Investing in the stock market is a way of setting aside money and leaving it to grow so you can collect rewards in the future. Legendary investor Warren Buffet defines investing as “The process of laying out money now to receive more money in the future”. The main goal of investing is to put your money into an investment vehicle, then hope it grows.
Remember, no one likes to lose money. Moreover, the pain threshold of an investor needs to be high because you will have some losing trades, it’s inevitable. If you’re considering investing in a stock and the thought of a loss upsets you, you are in the wrong mindset to execute trade and should consider moving on to a more secure investment.
A Brief Introduction To The Stock Market
The stock market is a complex system where shares of publicly-traded companies are issued, bought and sold. To some it is a dark abyss where the high flying billionaire’s gamble away their money. Actually, it’s not gambling and it’s not just for the rich, it’s for anyone that wants to increase their wealth through sound planned portfolios. Let me break it down:
If you put £100 on one hand of poker. If you win, you receive £X, if you lose you have lost your entire £100…
When you invest your £100 in a stock, you could win £X or lose £Y. It is very rare you are going to lose all of your money. You are risking money, but it isn’t based on luck, it’s based on research and expertise.
The catch with the stock market is, it is an adversarial system. A collection of millions of investors with diametrically opposing views want to buy and sell shares, if you want to sell your shares, someone has to be willing to buy it, this is how share price is calculated but we’ll get into that later. Because both investors can not be correct, it is an adversarial system. In short, one investor will profit and the other will lose. This is why it is very important to become well versed on the investment you are considering and manage your risk.
How Is Stock Issued?
When a company is set up with share capital, the directors can decide on the level of share capital and its division into fixed priced shares. A statement of capital must be delivered to the taxation officers of the country the company is formed in.
Stock is issued as shares on the market, issued shares are the authorised shares for trading on a public market. A company issues a share only once, after that, investors may buy it, and then later sell it. Issued shares can only be bought at the companies startup or via a secondary offering.
Why Does Share Price Rise And Fall?
There are so many factors that affect the price of a stock.
Some major things are, the media, the opinions of well known traders, natural disasters, political unrest and legislation changes, supply and demand or the lack of product produced by a company.
When one or even multiple of these factors are at work, it creates a certain type of sentiment (i.e. bullish or bearish) and a corresponding number of buyers and sellers. If there are more buyers than sellers the price tends to increase. On the other hand, if there are more sellers than buyers, the stock price falls.
These are some things you should consider when looking into stock price fluctuation:
- Stock Valuation
The price of a stock is determined by market activity. When deciding whether to buy or sell, an investor will look at the actual share price and it’s fair value. For example, if a stock’s actual value is £50 per share, and its fair value is £40 it may be worth purchasing. On the other hand, if a stock price is £50 and its fair value is £60, the stock would be considered overvalued and you would be wise to avoid it.
- Fair Value
Fair value, otherwise know as intrinsic value is the calculated price a company should be trading at. Normally you will find the fair value of most main stream companies such as Apple, Tesla, and Google is lower than the share price. Media and herd mentality drive purchases for these companies.
If major changes in revenue, profit, assets, or liability happen you can be sure the fair value of the company has changed. It’s not that hard to calculate the intrinsic value of a company, you can follow through one of our examples on our next posts.
- Triggering Events
These are events like we talked about earlier, media releases, political announcements, revenue reports etc. Knowing which event will cause a trend reversal is like seeing through a solid brick wall. It is really difficult.
- The Human Decision Process
The most interesting of the four. Inside every person there is a logical and an emotional component. We analyse situations using our logical side but when it’s time to act the emotions kick in.
For example, when we buy a car, we research fuel efficiency, engine type and top speed. But it’s time to put some money aside and ask different questions. What colour looks best? Is it big enough?
When making investment decisions, it is the same case. There is another person on the other side ready to buy what you’re selling, or sell what you want to buy. You must be able to process the relevant data and make good decisions. But because we get emotional when investing we make sub-par decisions, and trust me it will happen even to the most analytical individuals.
Why Are Changes So Hard To Predict
Let’s assume a stock price has been rising for several years. Investors realise that a correction will come and the stock price will fall. What we don’t understand is what will trigger the selloff or exactly when it will occur.
Therefore, some investors will jump ship waiting for the opportune time to get back in. However others will hold on willing to assume the risk will pass. This begs a couple of questions… If you’re on the sidelines, how do you know when to get in? And if you’re already in, how do you know when it’s time to sell?
If the stock market was predictable we could easily answer these questions. But it’s not, there are a few issues an investor should consider before taking a trade. Number one is determining whether the stock is fairly priced at that moment of time. The second issue is if there is an event on the horizon that can cause a downturn. The final issue is understanding the human aspect of decision making, and knowing its process. Heard of these before?
Stock Market Average Returns
On average, the stock market has a return of between 8 to 10% per year. This being an average it means you will not experience this every year.
In a bull market, you can see returns of 15% or more per year. Whereas in a bear market your loss can be as much as 20%. This should be a factor you take into consideration when deciding to buy particular stock in certain industries.
Second of all, compound interest is a way of increasing your wealth year on year. Warren Buffet attributes a lot of his success to compounding his account value over years of trading and accruing dividends. Here is compound interest in a basic description, when you invest £1000 and you are lucky enough to gain an 8% return (£80), instead of taking the money out of the company you reinvest it into more shares. This means next year, you have a £1080 equity in the company and if again you have an 8% return, your total dividend for the year is £86.40. Your earnings have compounded.
The 5 Golden Rules Of Investing
You need to be aware of these rules, they could make or break your investment. If you don’t follow them, you could find yourself disappointed and down. These are more like statements to live by.
- The greater return you want, the more risk you’ll usually have to accept.
- Don’t put all your eggs in one basket. Try to diversify as much as you can to lower your risk exposure, ie, invest in different companies, industries and regions.
- If you’re saving over the short term, it’s wise not to take too much of a risk. It’s recommended you invest for at least five years. If you can’t, it’s often best to steer clear of investing and leave your money in a savings account.
- Review your portfolio. A share might be a dud or you might not be willing to take as many risks as you did before. If you don’t review your portfolio regularly, you could end up with a share account which loses money.
- Don’t panic. Investments can go down as well as up. Don’t be tempted to sell or buy shares just because everyone else is.
How Do You Get Started In The Stock Market
The first thing you will want to do is choose a broker. We have reviewed brokerages based on our members personal experience so you can check them out HERE!
Chris personally uses Trading 212 as it offers the best analytical tools, but which one you choose is entirely up to you. You can get a free stock from Trading 212 by using our affiliate link.
Once you have chosen a brokerage and funded your account, it’s all about learning on the job. There is no better teacher than experience in the work place.
You can always come back to our blog to answer some questions, or contact us if you have a specific query you need answered.
Significance Of The Stock Market
In summary to this article the stock market is the most vital component of a free market economy.
It allows companies to raise money by offering stock shares and corporate bonds to investors. In turn the investors participate in the financial achievements of the companies, they can make profits through capital gains and dividends. But they can also make losses through uneducated trading and poor decision making.
The stock market is regulated in the US (the biggest exchange), by the Securities and Exchange Commission. The SEC is a federal agency that works independently from the government and political pressure. You must adhere to the regulations set by the SEC, failure to do so could lead to serious consequences. To protect yourself from the possibility of this ever happening, you should seek professional advice before investing your money in the stock exchange.