The best part is that you don’t have to do anything to get this profit; all you had to do was invest, sit back, and watch your investment grow.

Through history, stock markets have been physical marketplaces, though nowadays it mostly works electronically through the internet. Stockbrokers are companies and individuals that facilitate the buying and selling of individual stocks.

3. Deciding what to invest in

One of the major reasons people invest is to fund their retirement. In general, there are three major kinds of investments you can buy and sell lin stock markets.

  • Stocks: Publically traded companies sell stock to investors which grants them a portion of ownership of the company. Many companies pay investors dividends (percentage of companies earnings) to these owners.
  • Bonds: A bond can be thought of as giving a company a loan. You buy a bond and the company agrees to pay you back in a set amount of time with interest. Bonds do not give partial ownership of the company.
  • Mutual funds: Mutual funds are a shared investment between you and several other investors to buy stocks, bonds, and other kinds of investments. Mutual funds let investors pool their resources together.

The three major different kinds of investments carry different levels of risk and reward. Stocks, in general, carry the highest risk, but also tend to have the highest payout. Bonds, on the other hand, have relatively low risk but a lower reward. Mutual funds can be either high risk or low risk, depending on where you choose to invest your funds.

Speaking of where to invest your funds, remember the old proverb “don’t put your eggs all in one basket.”

Diversifying your funds means investing in several different stocks and bonds that cover multiple industries. Diversifying your investment portfolio is extremely important and minimizes the amount of risk you take on. Dumping all your money into one particular company or industry runs the risk of you getting hit hard on your investments if the company fails or the industry has a bad fiscal year. It is better to spread your investments so you won’t lose everything if some of your investments take a dive.

4. Funding your investments

All investments require initial funding in the form of money. It is a truism that you can’t get something from nothing, so if you want to get something out of the stock market, you have to put capital in.

There are a few options in how you can approach investing. You could go it solo, open your own investment portfolio on an online stock brokerage, and micromanage all your investments. Most online brokerages have a minimum investment amount you need to get started.

Alternatively, if you don’t feel comfortable managing your assets yourself, you can hire a financial advisor to help you out.  Financial advisors handle all of your investments based on your goals and normally take a percentage of dividends as payment.

There is also the relatively new option of robo-advising. A robo-advisor is an artificial intelligence that manages your money for you. Robo-advisors utilize sophisticated algorithms that are based on cutting edge economic science to automatically buy and sell stock in line with your set preferences. Robo-advisors lack the personal touch of a human advisor, but they tend to have very low minimum investments and low fees. For example, Betterment does not have a minimum investment amount and only charges 0.25% of your investments. Robo-advisors are a great idea if you want to start small and have some spare change to toss around the stock market.

To read more about the intricacies of robo-advising, click here.

5. Continuing your investments

Remember how we talked about compound interest way back in section 1? This is where it comes to the forefront. Once you have your portfolio set and have made a few initial investments, the goal is to accrue any dividends and continually invest more and more.

Slowly increasing the amount of your investments bit by bit lets your wealth grow exponentially, as each investment period you get a larger percentage of a large amount of money. Several brokerages and robo-advisors give you the option to automatically increase your investments every month. That way you know your accounts are continually growing every month, even if it’s just by a little bit.

Also, let’s talk about what to do if you find some of your investments not doing so hot. Many people’s initial reaction to a falling stock is to sell, sell, sell. Many investors panic when they see their stocks drop and quickly try to jump off the train, so to speak.

While this might seem like common sense, common sense if often not sensical in the slightest.

Stocks, in most circumstances, are meant to be a long-term investment. It is true that the market fluctuates over time, and some financial periods you may incur a loss. However, wherever there is a valley, there is also a mountain. When stock dips, it will recover again. That’s why it is important to wait out the storm and not sell your investments if you see signs of falling stocks.

The famous financial guru Dave Ramsey once said: “The only people who get hurt during a roller coaster are the ones that jump off.” Once you gain some confidence and conviction in your investments, it will be much easier to stave off the impulse to sell in the case of a market drop.

In fact, for the savvy investor, market drops can be a good thing. Falling stock means more people are willing to sell for cheaper, which means you could potentially pick up more stock for cheap and compound those gains when the market bounces back.

The main thing to remember is to have patience with your investments and give them time to rack up some dividends.

In the first few years of investing, you may not see that much of a return. However, in the long-term, the chances of getting a big return on your investments are almost guaranteed.

Final Thoughts

The bar to entry in the stock market has never been lower, so why not try your hand at investing? Worst case scenario, you lose a bit of money and learn some valuable lessons about markets. Best case scenario, you win big and build up a respectable fortune for yourself and be set for retirement.

About author

Fully qualified CISI Investment adviser for 5 year. Managed UK private client portfolios.
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