Stock market basics: things every investor should know

The basics of the stock market are as follows: companies offer shares of stock — also known as equity — to investors interested in participating in the expected prosperity of that company. In order to do so, the issuing business becomes a publicly traded company.

In exchange for the investors' money, each share provides a small piece of ownership in the company, which includes access to:

• Corporate earnings as capital gains or dividends

• Any appreciation in the share price over time

• Voting rights with some types of shares

The investor accepts the possibility of loss and gain, depending on how well the company performs.

The stock market is comprised of exchanges — including the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASDAQ) — that combine the functions of a marketplace and auction house. Once a company lists its shares on a stock exchange, its trading price fluctuates as buyers and sellers assess their value. Within the auction function, the offer (or ask) is the price a seller is willing to sell, and the bid is the price a buyer is willing to buy. You have a trade when you have a match of the ask and the bid. Supply and demand work to raise and lower ask and bid prices until you have matches.

So, how does stock market trading work? Companies can directly sell shares on exchanges through initial and secondary public offerings when they need funding. However, with stock market trading, investors can't access exchanges directly. They go through brokerage accounts to trade various assets, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Traditionally, brokers worked face-to-face with individual investor clients. With technology, the brokerage relationship has evolved to include the following offerings:

• Full-service brokers — or managed brokerage accounts where a human advisor provides investment management services to build an investment portfolio based on your goals

• Robo-advisor discount brokers — or managed brokerage accounts that use digital platforms to provide basic, low-cost portfolio management on autopilot, with algorithm-based investment services based on answers you provide to set questions

• Self-directed trading — or unmanaged brokerage accounts where you make the trades through the brokerage website entirely on your own

Brokerage fees are the charges you incur for investment services, which will vary by investment firm, platform, and degree of human involvement. Besides management fees, brokerage costs can include trade commissions, 401(k) fees, and mutual fund fees, among others.

Unmanaged brokerages may charge a small per-transaction fee, although many offer $0 trades today. Some robo-advisors can charge a percentage of assets under management (AUM), while others are free. Online services with access to a team of advisors also might charge a percentage of AUM. Similar services with a dedicated certified financial planner (CFP) may add a flat annual fee. Brokers who manage portfolios as part of financial planning services may be commissioned by investment vendors. Working with financial advisors who act as fiduciaries and work as fee-only from their investor clients is the preferred way to avoid conflicts of interest.

Controlling fees is essential: even small brokerage fees can significantly reduce your portfolio's return. However, if additional human involvement increases the return on your investments markedly, that can more than compensate for the impact of fees. Most brokers' websites will include details on brokerage fees. If not, call the company's customer service and get clarity on the fees before opening an account.

Like any other financial service, investing has a vocabulary of its own. While it gets more complex the deeper you go in your investment journey, for Stock Market 101, there are just a few investment terms you need to know.

A bear market is an environment in which prices in a securities market decline by 20% or more compared with recent highs, leading to negative investor sentiment in light of what is seen as declining economic prospects.

An environment in which prices in financial markets rise by 20% after two declines of 20% each, leading to optimistic investor sentiment. Investor confidence expects that positive outcomes will continue for months, if not years.

Common stock represents ownership in a public company. It usually carries voting rights that allow shareholders to elect the board of directors and a voice on corporate policies. Common stock can have multiple classes that grant different voting rights to each class, allowing the company's founders to control aspects such as its strategic direction.

ETFs are baskets of securities that function similarly to a mutual fund. However, they trade similarly to individual stocks and can track a particular index, sector, commodity, or other asset. They have become tremendously popular and account for trillions of dollars in assets ranging from an S&P 500 index fund to themes like specific industries, various bond maturities, or the disruptive technologies niche.

A mutual fund is an investment vehicle consisting of stocks, bonds, or other securities. It pools assets from shareholders to give small or individual investors affordable access to diversified, professionally managed portfolios. Funds can reflect different market capitalizations, types of bonds, value versus growth stocks, or industry sectors.

Unlike common stock, preferred stock typically does not have voting rights. However, preferred shareholders have priority over common shareholders regarding access to dividends and the distribution of assets in case of insolvency.

A sector is how the Global Industry Classification Standard (GICS) classifies stocks by industry as follows:

• Energy

• Materials

• Industrials

• Consumer Discretionary

• Consumer Staples

• Health Care

• Financials

• Information Technology

• Communication Services

• Utilities

• Real Estate

The sector classification is helpful to investors who want to design their portfolios to reflect their risk tolerance and overall preferences. For example, conservative investors may prefer more price-stable sectors such as utilities and health care, while more aggressive investors will seek the greater volatility of energy and information technology.

A stock exchange is where stocks are bought and sold. As an investor looking for a particular stock, you will go to a stock exchange to find potential sellers, where someone holding those shares will be looking for potential buyers. The NYSE and the NASDAQ are the best-known U.S. stock exchanges.

A stock market index tracks the performance of several different stocks. An index may have enough stocks to indicate how the overall stock market is doing or just enough to represent a specific market sector or industry. The S&P 500, for example, includes the 500 largest U.S. companies whose weight in the index depends on their market capitalization, while the Dow Jones Industrial Average (DJIA) includes 30 large U.S. corporations where each one's weight in the index is based on its share price. You can invest in entire indexes through index funds or ETFs.

Once you've decided to start investing in the stock market — especially if you decide to do it on your own — six tips can significantly increase the odds that you'll succeed. They may provide guardrails as you enter a broad, diverse universe with countless options and distractions.

