Lesson 4 of 43: 17 Basic Stock Market Investing Concepts You Need to Know

 

When it comes to learning how to invest in the stock market, there’s a lot to cover. Our goal here is to walk you through a quick “crash course” orientation on how the stock market works.

Rather than present you with a giant glossary defining every term, metric, and word associated with the market, we’re going to focus on just the most important foundational concepts you need to get started.

This list is built around the most common questions we hear from smart investors who are just learning to trade.

Let’s dig into some basic concepts that will help you better understand the stock market.

(NOTE: This is one of 40+ lessons in our FREE course: How to Invest in Stocks: Learn How to Buy Stocks, Make Money, and Avoid Mistakes. We'll bring you from beginner to confident investor fast, helping you make money and avoid mistakes along the way.)

1) What does it mean to buy a company’s stock?

Most companies (public and private) have shareholders. A shareholder is someone who holds a share of the company and is therefore considered a partial (or full) owner.

What makes public companies unique is that at some point they decided to sell their company to the general public through an initial public offering (IPO).

After the IPO process, shares in their company (little pieces of ownership) are available for anyone to buy.

So when you purchase a share of Mastercard (MA) stock, you’re literally buying a tiny ownership stake in the company. This entitles you to vote on big shareholder issues, collect their dividends, and participate in their growth through increases in their stock price.

2) What is preferred stock vs. common stock?

Common stock is the normal stock that we all think about when we discuss Apple (AAPL), Amazon (AMZN), or Coca-Cola (KO).

Common stock shareholders are entitled to vote at shareholder meetings (or remotely, via online or mail proxy vote) and collect any dividends available to common shareholders. The downside is that if a company were to go bankrupt and be liquidated, common shareholders are paid last, after preferred shareholders, creditors, and bondholders.

Preferred shares often come with a dividend, but don’t necessarily have voting rights. And if the company were to be liquidated due to bankruptcy, they would be paid out before common stock shareholders.

Honestly, common stock is probably all you need to care about.

It’s unlikely that large well-funded companies such as United Technologies (UTX) are going to go bankrupt, so we wouldn’t worry about common shares completely losing their value.

Preferred shares are mostly for more complex investors who have experience trading them.

For now, just focus on common shares and the ticker symbols that come up when you Google a public company’s name.

3) What are stock exchanges?

A stock exchange is a platform on which shares are traded back and forth. It’s a market that connects buyers and sellers.

Every stock is listed and traded on a certain exchange, such as the Nasdaq or New York Stock Exchange (NYSE). These exchanges have certain requirements for companies that wish to be traded with them, such as maintaining a minimum price of at least $4 per share.

The NYSE tends to have larger companies whereas the Nasdaq tends to be more technology-heavy.

Honestly, where a stock is traded doesn’t matter much. We wouldn’t like a stock more or less because it was traded on a certain exchange.

The one exception is over-the-counter (OTC) exchanges which trade pink sheet stocks. These are often speculative companies with very little trading volume that can regularly spike or plummet.

Stocks trading on OTC exchanges aren’t required to register with the Securities and Exchange Commission (SEC) or report quarterly earnings. OTC exchanges also contain many companies that were previously delisted from the Nasdaq for various reasons.

While there are certainly exceptions, we’d exercise caution before buying stocks on an OTC exchange.

The good news is pretty much every stock you know is listed on the Nasdaq or NYSE exchanges, not on OTC exchanges.

And you don’t need to know what exchange a stock is listed on in order to buy and sell. You just go your brokerage website (or call) and ask to trade its shares. The exchange happens behind the scenes. It never really comes up.

Also, don’t confuse the exchanges with the indexes, such as the S&P 500, Dow Jones Industrial Average (DJIA), or the Russell 2000.

Exchanges are markets where shares are bought and sold. Whereas indexes are collections of similar stocks meant to represent a certain theme.

For example, Apple (AAPL) shares are traded on the Nasdaq stock exchange and they're included in the S&P 500 index and the Dow Jones Industrial Average because they’re among the largest companies traded in the U.S.

4) What is an index?

Put simply, an index is a list of stocks meant to capture a common theme.

