We admit the stock market isn’t the easiest thing in the world to understand. Between the different securities and stock indices, investing concepts and stock trading strategies, acronyms and jargon, you can be excused for being a titch, well, confused. This article strives to make the stock market less complicated, and a whole lot less overwhelming. That way, you can begin to get the most out of your money – and your investment strategy.
What is a stock?
Stocks, or equities, are securities that represent an ownership share in a public company (also known as a publicly-traded company). Privately-held companies do not issue shares.
So when you own stock, you essentially become a shareholder in a company because you share in their profits. Why do companies issue stock? To raise money so they can expand or improve their operations. Investors buy stocks in the hopes of growing their money more quickly than with fixed interest investment vehicles, like GICs. Stocks are made available to investors and traders through a stock market exchange, like the Toronto Stock Exchange (TSX) or the NASDAQ in the U.S.
The two main kinds of stocks are common stock and preferred stock. Common stock may pay a dividend, although it is not guaranteed. Owners of preferred stocks typically rely on a fixed annual amount of income from their shares.
How does a stock price move?
The law of supply and demand is the primary driver for changing stock prices. It’s not dissimilar to buying real estate in a hot neighbourhood: you have to expect to pay more because there’s limited inventory of homes.
When there’s a high demand for a stock but few people are selling, stock price goes up. If there’s a low demand with many sellers, it will drive the price down.
Which brings us to the bid-ask spread. If you're buying stock, you’ll pay the bid price. If you’re selling stock, you’ll offer it at the ask price. The difference between the two amounts is known as the spread. A stock with a tight or lower bid-ask spread means it’s actively traded, and offers good liquidity. We’re talking the Googles, Apples and Teslas of the world.
A wide range of market catalysts can increase or decrease demand for a specific stock, including a company’s earnings report, a market correction, competitive pressure, new product launch, and many more.
What is the stock market and stock exchanges?
Think of the stock market as a huge investment store, in which investors buy and sell shares of publicly-traded companies from one another.
The thing we know as the stock market is comprised of different stock exchanges. Exchanges are actually the entities that make the buying and selling of shares possible. For instance, a company will work with a specific stock exchange to offer stock to investors.
There are literally hundreds of exchanges of all sizes around the globe. Close to home, the most dominant exchanges include the Toronto Stock Exchange in Canada, and the New York Stock Exchange and NASDAQ in the United States.
How does the stock market work?
When it comes to buying and selling stocks, there are two main components: the primary market and the secondary market.
Primary markets
This refers to the buying and selling of stocks at a company’s initial public offering (IPO). This is when a privately-owned company decides to sell a number of shares to raise capital and expand. IPOs are facilitated by brokerages such as Scotia iTRADE, who can accept expressions of interest on behalf of investors.
Secondary markets
Instead of going to primary markets to buy shares directly from the companies, most investors buy them second-hand, from other investors. All stocks traded on the secondary markets were first bought on the primary market, then sold by their buyers on the secondary market.
The secondary market contains two sub-categories of markets: auction markets and dealer markets.
- Auction markets
In an auction market, everyone who wants to trade stock announces the prices at which they’re willing to buy stock and/or sell stocks. The New York Stock Exchange (NYSE) and Toronto Stock Exchange (TSX) are well-known examples of auction markets, in addition to the Tokyo Stock Exchange, the London Stock Exchange, the Shanghai Stock Exchange and the Hong Kong Stock Exchange. Today, most buying and selling is done online. By the way, gone are the days when stock exchanges had real trading floors.
- Dealer markets (or Over-the-counter markets)
Dealer markets, sometimes called over-the-counter (OTC) markets, include multiple “market makers” listing prices at which they will buy or sell a specific stock. More on market makers below.
You can access the stock market and start buying and selling shares by opening an account with a full-service investment firm or an online brokerage, stockbroker, or financial advisor. Online brokerages like Scotia iTRADE cater exclusively to self-directed investors, and offer competitively priced trading fees.
You’ll find stocks have unique ticker symbols. For example, the Bank Of Nova Scotia’s ticker symbol on the Toronto Stock Exchange is “BNS”; the ticker for Apple on the NASDAQ is AAPL.
To help provide stability to financial systems and protect investors, stock markets are regulated by independent organizations. The Ontario Securities Commission (OSC) is one of the largest regulators in Canada. In the United States, it’s the U.S. Securities and Exchange Commission.
