The stock market has seen many people participating in it over the years. This is because investing is an effective way for people to make their money work for them and build wealth over time. Investing in stocks can offer several benefits and opportunities for people, provided they invest smartly. In this article, we take a look at what stocks are, and why people choose to invest in this financial instrument. Make sure to keep reading to learn more.
What are stocks?
A stock represents a share in the ownership of a particular company. It includes a claim on the company’s earnings and assets. As such, someone who buys a stock (known as a stockholder) is a partial owner of the company. When the value of the business rises, so does the value of the stock. When the value of the business falls, the value of the stock also drops.
Nowadays, stocks are typically bought and sold electronically through stock exchanges such as the New York Stock Exchange (NYSE)) and the NASDAQ. While some companies sell stocks directly to investors, most only sell stocks through a brokerage firm such as Saxo markets.
Investors generally buy and sell stocks for a variety of reasons. These include the potential to grow the value of their investment over time, to potentially profit from shorter-term stock price moves, or to even earn an income by investing in dividend-paying stocks. That said, it is important that investors remember that the price of a stock can easily fall as it can rise. There is no guarantee that an investor will be able to make money, and they must also protect themselves from the risk of loss.
What is the stock market?
The stock market refers to several exchanges where shares of publicly held companies are bought and sold by traders and investors. These financial activities are conducted through formal exchanges and also over-the-counter (OTC) marketplaces. The stock market allows buyers and sellers of stocks to meet, interact, and transact with one another.
The stock market allows for price discovery for shares of corporations, and it also serves as a barometer for the overall economy. Buyers and sellers are assured of a fair price, high degree of liquidity, and transparency and market participants all compete in the open market.
Why should people invest in stocks?
Potential for long-term growth
Historically, stocks have generally shown the potential to generate significant long-term returns. Over time, the value of well-performing stocks can appreciate, allowing investors to potentially grow their wealth and outpace inflation.
Ownership in companies
When traders invest in stocks, they become a partial owner of the company’s shares they hold. This ownership can provide various benefits, including the right to vote on corporate matters, receive dividends, and participate in the company’s growth and success.
Diversification
Investing in stocks allows traders to diversify their investment portfolios. By owning shares of multiple companies across different sectors and regions, investors can spread their risk and reduce the impact of any single company’s performance on their overall portfolio. This means they will avoid putting all their eggs in one basket and be able to ride out any waves that occur in the stock market.
Dividend income
Some stocks pay dividends, which are portions of the company’s profits that are distributed to shareholders. Dividend-paying stocks can often provide a regular income stream, making them very attractive to investors seeking income in addition to potential capital appreciation.
For instance, a trader investing only in airline stocks may find that the sector is not doing so well. This means they would end up incurring a loss. However, if they invested in different stocks, they can counterbalance the effects of unfavourable price movements in one sector with positive price movements in another. All in all, diversification is a proactive way to balance a portfolio and protect investments.
Liquidity
Stocks are considered relatively liquid investments, meaning they can be bought and sold easily on stock exchanges. This liquidity provides flexibility and allows investors quickly convert their holdings into cash if needed.
Access to professional management
Many individuals prefer to invest in stocks through mutual funds or Exchange-Traded Funds (ETFs). These investment vehicles typically pool money from multiple investors to be managed by professional fund managers. This allows individuals to take advantage of professional investment expertise, research, and portfolio diversification.
Investment options for various budgets
Stocks often offer investment options for individuals with varying budgets. With the availability of fractional shares and low-cost brokerage platforms, even investors that have limited capital can choose to participate in the stock market and build their investment portfolio gradually over time.
Flexibility and control
Investing in stocks allows traders the opportunity to make decisions based on their investment goals, risk tolerance level, and market analysis. Investors have the freedom to choose the stocks they want to invest in, determine the amount of capital they allocate to a particular stock, and make decisions on buying, selling, or holding based on their own research and analysis.
Compound interest
This is a key component that allows investors to growth their wealth over time. In short, compound interest is the interest that is calculated on the initial principal of the loan or deposit. So, it is simply interest an investor earns on interest. The earlier a trader starts and the longer they invest in the stock market, the more their investment vehicles will have time to experience the power of compounding interest.
Risks of investing in the stock market
Although there are a lot of benefits when it comes to investing in the stock market, there are also a few risks that investors need to keep in mind. The biggest risk of investing in stocks is the stock market’s volatility. On average, the stock market declines 10% from its high about every 11 months and 20% around every four years, and more than 30% at least once per decade. Due to this volatility, investing in stocks is not an activity for everyone. Here are a few more risks investors may want to be aware of so they can better prepare themselves when they invest in stocks.
Commodity price risk
This is simply the risk of a swing in commodity prices affecting the business. Companies that sell commodities typically benefit when prices go up but suffer when they drop. On the other hand, companies that use commodities as inputs see the opposite effect.
As commodity prices climb, consumers tend to rein in spending, and this will impact the entire economy, including the service economy.
Headline risk
This is the risk that media stories will hurt a company’s business. With the world becoming more interconnected, this has provided a torrent of news, so no company is safe from headline risk. Often, one bit of negative coverage can lead to a market backlash against a specific company or an entire sector, and sometimes both. Larger negative coverage can even punish entire economies and have a palpable effect on the global economy as a whole.
Obsolescence risk
This is the risk that a company’s business is most likely going to be unnecessary in a few years. After all, very few businesses live for a long time. The biggest obsolescence risk is that someone may find a way to make a similar product at a cheaper price, driving the company out of business. With global competition becoming increasingly technology savvy and the knowledge gap shrinking, obsolescence risk will likely increase over time.
Bottom line
While investing in stocks can potentially be a lucrative endeavour, it is important to note that doing so involves some degree of risk, and the value of stocks can fluctuate significantly in response to certain market conditions. As such, it is essential investors conduct thorough research, diversify their investments, and consider any financial goals and risk tolerance before investing in stocks. Make sure to seek professional financial advice or find suitable educational materials to start making informed investment decisions in the stock market.