For example, the S&P 500 (one of the most well-known indexes) is made up of the 500 largest publicly-traded companies in the U.S., such as 3M (MMM), Amgen (AMGN), Kohl’s (KSS), Lowe’s (LOW), PayPal (PYPL), Pfizer (PFE), and many more.

The Dow Jones Industrial Average (DJIA) is comprised of 30 large U.S. stocks, such as McDonald’s (MCD), Cisco Systems (CSCO), Coca-Cola (KO), Caterpillar (CAT), and Exxon-Mobil (XOM), and others.

The Russell 2000 index is comprised of 2000 small stocks.

The prices of all the underlying stocks in an index are used to create the overall price of the index.

Investors use indexes to measure a certain section of the stock market. For example, want to know how small cap stocks are doing? Look at the Russell 2000.

Or, to get a complete view of the American stock market, you can look at the Wilshire 5000 Index which represents all publicly-traded companies in the U.S.

5) What is an IPO?

An initial public offering (usually just called an "IPO") is the first time a company makes its shares available for purchase on the open market.

There are many reasons a company might go public, but one of the biggest is to raise cash. By selling its shares during an IPO, a company can add a lot of money to its coffers.

Going public is a long process and investors usually get excited about big IPOs for two reasons.

First, it’s the first time shares of the company are available to the public. For example, when Facebook (FB) first went public back in 2012, it received a lot of press coverage because investors who were familiar with its products finally had a chance to own a piece of the company.

So part of the excitement around IPOs is allowing common investors to finally own a piece of a company they know.

The second reason IPOs get a lot of attention is because investors and analysts like to watch how much the stock moves on the day of its IPO. The upward movement of the price is viewed as sort of a gauge of investor excitement around the company and its prospects.

For example, when Google (GOOGL) first went public in 2004, their stock price soared 18% the first day. Investors were excited about this huge rally and buzzed about the company’s future prospects.

Another classic example was LinkedIn, which rose by over 100% on its first day of trading!

Although IPOs are fun and exciting, they don’t always make great investments because their trading is often erratic and driven by emotions. And there’s evidence that IPOs are underpriced on purpose to draw in more investors and drive up first-day gains.

Also, it’s not easy for common investors to get in on the IPO price offered by the company. Usually, they end up stuck with the higher market price after the stock has spiked in open trading.

IPOs are fun to watch. But in our experience, there are better places for your money.

6) What is a stockbroker?

When people refer to a “stockbroker,” they usually mean either one of two things.

Sometimes they mean a person who provides you with trading advice, helps you manage your money, and invests on your behalf in exchange for a fee. Another name for this would be an investment advisor.

If an investor referring to a "stockbroker" means an "investment advisor," they might say something like, “My broker called me today and suggested we invest some cash in dividend stocks since I'm planning to retire soon.” 

Advisors go through extensive training and must pass licensing exams in order to provide their customers with investment advice in exchange for a fee.

However, often when investors talk about their “stockbroker” they’re simply referring to the brokerage company that places their trades. For example, an investor might say, “Today I called my broker and sold all my Facebook stock.”

What they mean is they called Vanguard, Fidelity, Charles Schwab, E*TRADE, or another brokerage and placed a sell order on their Facebook stock.

Today, it’s easy to place trades online and investors don’t tend to have a dedicated stockbroker just to make trades. You can log into your broker’s website and place the trade yourself, or call and one of their representatives will place the trade for you.

While an investment advisor can be a great help in planning your finances and navigating the market, they’re not needed if all you want to do is place trades yourself.

You can sign up for a good broker and place your own trades online or via phone.

7) What is a market cap?

When investors talk about "market caps," they’re simply referring to how big a company is.

The full phrase is “market capitalization,” which is the total value of the company. You arrive at the value by multiplying the number of shares it has on the stock market by the price per share.

Since share prices fluctuate each day, the market cap of the underlying company also fluctuates.

For example, a big company like Apple (AAPL) is considered a large-cap stock.

As of today (10/24/18), Apple has 4,829,926,000 shares outstanding on the public markets. Their stock price closed today at $215.09. If you multiply those two numbers together, you arrive at a market capitalization of $1.04 trillion. Wow.