Who are market makers?
Market makers are typically large brokerage or financial firms who ensure there's enough volume of trading – or liquidity – in the market. Without them, it would difficult for you to sell your securities as there would be a lack of buyers. The same goes for buying shares. Market makers ensure there’s enough stock available.
So what’s a stockbroker? Stockbrokers, or simply brokers, are intermediaries who bring together assets to buyers and sellers, and then make money when transactions are completed.
When you invest on your own, you make your own trading decisions, like the number of shares you’ll buy and at what price.
What is stock market volatility?
If any investor could accurately predict market volatility, they would be wildly successful. The possibility of accurately predicting the future is nil as market volatility is a very complex subject.
In its simplest form, market volatility is the rate at which a stock’s price fluctuates daily. For example, steady changes with no great swings in stock price suggests low volatility. A stock with high volatility should give an investor pause for concern.
Low volatility refers to minor fluctuations in stock prices, and high volatility means large ones. At any given time, the markets will be going in one of three directions: up, down or sideways.
There are many factors that can cause market volatility, including the health of global and Canadian governments, natural disasters, pandemics like coronavirus, wars and so on. For more on catalysts that can impact market volatility, check out How and Why do Stock Markets Rise and Fall?
If a catalyst is big enough, it can lead to a bear market or bull market.
Bear markets
A bear market is defined as an extended period of time in which stock prices have decline at least 20%. Bear markets can be triggered by any number of events, from rising unemployment rates to pandemics. During bear markets, investors tend to favour investments with guaranteed returns, such as bonds, annuities and GICs, over stocks.
Bull markets
A bull market will follow a bear market, and is defined as a time period in which there is a minimum 20% increase in stock prices. Investor optimism helps drive bull markets – people feel good about their futures and the economy’s. During bull markets, investors anticipate that they’ll make more money buying and selling stocks on the market than you will with fixed income investments.
What are stock market indices?
Stock market indices (the singular version is index) are groups of stock that can help investors monitor the performance and trends of specific sectors of the stock market.
Some of the world’s most recognized indices can be found in the United States, including the NASDAQ Composite, the Dow Jones Industrial Average (DJIA) and the S&P 500, all of which are decades-old Wall Street staples. In Canada, we have the S&P/TSX Composite Index, which tracks the largest companies by market capitalization on the TSX.
If you hear that an index has dropped, that means the average value of all the stocks within that index is down from the previous trading day.
The stocks that make up indices are grouped together based on common factors. The main types of indices include:
Sector Indices comprise stocks from different sectors, such as technology, pharmaceuticals, consumer goods and so on.
Global Indices may include stocks from foreign companies
Indices not only have unique baskets of stocks, they are weighted and calculated differently. Occasionally, an index will be rebalanced so that certain stock don’t have too much influence on outcomes.
Why do companies list their stock on exchanges?
Let’s pretend you’re a business owner who needs to raise capital to expand your operations. Broadly speaking, you have two options: borrow it from a lender or sell stock as a publicly-traded company. “Going public” can generate millions of dollars, as well as give your business a certain prestige.
In addition to business growth, there are other benefits of selling stock on an exchange. If your stock is performing well, lenders are more likely to extend credit to you. Additionally, you may be able to buy or merge with other companies using shares instead of cash.
A company that goes public and offers stock for the first time will initiate an IPO, or initial public offering.
How have stock markets performed over past few years?
The U.S. stock market has outperformed all other securities, as well as real estate, over the past few decades.
If you had invested $100 in the S&P500 in 1928, your investment would be worth more than $500,000 today. [NTD: you need a footnote with the source for this data] Let’s review some numbers closer to home. Here’s how stocks performed against some other popular types of investments:
The impressive historical performance of stocks is not to suggest that stock market investing is the best idea for all investors.
A lot has to do with both your short-term goals, investment horizon and investment strategy. Remember, stock price volatility can be extreme, so there’s more risk involved if you’re investing for the short term.
If both your investment horizon and investment strategy are longer-term – for instance, you’re decades away from retirement – the price volatility may not be a great concern because you have decades to benefit from the stock market’s historically better returns.
With a shorter investment horizons, most investors will turn to more “reliable” investments, like bonds.