The safest way to start investing is to simulate activity until you feel comfortable risking your funds. There are, in fact, risk-free ways where your money stays in your pocket. These include:

• Paper trading — where you keep track of the stocks you would have bought with fictitious money

• Playing stock market games — where you manage a portfolio in competition with friends or strangers

• Virtual trading — where using a stock simulator gives you a more realistic experience because your fictitious trades are made on a broker's actual trading platform

Track some companies for a few months. Listen to what is being said about them, and compare that to how their stock prices go up and down.

Everyone has a specific comfort level with risk, known as risk tolerance. With investing, risk tolerance is your ability to withstand losses as you watch the value of your investments go down when they perform poorly. For example, how much of a $5,000 investment could you lose without panicking?

Your risk tolerance is influenced by your goals, when you need the money, how close you are to retirement, and your portfolio size. Knowing your risk tolerance will help you make wise investment decisions. For example, stocks are categorized as large capitalization, small capitalization, aggressive growth, and value stocks — each with a different risk level. If your tolerance is low, you'll lean toward conservative investments, such as bonds and dividend-paying stocks. If it's high, you'll lean toward more volatile, more aggressive, and higher-risk stocks.

Working with a financial advisor is an ideal way to understand your risk tolerance, as they have experience asking the best questions to define it. They then work with you to develop an investment strategy that dovetails your comfort level with the return needed for your investments to meet your long-term goals.

As a beginner stock market investor, picking an individual company that proves to be a profitable investment can be challenging because results depend on the individual company's performance. A sector or entire index, such as those represented in ETFs, is an easier pick because it is naturally diversified.

ETFs are preset groupings of stocks packaged to be sold as a single equity that reflects a broad index or market segment. Unlike a stock, an ETF may have an annual fee that investors pay for managing the fund, although some may be very low-cost or free. They trade on stock exchanges throughout the day, so you can place a trade whenever the market is open, knowing the exact price of the ETF. As a result, they are highly liquid, transparent, and cost-efficient: everything you'd want your stock pick to be.

ETFs offer easy diversification

Diversification is the act of owning a variety of assets that react differently to market forces. It reduces the risk of a single stock's performance severely hurting your portfolio's return. For example, if your portfolio holds diversified assets, a market event may cause some to rise in value while others fall. If you own an ETF that mirrors the S&P 500, its represented stocks cut across many industries. While stocks in the same sector will likely move in the same direction for a specific reason, with multiple sectors, you can cushion the blow to one sector or another by diversifying.

Benefits of ETFs

• Liquidity since you can sell your ETF holdings quickly and receive your proceeds promptly

• Reduced volatility as an ETF represents several companies or sectors, not just one

• Bond-based ETFs offer less volatility but allow stability and safety through diversification into fixed-income instruments such as U.S. Treasury Bonds or robust corporate bonds

• Diversity among the thousands of ETFs available on exchanges, from large cap to small cap, across sectors, even including Real Estate Investment Trusts (REITs), which invest in all forms of real estate

• Tax efficiency comes from the fact that securities are usually offered “in kind” by the ETF provider instead of bought and sold, so capital gains tax liability rarely exists

At first, you may be tempted to buy and sell stocks frequently as you react (or overreact) to current events. However, short-term stock movements rarely affect a well-chosen company's performance over time. You're better off determining what event triggered the price movement and if it affected the company's underlying value.

Frequent trading can also expose you to paying capital gains taxes each time you sell an asset at a profit. A stock you own can increase in value, but no taxes are due until you sell it. It is important to note that, selling a stock after holding it for over a year lowers the tax rate from a short-term capital gain (10% to 37%) to a long-term capital gain (0% to 20%), depending on your taxable income.

Some new investors are attracted to the excitement of day trading, but this can be a costly way to learn to invest. Not only do you need sharp analytical skills to know precisely how a stock will move daily, but you may trigger short-term capital gains taxes frequently should your investments succeed. Taxes can consume much of your gains, especially if you're in a higher tax bracket.

Your goal should be to hold an asset for at least a year or more to qualify for the lower capital gains tax rate, but ideally for three to five years or longer. Among other benefits, long-term investing offers:

• A greater chance for positive returns, because the market has gone up in 37 of the past 50 years, so holding for a few years, can get you past any short-term downturns

• Access to even greater gains if you can avoid the temptation of taking a small win since a winning company is likely to continue generating positive returns

• The benefit of compounding your returns since a general upward trend builds on past successes and adds up over time, despite all volatility. Assuming reinvested dividends, the S&P 500 achieved an average annual return of 10.13% between 1957 and 2022.

Several ratios that compare data from a company's financial statements offer a valuable picture of a company's health, especially when you use multiple ratios. Seeing how a company's ratios compare with its industry can increase your confidence in making investment choices as a more informed investor.

Four of the fundamental ratios people use to select for portfolios include:

• The price-earnings or P/E ratio is a measure that investors and analysts use to compare one company against similar companies or against itself over time, calculated by dividing its share price by its earnings per share. It reflects investors' perceived value of the company's future earnings potential by indicating how many dollars investors can expect to invest before seeing a dollar in earnings.

• The working capital ratio divides a company's current assets by its current liabilities to measure liquidity, which indicates how easily it can turn its assets into cash and meet its short-term obligations.

• The earnings per share or EPS indicates a company's profitability by dividing its net income by the weighted-average number of common shares outstanding during the year to see the portion of its profit allocated to each outstanding share.

• The debt-to-equity or D/E ratio divides total liabilities by total shareholders' equity to measure how leveraged a company is and how much it's funding its operations with borrowed funds.

As a beginning investor, you may wonder how to understand the stock market well enough and decide not to learn to manage your portfolio. You understand the importance of investing but prefer to call on expert help. If so, an experienced financial advisor can help you define your goals and risk tolerance, make investment decisions, monitor your portfolio, and make adjustments when needed.