What Is the Stock Market? Understanding How the Stock Market Works
Never in history has stock market investing been more accessible to the average investor. But if you’re new to buying and selling stocks, it can seem like a steep learning curve. In this article, I’ll guide you through the basics of how the stock market works, and how you can get started investing in the markets today.
What Is the Stock Market?
A stock market is a group of markets and exchanges worldwide, allowing for the buying and selling of shares of publicly traded companies and several other security-related activities.
Where are the Major Stock Markets Located?
Around the world, there are 60 major stock exchanges. Canada’s largest exchange is the Toronto Stock Exchange (TSX), but at less than $2 Trillion in total stock market capitalization, it is tiny compared to the world’s largest stock exchanges. For example, the world’s largest stock market is the New York Stock Exchange, with a total market cap of almost $30 Trillion.
Rounding out the top 5 are the NASDAQ ($11 Trillion), the Tokyo Stock Exchange in Japan ($5 Trillion), the two largest Chinese markets, the Shanghai Stock Exchange and the Hong Kong Exchange, at just under $5 Trillion each. Overall market value refers to the total market capitalization of all of the stocks listed on the exchange.
What Is a Stock Market Index?
Because thousands of individual stocks are traded on the markets every day, it’s much easier to track the overall market’s performance rather than track each stock. This is done using stock market indexes.
In North America, the largest stock market indexes are the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite. We have the S&P/TSX Composite Index in Canada, representing the 230 largest companies on the Toronto Stock Exchange. These companies comprise around 70% of the overall market value of the TSX.
Investors can buy investment funds that track the overall index of various stock exchanges. These index funds include mutual funds and ETFs.
What Is a Stock?
Before we dive deeper into how stock markets work, we should probably look at individual stocks first. This will be helpful for anyone new to stock market investing.
Stocks, also known as shares, represent partial ownership in a corporation. When you purchase shares, it means that you own a small slice of that company. No matter how tiny, that ownership stake grants the shareholder certain rights, like voting rights and a claim on company assets and earnings.
Keep in mind that large corporations, TD Bank or Apple, for example, issue millions of shares. So, when you purchase 10 or 20 shares, it really is a drop in the bucket from an ownership standpoint. What’s more important is that even 20 shares in a world-class corporation is a valuable thing, and chances are you’ll be rewarded for it in the long run.
Common and Preferred Shares
There are many different classes of stock, but the two main types are common and preferred. As the name suggests, common stock is by far the more heavily traded of the two. One thing that is unique to common shares is that they come with voting rights. In other words, shareholders have the right to vote to appoint directors to the company board at annual general meetings and on other items of vital importance.
Preferred shareholders don’t have voting rights, but they have a priority claim on dividends and company assets if the corporation were ever to become insolvent. Unlike common shares, preferred shares pay a fixed dividend, at a higher average yield than common shares.
Why Do Companies Issue Shares?
Companies sell shares as a way of raising large amounts of capital to fund their expansion. While many of the world’s largest corporations may have begun as an idea in the mind of a single entrepreneur, at some point, massive amounts of capital are required to grow the business into a multinational organization.
Large companies can also borrow to fund their growth. This is referred to as debt financing. The challenge with debt financing is that the company must have fixed assets available to back the loans, which isn’t always possible.
Bull Market vs. Bear market
You may have heard the stock market referred to as a ‘bull market’ and a ‘bear market’, and wondered what that meant. A bull market occurs when prices rise or are predicted to rise across a broad section of the financial market.
The most recent example of a bull market began after the great recession of 2008. In the 11 years that followed, US stock prices rose consistently. This was a particularly long bull market run, as they are usually less than 5 years in duration.
The 2008 recession, as mentioned above, is a prime example of a bear market. Prices are falling or expected to fall across the financial markets. That’s exactly what occurred following the US financial crisis, which was largely caused by deregulation in the financial markets.
How Risky Is Stock Market Investing?
People who are wary of stock market investing often point out the risks involved. This can lead others to believe that the stock market is something that should be avoided. Nothing could be further from the truth.
No stock, mutual fund or ETF, is guaranteed. And in the short term, any individual investment can drop in value; some stocks are highly volatile, in fact. But if you’re investing in the stock market for the short term, you’re doing it all wrong.
Short-term savings, i.e., the money you plan to spend in the next 1-3 years, should only be invested in low-risk vehicles, such as savings accounts, money market, GICs, and other safety class investments.
If you’re investing for the long term (10+ years), you have time to ride out the short-term fluctuations the occur in the market, and history suggests that you will always end up ahead by investing in high-quality equity investments versus low-risk accounts like savings or GIC.
But you can’t just throw money at a stock or investment fund and expect to get rich either. Our money is connected to our emotions, and humans often make poor investment decisions based purely on how they are feeling at any given moment. This is why it’s important to seek professional advice before making any stock market investment and maintain a long-term mindset.
How Do You Invest In the Stock Market?
There is more than one way to participate in the stock market. You have the option of buying individual stocks, or you can purchase a basket of stocks inside a pooled investment, like a mutual fund or Exchange Traded Fund (ETF). Mutual funds allow investors to own a well-diversified portfolio of stocks (and bonds) without requiring large sums of money. Many financial institutions let you start a mutual fund with a contribution of $25/month.
A big downside to stock mutual funds, however, is that the fees are very high. Investors can pay upwards of 2.5% in fees annually. Over time, this can eat away a significant portion of your return.
In recent years, investors have begun to turn to ETFs as an alternative to mutual funds. ETFs offer many of the same benefits, easy access to the markets, diversification, and rebalancing, but they are available at a much lower cost. Some of the most popular ETFs charge less than .10% in fees.
Investing Through a Discount Brokerage
Back in the “old days,” most investors had to go through a full-service stockbroker to buy and sell stocks. This was costly and inconvenient, but at the time, it was really the only option.
Nowadays, the middleman has been removed, and you can buy and sell stocks instantly on a laptop from the comfort of your living room, using a discount brokerage. Heck, you can even trade on your smartphone. This investing is referred to as “self-directed” because the investor makes the decisions and places trades.
To trade online, all you need is a self-directed investing account and an internet connection. In Canada, there are at least a dozen discount brokers to choose from. All of the big banks have their own, and there are several independent online brokers as well.
The two main benefits of self-directed investing are that it’s inexpensive and convenient. Depending on where you hold your account, you can buy and sell stocks and ETFs for free and access your account 24/7.
Recommended Discount Brokers
As I mentioned earlier, there are several highly-rated discount brokerages in Canada. Here at MapleMoney, we prefer the ones who balance top-notch features with the lowest prices.
For that reason, our top choice is Questrade, for its combination of low fees and a robust trading platform. With Questrade, ETF purchases are free, and stock trades start at $4.95. That’s a steal when compared to the big bank brokers and their $9.95 trading fees.
Wealthsimple Trade is a good alternative to Questrade. They are the self-directed arm of Canada’s largest robo-advisor, and they offer no-fee stock trades and ETF purchases. The big drawback vs. Questrade is that their platform is mobile online. They don’t have a desktop version, which won’t be suitable for all investors.
Final Thoughts on Stock Investing
If you want to buy and sell stocks, there’s no better time to get started than right now. Online brokers like Questrade, Wealthsimple Trade, and others allow you to open an account and begin trading online without having to visit a brick and mortar location. You will need to provide them with your ID and your primary bank account number before getting started.
If you think of trading stocks or ETFs, make sure you consult with an investment professional before getting started. They can advise you on choosing the correct asset allocation, how to properly diversify, and ensure that your investment objectives align with your account holdings.