Understanding The Stock Market: Buckle In For A Wild Ride
Estimated reading time: 10 minutes
So, you think you’d like to invest in the stock market? Stocks can be exciting, scary, fascinating, and evocative of a million other feelings. But before you get in on the trading game, it’s important to understand the basics of the stock market.
First of all, roll up your sleeves and prepare for a wild ride. Understanding the stock market can be nothing less than daunting, but if you make informed, methodical choices, this wild ride won’t be quite so harrowing.
The Stock Market Motto: Buy Low;Sell High
You’ve probably heard people say the trick to the market is “buy low; sell high,” but the real tactic isn’t quite that simple. It takes a while to learn about the market so you can identify when your investment has peaked, plateaued, or (finally) stopped sinking like a stone. Whether you’re just starting in the stock market or a savvy investor, you’re still likely to experience a full ride of emotions.
Whether the market is on the rise (bullish) or if there’s a sell-off (bearish), stock trading is certainly not for the faint of heart. But even though the market often seems (and actually is) scary, the secret to success is long-term consistency and patience guided by unbiased information to help you make wise choices.
We won’t go into all of that today. I want to start you out with a basic understanding of the stock market. This includes the terminology, and how to find your comfort zone that allows you to sleep at night.
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Understanding the Stock Market
You know those carnival rides that spin around and around until you turn green? Well, they have nothing on some days in the stock market. So, buckle in for a wild ride!
When I met with clients, I would generally get an early indication of their investment experience and comfort level with the stock market. What I discovered time and time again is that clients often think they want to purchase a “hot” individual stock. Maybe they got a tip from a friend, or they heard about a company in the news and hope to make a quick buck.
In almost every case, the reality was that their interest (and really their comfort level) was guiding them toward a mutual fund (also known as a traditional or open-ended mutual fund). Mutual funds can be a more comfortable option for less experienced investors. Admittedly, less sexy than individual stocks, there’s less risk involved, and they tend to help build confidence with newer investors.
Mutual Funds: Lower Risk with Rewards
To understand why mutual funds are often a more comfortable investment option, we should first explore the difference between an open-end mutual fund and a closed-end mutual fund.
- Open-end mutual funds: These traditional mutual funds are continually issuing and redeeming shares, providing liquidity to you, the investor. Due to this constant “openness,” there’s never a set number of shares outstanding. These funds are always changing and, thus, liquid.
- Closed-end mutual funds: The closed-end fund operates more like an individual stock and is traded on an exchange. There are a fixed number of shares offered by an investment company through an initial public offering (IPO); hence, it’s “closed.” Shares are traded on an exchange intraday, like stocks.
Several guides in my resource library can help you get a better understanding of mutual funds. If you feel like your investment risk-tolerance is aligned to mutual funds, this an excellent option to explore.
With investing, it’s really all about your personal risk tolerance. Your choices will range anywhere from very conservative investments, to growth funds, to full-on speculative investments. It’s important to identify your risk tolerance so you make an investment you are most comfortable with.
Defining Stock Market Investment Terms
If you feel the stock market is your preferred investment choice, then it’s essential to familiarize yourself with the terminology and background of the market. Your understanding of the Stock Market is imperative as it will help minimize your overall investment risk in both the short and long-term. Here is a breakdown of the definitions of conservative funds through speculative funds.
Money market fund: A money market fund invests in short-term debt securities, which (usually) provide you with check-writing privileges. Money market funds are conservative investments for those with lower risk tolerance.
Income fund: An income fund provides investors with revenue (pretty straightforward). This fund is usually ideal for retirees due to its conservative nature. Generally, the closer to retirement, the more conservative you’ll want to be with your risk.
Balanced fund: Once again, the name of this type of fund is obvious. It’s a balance of a growth fund and an income fund.
Growth fund: As we move into growth funds, we also move into more significant risks. This fund is typically more diverse and offers a higher growth potential (but of course, that brings higher risk).
Specialized (sector) fund: A specialized fund invests primarily in a particular industry or geographical area. I’ll expand on this idea in my example below.
