ELI5: The Stock Market

Today we get back to basics and answer some of the most common questions about the stock market.

What is a Stock?

A stock is a piece of paper or electronic record that represents an ownership "share" in a company. Stocks are commonly referred to as shares. 

Companies need to raise money (aka capital) to run their business. Capital is used for employees, equipment, advertising, the list goes on. To raise capital, a company may issue shares to the public for a price, trading some ownership in exchange for money. This can be done by listing on a stock exchange.

What is a Stock Exchange?

A stock exchange is where investors buy and sell shares. Think of it as a marketplace for investors. There are a number of exchanges around the world, the largest being the New York Stock Exchange (NYSE). As of 2019, the NYSE had a market capitalization of ~$30 Trillion.

Each exchange has their own speciality and listing criteria. Some are focused on bigger companies, some on smaller companies. Many are focused on the country they are based out of. Every exchange is unique.

Why Buy Stocks?

Stocks allow you to participate in the growth of companies. As the companies get larger and their outlook improves, the value of your stocks will increase. If you sell at a price higher than what you paid, you profit. Some companies also pay you a small portion of their earnings. These payments are referred to as dividends.

How Are Stocks Priced?

Stock prices are determined by the market. The market is all the investors making buy and sell decisions.

Investors analyze stocks by looking at company management, profitability, growth and much more. Their analysis determines the price they're willing to buy and sell for. The collective pricing decisions of all investors establishes stock prices.

How Do I Pick The Right Stocks?

Odd are you won't. Stock picking is incredibly hard for a number of reasons:

1) There are way more bad stocks than good ones. Only 4% are good investments. Needle in a haystack.

2) You can't see the future and there's too much uncertainty in the markets to make accurate predictions. Beware of people who guarantee returns.

3) The market is extremely competitive, filled with highly-trained professionals.

4) Despite all their qualifications and experience, even most professionals can't pick stocks reliably. Over 80% of active managers fail to beat their benchmark index.

What is an Index?

An index is a list of investments that represents a segment of the financial market. The most popular is the S&P 500 which tracks the 500 largest companies in the US.

If Stock Picking is so Hard, How do I Invest?

Instead of buying individual stocks you can buy index funds. Index funds allow you to buy a large basket of stocks in a single fund that will track an index. Instead of trying to capture the growth of individual stocks, index funds allow you to capture the growth of the entire market. This is known as passive investing.

Removing the effort needed for stock picking, passive investors can instead focus on the essentials. Such as managing risk, goal setting, and keeping your fees low.

Conclusion

The stock market can be intimidating, filled with flashing numbers and industry jargon. But the stock market is only complicated if you choose to get into the weeds. You'll do fine with a strong understanding of the basics. Successful investing is boring, it relies on rational decision-making rather than big words and complicated strategies.