A small cap stock is a small company, such as GoPro (GPRO). As of today (10/24/18), their market cap is only $894 million.

Here are the official categorizations for companies based on their size:

  • The nano-cap stock definition is companies with a market cap between $0M - $50M.
  • The micro-cap stock definition is companies with a market cap between $50M - $300M.
  • The small-cap stock definition is companies with a market cap between $300M - $2B
  • The mid-cap stock definition is companies with a market cap between $2B - $10B.
  • The large-cap stock definition is companies with a market cap between $10B - $300B.
  • The mega-cap stock definition is companies with a market cap of $300B and above.

Most people simply call big companies “large-cap stocks,” mid-size companies “mid-cap stocks”, and small companies “small-cap stocks.” People typically don’t get as specific as “nano-cap” or “mega-cap.”

Is one size of stock better than another? In a short answer, no. You can make great money with stocks of all sizes. We’ll cover this in much more detail in a future lesson (Lesson 6 of 43: Market Cap: An Overview of Small-Cap, Mid-Cap, and Large-Cap Stocks).

8) What are a stock’s sector and industry?

Sector and industry are simply ways of classifying a stock based on what type of business it operates.

For example, Apple (AAPL) is classified in the Technology sector. And within that sector, it’s classified in the Consumer Electronics industry.

There is a Global Industry Classification Standard (GICS) that classifies all stocks into 11 major sectors. Within those sectors, there are industry groups, industries, and sub-industries.

You can see their groupings on the GICS website and below:

Here are the 11 major sectors on the stock market and a few example industries:

  1. Financials: Banks, investment funds, insurance
  2. Utilities: Electric, gas, water
  3. Consumer Discretionary: Retailers, media, consumer services
  4. Consumer Staples: Food, beverage, household goods
  5. Energy: Oil, gas, power, refineries
  6. Healthcare: Biotech, hospital, medical devices
  7. Industrials: Construction, defense, aerospace, machinery
  8. Technology: Electronics, software, semiconductors
  9. Communications: Wireless, cable, internet providers
  10. Materials: Mining, chemicals, raw materials
  11. Real Estate: Residential, commercial, industrial real estate

The stocks in each sector and industry tend to carry certain common properties because they operate in the same business. For example, utility stocks often look and behave similarly but are very different than financial stocks.

We don’t have a preference for certain industries or sectors. Depending on your investing goals, you can find excellent stocks across the entire market.

9) What is an investing style?

An investing style is basically a strategy you pursue to try and make money in the market.

There are many investing styles, but the most common ones you’ll hear discussed are:

  • Value investing
  • Growth investing
  • Technical analysis
  • Fundamental analysis
  • Dividend stocks
  • Penny stocks
  • Swing trading
  • Day trading
  • Growth at a Reasonable Price (GARP)
  • and many more

For example, value investors seek to buy companies that are currently trading below what they’re really worth in hopes their price will move up towards fair value.

Growth investors look for companies with strong sales and earnings growth because they believe these companies will continue to deliver strong results in the future. 

And dividend investors buy dividend stocks for their steady dividend income and/or their stability during market turbulence.

Each investing style has its pros and cons and which is best depends on your personal goals as an investor.

We’ll cover each of these in much more detail in a future lesson (Lesson 8: Investing Styles & Strategies: 17 Ways Investors Make Money in Stocks).

10) What are dividends and how do dividends work?

A dividend is a cash payment from a company to its shareholders.

You can think of dividends like this:

You’re handing over some amount of money to buy a tiny portion of a company, and in return, the company will pay you a tiny portion of their profits (since you’re now an owner).

Many companies (literally thousands) pay dividends to their shareholders on a regular basis.

Dividends are usually paid out quarterly and over a full year they typically add up to somewhere between 1% - 6% of the amount you would pay to buy a single share of stock.