International or Global fund: International funds invest in companies located anywhere outside the country in which you, the investor, reside. A Global Fund invests in countries throughout the world, including the country where you live. Both funds tend to be very risky due to currency risk, politics, and global factors that substantially impact the fund’s value.
Hedge fund: Remember the wild ride of emotions and all the feels I mentioned earlier? Here it is! A hedge fund uses leverage, which means it purchases on margin options (“legalized gambling,” as I like to say), short sales, and speculative investment strategies. Hedge funds tend to do better in a bearish market. So when the market goes down, hold on tight!
Individual Stocks Versus Mutual Funds
Now that we’ve got the definitions out of the way let’s explore the difference between individual stocks and open-end (traditional) mutual funds.
Let’s say that you buy 100 shares of Caterpillar (CAT) stock. At the close of market, that individual stock is either going to close up or close down. Your shares will either be worth a little more than you originally paid for them, or possibly a little less.
When you invest in a mutual fund, you aren’t subject to the fate of just one company. With mutual funds, several different stocks are “pooled” together into one mutual fund, so your risk is much lower.
In this example, if you invested in a mutual fund that included Caterpillar AND John Deere (DE), Home Depot (HD), and Lowe’s (LOW), the landscape would change. If these were all in the same mutual fund, it could be a specialized (sector) fund. It’s because these are all within a particular industry, yet also competitors. This diversity is what makes mutual funds less risky than owning individual stocks.
Let’s say you’re holding onto that individual Caterpillar stock and the Caterpillar plant burns down. Your investment is now gone. BUT if you bought into a specialized mutual fund with Caterpillar, John Deere, and the others, you’re much safer. If the Caterpillar plant burns down, your investment in that “portion” of the mutual fund went to zero. BUT the value of John Deere’s portion (the competitor) will most likely increase.
You can see how mutual funds play together to offer a safer, less risky investment option overall.
Savvy Stock Market Investing is All About Consistency
As I was saying before, the secret to savvy investing is consistency. Slow and steady wins the race, and nowhere is that more true than investing.
One way to keep your investments consistent is to set up DCA. You may have heard of the term Dollar Cost Averaging (DCA), which sounds more elaborate than it is. All DCA means is that you’re investing the same dollar amount on the same date every month.
Setting up DCA is a great way to start investing. You set it up to automatically pull from your checking, savings, or money market account (basically any cash account). The investment usually builds up pretty quickly.
If you decide to go with an investment in mutual funds, there are some funds where you can invest as little as $100.00 a month. For example, if you want to spend $100 per month on into a balanced fund, you can set the date (like the 17th), and you’ll see the same amount withdrawn from your account monthly.
You’re investing the same dollar amount on the same date each month, but the average share price will vary from month-to-month. Maybe the average share price was $16.00, but in month-two, the average share price had increased to $17.25, and in month-three, the average share price had decreased to $15.50.
Dollar-cost averaging helps to smooth out the highs and lows of the stock market because you’re investing each month consistently. Some months, you’ll purchase fewer shares because the average share price was elevated, and in other months, you’ll buy more shares because the average share price was lower.
Ready to Get Started?
Are you ready to get started? I can just about guarantee that you will feel more comfortable with the terms and basics of understanding the stock market as you become more familiar with them. A lot of it comes down to knowing when to buy and sell (and staying patient the rest of the time).
When clients ask when to buy or sell, I use this analogy to help them understand the highs and lows of the market. When the market is falling, I think of it as though coffee is on sale. I love coffee, so I want to stock up on as much coffee as I can when it’s on sale!
Personally, I prefer shoes first, then coffee — but I digress. If the market is running higher than usual, it’s now time to sell my coffee, take my profits … and then buy more shoes!
The most important takeaway is to invest in a way that fits your risk tolerance and makes you feel comfortable. If you don’t want the anxiety of a wild ride, stick to mutual funds. If you’re ready to take some risks, then investing in individual stocks is nothing less than exhilarating. Arm yourself with knowledge and understanding of the market and you’ll be ready to stand up to the bears (and the bulls)!
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