Advantages & Disadvantages of different investment options
Investors have a dizzying array of options from which to choose. It may help to remember that the majority of them can be arranged in four categories:
- Stocks, or shares, are considered the riskiest of the asset classes because of the short-term unpredictability of the stock market.
- Bonds, whether government issued or investment grade corporate bonds, offer fixed rates of interest and are deemed less risky than stocks.
- Cash and cash equivalents, such as T-bills, money markets, certificates of deposits, savings accounts and so on, offer the least risk to investors; however, returns have been exceedingly low over the past two decades.
- Property/real estate, including commercial property, uses rental income and growth in the value of real estate to generate returns; because they’re “liquid assets”, they cannot be immediately sold like other assets
Now that we’ve covered the main categories, let’s drill down to some specific investment vehicles.
What are mutual funds?
Mutual funds are professionally-managed investment vehicles that may include stocks, bonds and other assets. You won’t find mutual funds listed on stock exchanges. They are available through banks, brokerage firms, online brokerages and others.
Every mutual fund has an unique objective and strategy that defines how the fund is managed. As an investor, you’re buying units in the fund, and every unit represents a portion of the fund’s value. Mutual funds come with annual fees, called management expense ratios or MERs, which can vary wildly.
What are Exchanged-Traded Funds (ETFs)?
Exchange-traded funds, or ETFs, are funds built like mutual funds but trade on stock exchanges like ordinary stocks do. ETFs use different stocks, commodities, bonds or a mixture of investment types to track specific stock market indices (like Wall Street’s DJIA, Canada’s S&P/TSX Composite Index and so on). Because they are listed on stock exchanges, the price of exchange-traded funds will fluctuate. ETFs offer lower management expense ratios than mutual funds.
What are index funds?
Like an ETF, an index fund is made up of a basket of investments that tracks the performance of a specific index. (Example: the S&P/TSX Composite Index Fund will hold stock of the companies found on the S&P/TSX
Composite Index.) The fund rises in value as the index that it’s based on rises. However, index funds cannot be purchased and sold on stock exchanges like ETFs. As a holder of index funds, you may earn dividends or interest which are paid out a fixed time period.
What are options?
Options are contracts to buy or sell stock based on a fixed, agreed-up price at a set date. You’re under no obligation to buy the stock – you’re simply buying the contact, which can let expire or sell to another investors. Options are complex and potentially risky investment tools, and not recommended for the majority of investors and traders.
How do I start to invest in the stock market?
Before outlining some concrete steps, let’s assume you’ve determined your risk-tolerance, investment goals and investment horizon. They really are critical aspects of your overall investing approach. Ready? Let’s go...
Broadly speaking, you have a choice between a managed/full-service brokerage or a discount/online brokerage. With the former, a financial professional oversees your account and any trading within it, so you’ll pay more in fees than you would with a do-it-yourself option.
A discount broker will provide you with a wide range of tools, research and resources to execute your own trades online. You’ll be able to buy and sell stock, bonds, ETFs, and so on. Commissions tend to be a fraction of the fees you would pay with a full service brokerage.
The new kid on the trading block is robo-advisor accounts. Using algorithms, robo-advisors initiate trades on your behalf with less cost than a full-service brokerage.
Most brokerages offer a variety of account types:
- Non-Registered Accounts, including cash and margin accounts
- Registered Accounts for RRSPs, RRIFs, LIRAs, LIFs, TFSAs and RESPs
- Non-Personal Accounts, such as informal trust accounts, investment clubs, trust or estate accounts, sole proprietorship and corporate accounts.
Ready to open your brokerage account? Scotia iTRADE is a top rated discount brokerage offering low cost commissions and innovative technologies for any level of investor.
What are some guidelines before investing in the stock market?
A few words of advice to keep in mind as you prepare to buy and sell shares on the stock market:
- Define your goals beforehand and always stay within the limits you’ve set for yourself
- Never stop learning – because there is indeed a lot to learn
- Avoid getting too emotionally involved when trading – reason is still an under-appreciated quality among investors and traders
- Be realistic, be patient – never go into a trade expecting quick returns, always think of stock market investing as a longer-term proposition
- Stay up-to-date on market news as it can directly impact stock prices and stock market trends
- Keep a track of your shares, and determine preferred exit times (that’s the time in which you will sell your shares)
- Stay clear of the herd mentality – do your own research, stick to your own goals, adhere to your own strategy