Here are a few more basic concepts to remember about dividends:

  • Dividends are usually paid out quarterly (but not always, they can range from a single one-time payment up to regular monthly payments).
  • Dividend payments usually remain fairly steady or trend slowly upwards over time (but they can also sometimes decline if a company is struggling financially).
  • Often slower-growth companies pay dividends and faster-growth companies do not (there are exceptions).
  • Dividends (or high dividends) don’t automatically make a stock a “good” investment or better than other stocks.
  • Dividend yield is a powerful metric to measure how much you’d make in dividends each year compared to how much you’d have to invest.
  • Most dividend yields range from 1% up to 6%, but there are some companies that can go much higher.

11) How are stocks different from other investments?

Without going into too much detail here, let’s run through a quick comparison of stocks vs. other common types of investments.

Stocks:

  • Shares of ownership in a publicly-traded company.

  • Usually perform well over long periods of time, but investors risk making mistakes when buying and selling stocks without a strategy.

Mutual Funds:

  • Giant portfolio made up of hundreds of stocks that are bought and sold by a financial company.
  • Investors buy the mutual fund and trust the financial company to make smart investing decisions.
  • Mutual funds often come with fees that weigh down their already mediocre performance.
  • Only priced and traded once per day, after the markets close.
  • Low-fee funds can be good for a passive long-term investor who doesn't want to actively research and trade themselves.

Exchange-Traded Funds (ETF):

  • A fund that tracks the price of hundreds of stocks (or other assets) without actually buying or selling any of the positions (it simply tracks their price as a group).
  • Often tracks a simple index (like the S&P 500 or Russell 2000) with lower fees than mutual funds but also less active management. 
  • Generally a good option for passive investors who want to buy something and hold without doing ongoing research.
  • Also good for investors who want to trade an entire area of the market (such as tech stocks, gold, or the Russell 2000) with relative ease and liquidity.
  • Priced and traded throughout the day just like a stock.

Bonds:

  • Investors lend money to a corporation or government entity and receive ongoing interest payments in return.

  • Generally stable (as long as the organization issuing the debt is stable), but historically performs much worse than stocks.

  • In our opinion, bonds are not a great long-term investing strategy for most investors.

Robo-Advisors:

  • Companies that use computer-based algorithms to invest in ETFs based on your goals.

  • They use no human intervention to make investment decisions and charge a small ongoing management fee.

  • Betterment and Wealthfront are well-known examples of robo-advisors.

  • Can be a good option for passive investors who want a “do it for me” approach.

Advanced Stuff:

  • There are many other types of securities that take some advanced training and experience. Examples include trading commodities, Forex (foreign exchange currencies), derivatives, short selling, levered funds, futures, options, and more.

12) What is a bull market vs. a bear market?

Put simply, a bull market is when stocks are going up and a bear market is when stocks are going down.

When people talk about a bull market, they generally mean an environment in which stock prices are going up and are expected to keep going up. These are the good times when our stocks keep grinding higher and higher.

Bull markets are often accompanied by a strong underlying economy with healthy GDP growth, low unemployment, and a generally rising tide.

If you’re “bullish” about the market or a particular stock, you think it’s headed upwards.

On the other hand, a bear market is defined as a 20%+ decline in market prices over a two-month period. Typically a bear market will see 20%+ declines across several major indexes, such as the S&P 500, Dow Jones Industrial Average (DJIA), and Nasdaq.

If you’re “bearish” about the market or a particular stock, you think it’s headed downwards.

According to Investopedia:

“The use of "bull" and "bear" to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air, while a bear swipes its paws downward.

These actions are metaphors for the movement of a market. If the trend is up, it's a bull market. If the trend is down, it's a bear market.”

13) What is a stock market crash?

A “stock market crash” is a broad term that basically means a violent selloff and a significant decline in stock market prices over a short period of time.

Crashes tend to be driven by panic and often draw the attention (and participation) of common investors.

Crashes often happen at the end of a long bull market when investors have gotten greedy and careless after years of upward stock prices. They can also be driven by underlying weakness in the U.S. economy, such as the subprime mortgage crisis of 2008 - 2009.

A stock market crash is different than a market “correction,” which is defined as a 10%+ decline in market prices from a recent high.

While a correction may be unpleasant, it’s a normal and healthy part of the stock market. Market corrections typically don’t happen in a single day but over a period of days, weeks, or months.

