The stock market is the formal trading center for buying and selling companies.
Normally you will not buy a whole company: the total cost is too high. So at the stock market you buy and sell a share of the company. As an example, if you went to the New York Stock Exchange (NYSE) and bought 100 shares in Wal Mart (Symbol WMT, the largest company listed on the NYSE according to the 2010 Global 500) you would own a portion of Wal Mart. A very small portion: you have bought 100 shares out of the 3.6 Billion shares of Wal Mart common stock, and you paid about $5200 for your 100 shares when the company is worth $191B.
Investing in the stock market has traditionally been one of the best ways to accumulate wealth, particularly if you are a passive investor. Other than during market crashes stock prices on the average tend to rise: as the population grows, as inflation grows, as the economy grows, so will stock prices. This is not an infallible rule: inflation can become deflation, economic centers can move to other countries, and just plain bad business management (e.g. Enron) can cause losses. But if you research your market, and keep abreast of developments many of these pitfalls can be avoided. Refer also to “Reasons why the stock market is still a good investment” for returns over the past 30 years.
The logistics of investing on-line is simple. You open an on-line account and deposit an amount of money in it. All brokerages require cash upfront. Once you have registered you can choose your stocks and trade. It is YOUR responsibility to ensure you are doing it wisely.
There are two main sources of wealth form investing in common stock. The first is in the form of dividends, a percentage of profits that companies may pay out annually to all the shareholders. Some companies have a strict dividend policy, such as a payment of 30% of profit each year. Other companies have no policy and pay what they feel is acceptable. The companies trading in the American stock markets paid an average dividend of 2% of current share price (the dividend yield) (Indexarb). This is equivalent to an interest payment of 2%, always on the latest share price (not purchase price) so that if the share price rises so will the absolute dividend yield.
The second method of wealth accumulation is due to the increase in stock prices. However, it must be realized that you have no loss or gain due to share price fluctuations until you sell your stock. It is therefore often worth keeping shares (in good companies) even through bad times. As long as they are paying a dividend you are receiving a return on your investment, and once the share price recovers your wealth recovers.
You do, however, need to be aware of transaction costs – the cost of trading in stock – and other unavoidable costs. A quick review of on-line brokerages showed an average trade price of $8.00. So if you buy $1000 of stock, the total cost will be $1008. If you sell immediately, it will cost another $8.00, meaning your total cost is $16. The price of stock would need to have risen from $1000 to $1016 for you to break even.
You also have to be aware of price ‘spreads’. To buy a stock may cost $100.50. To sell it buyers may only pay $99.50. The nominal price is $100, but there is a spread of $1.00 between buyers and sellers. The stock price needs to increase by this 1% for you to break even.
If we look therefore at both transaction costs (on the buy side and the sell side) as well as ‘spread’ we see we need an increase of about 2 – 3 % for our investment to break even. Day to day fluctuations can be 1-2% on good days, so to be on the safe side we are looking for a 5% increase, or dividends of 5%. This is the reason that stock investments are generally considered long term investments, and not suitable if you are looking for ready cash: too many transaction costs would destroy any gains.
The easiest way to invest on the market is through Mutual Fund or Unit Trusts. These generally provide an average return over a number of companies, lessening the risk of failure in any one, but also lessening possible gain. For an uninformed investor this is probably the best option.
There are other options in the stock markets: particularly derivatives and hedge funds. These are high risk for high return (or high loss) and are only really suitable for professionals.
[It is advised that you consult your tax advisor or investment advisor before you invest in stocks, to fully understand the tax implications. The use of Wal Mart was purely illustrative and no suggestion of stock preference was intended .]