Another common term is a "bear market,” which is defined as a 20%+ decline in market prices over a two-month period.

When investors discuss a correction or a bear market, they’re often talking about the stock market overall. They’ll say, “The S&P 500 is now in correction territory.” 

This means the S&P 500 has declined by more than 10%.

However, these terms can also be applied to individual stocks. So, if you hear an analyst say, Walmart (WMT) is currently in a bear market.”

They’re saying that Walmart stock has declined more than 20% and stayed there for at least two months.

We’ll cover market crashes and how to handle them in a future lesson (Lesson 10: Stock Market Crashes: Why Markets Decline & How to Survive).

14) Can I try to time the market and sell stocks if I think a crash is coming?

We did a full analysis on this common question as part of our Profit Lab series, which you can read here: “Should I Sell Everything Now to Avoid a Stock Market Crash?

But here’s the short answer: Research suggests timing the market is extremely difficult for the average investor to do and will likely cause you more harm than good.

Why?

There are two big reasons why it's not a great strategy to try and avoid a possible stock market crash:

  1. It's really hard for the average investor to do successfully.
  2. Missing out on a possible rally by putting cash on the sidelines can really hurt your long-term returns.

Trying to time the market is a classic mistake that we’ll cover in greater detail later.

But for now, the most important thing to remember is that while the media and talking heads make a living out of predicting where the market will go, it’s very difficult for the average investor to do correctly.

Most of the time, it will end up hurting your returns.

15) What does it mean to beat the market?

Experienced investors often measure their performance not based on whether they made money investing, but whether they beat the market.

What does that mean? To “beat the market” means your investing gain this year (in percent) was greater than the gain of a common stock market index such as the S&P 500 or the Dow Jones Industrial Average.

There are two ways to look at performance. We’ll summarize them here but really unpack them and make a recommendation on which is best in a future lesson.

The simple way to look at investing performance is to ask, “Did I make a profit this year and grow my savings?”

While this is a very simple (and somewhat flawed) way of measuring your performance, there’s a common sense charm to it. We invest in stocks to make money, so if we made money this year we did well. And if we lost money, we did poorly.

The more experienced way of looking at performance is to ask, “Did I make more profit this year than the S&P 500?”

The idea here is that you could've just invested your money into an S&P 500 mutual fund or exchange-traded fund (ETF) for a very low fee and simply let the fund do the investing work for you. Instead, you decided to research and trade your own stocks.

You want to know if all that hard work paid off and you made more money doing it yourself than just putting it into an index fund.

Let’s quickly illustrate how each type of investor might view an example year of performance.

Let’s pretend that the S&P 500 goes up by an incredible 35% this year, and your personal portfolio of hand-picked stocks goes up by 5%:

  • The first type of investor would look and say, “Well, maybe I didn’t do as well as the S&P 500 but I made 5% on my money - that’s great!”
  • The second type of investor would look and say, “Ughhh I did so much stock research and trading and only got a 5% return when I could’ve earned a 35% return if I just bought an S&P 500 fund and went on vacation!”

Now, let’s look at another scenario. Pretend that the S&P 500 goes down by a devastating -37% this year (like it did in 2008), and your personal portfolio of hand-picked stocks goes down by -3%.

  • The first type of investor would look and say, “Ughhh this is terrible, I can’t believe my portfolio declined by 3% and I lost some of my hard-earned money!”
  • The second type of investor would look and say, “Wow! The S&P 500 declined by -37% and my portfolio barely went down at all. I did an incredible job and beat the market by a stunning 34%!”

Which investor is right? We’ll break it down in a future lesson. In the meantime, think about which approach resonates most with you.

16) Could I lose money if I invest in the stock market?

Investing in the stock market comes with real risks and it’s definitely not a simple guaranteed profit.

Could you lose all of your money? Yes, you could. 

You could also earn a 10,000% profit in your first year of trading and become a multi-millionaire. 

While anything is possible, neither of those outcomes is very likely. It's better to focus on what's most likely to happen rather than imagine extreme scenarios. 

Over the long term, smart investors tend to make a lot of money in the stock market rather than lose money. The danger comes mostly in impulsive investors making poor decisions or common mistakes over the short term. 

We'll dig into stock market risks in a future lesson (Lesson 11: What Are the Risks of Investing in Stocks?), but here are a few things to keep in mind:

If you buy stocks, it’s extremely likely that you will lose some money on some positions. That’s a standard part of the game. Even the best investors lose money on some of their investments. Sometimes even 30% - 50% of their stocks end up sold for a loss.

That’s OK. It's normal. What matters is how your stock portfolio returns overall. If you expect every stock to go up and won’t ever sell a position that has a loss, then stock investing may not be for you.

The bottom line is you will definitely lose some money in the market buying stocks, but if you do it right you will make money overall.

For example, if you sell two stocks for a -$200 loss each, and three stocks for a $500 gain each - that’s great. You made $1,100.

Now, aside from losing money on some positions (while ideally gaining more on others), you can also lose money overall when the stock market has a correction, bear market, or stock market crash.

However, as we discovered in our last lesson ("How Much Money Can You Make Investing in Stocks?"), the market tends to go up over time. And there haven’t been many 10-year periods, or any 15-year periods, where the market has failed to produce a gain.

So, if you invest well for the long term, you should be able to ride out overall short-term losses in your total portfolio and see profitable gains.

In our experience, the bigger risk is underperforming the market by stumbling on some of the classic mistakes that investors make.

17) Are there taxes on stock market profits?

There’s a famous saying in finance, “It’s not what you make, it’s what you keep.”

While we’re all used to being taxed on our regular wages, there are also taxes on stock market investing profits.

The good news is that investing taxes are often lower than typical income taxes.

While we’re not tax experts (consult a tax specialist with your personal tax questions), we’ll dig into some investing tax strategies in detail in an upcoming lesson.

For now, just understand a few of these basic investing-related tax concepts:

Capital Gains: If you sell a stock for a gain, you’ll have to pay taxes on the amount of that gain (not the total amount sold, just the gain). If you held the position for less than a year, it’ll be taxed as ordinary income (just like your salary or wages). But if you held it for over a year, it’ll be taxed at a special long-term capital gains rate - usually 15% or 20%.

Dividend Taxes: Most dividends are considered “qualified dividends”, which means they're taxed at 15%. However, there are some exceptions. Your broker will break down which dividends were qualified and which weren’t on the tax form they provide you.

Capital Losses: If you sell a position for a loss, you can place the amount lost against your capital gains to reduce your taxes. For example, if you gain $10,000 on one stock and lose $2,000 on the other stock, you will only be taxed on an $8,000 gain.

Harvesting Losses: Typically towards the end of the year, investors will review their portfolio and look for any losing positions they can “harvest” as a capital loss. Doing so will reduce their tax burden for the year by offsetting any capital gains.

Keep in mind the above covers federal tax rates, but your state may also have state taxes on investment gains. It also doesn’t include the healthcare surtax of 3.8% paid by investors making more than $200,000 in annual income.

Because taxes can seriously erode the power of compounding returns, it’s great to take advantage of tax-free retirement accounts such as an HSA, IRA, Roth, etc.

We’ll break these down in a future lesson and cover some completely legal ways to minimize your taxes and maximize your investment gains (Lesson 18: How Taxes Impact Your Stock Investing).

Now, let's dig in on stocks vs. other investments and which could be right for you: "Lesson 5: Stocks vs. Bonds, Mutual Funds, ETFs, Real Estate, and Robo-Advisors"

This lesson is from our free course, “How to Invest in Stocks: Learn How to Buy Stocks, Make Money, and Avoid Mistakes.”

We cover many powerful strategies for making money in the stock market while avoiding common mistakes.

The course has over 40 lessons with handouts, guides, and strategies based on decades of stock investing research and experience.

We can bring you from beginner to confident investor FAST, helping you make money and avoid mistakes along the way.

In the next few lessons you will learn...

  • Why bonds are a terrible long-term investment vs. stocks
  • Why you should avoid Wall Street's mutual funds
  • How you can make money with low-cost robo-advisors
  • How much time investing in stocks will take each month (hint: not a lot)
  • Which are better, mutual funds vs. ETFs

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