Stock market basics: 10 tips for beginners

News shows, Hollywood films and TV all assume that you know what the stock market is and how it works. Everyone knows that you can make a lot of money in the stock market if you know what you’re doing, but beginners don’t often understand how the market works and exactly why stocks go up and down. Here’s what you need to know about the stock market before you start investing.

What is the stock market?

Stocks, which are also called equities, are securities that give shareholders an ownership interest in a public company. It’s a real stake in the business, and if you own a majority of the shares of the business, you control how the business operates. The stock market refers to the collection of stocks that can be bought and sold by the general public on a variety of different exchanges.

Where does stock come from? Public companies issue stock so that they can fund their businesses. Investors who think the business will prosper in the future buy those stock issues. The shareholders get any dividends plus any appreciation in the price of the shares. They can also watch their investment shrink or disappear entirely if the company runs out of money.

The stock market is really a kind of aftermarket, where people who own shares in the company can sell them to investors who want to buy them. This trading takes place on a stock exchange, such as the New York Stock Exchange or the Nasdaq. In years past, traders used to go to a physical location — the exchange’s floor — to trade, but now virtually all trading takes place electronically.

When news people say, “the market was up today,” typically they are referring to the performance of the Standard & Poor’s 500 or the Dow Jones Industrial Average. The S&P 500 is made up of around 500 large publicly traded companies in the U.S, while the Dow includes 30 large companies. These track the performance of the collections of stock and show how they fared on that day of trading and over time.

However, even though people refer to the Dow and the S&P 500 as “the market,” those are really indexes of stocks. These indexes represent some of the largest companies in the U.S., but they are not the total market, which includes thousands of publicly traded companies.

Of course, you’ll need a brokerage account before you start investing in stocks. As you’re getting started, here are more guidelines for investing in the stock market.

How to start investing in stocks: 10 tips for beginners

• 1. Buy the right investment

• 2. Avoid individual stocks if you’re a beginner

• 3. Create a diversified portfolio

• 4. Be prepared for a downturn

• 5. Try a stock market simulator before investing real money

• 6. Consider using an online broker or robo-advisor

• 7. Stay committed to your long-term portfolio

• 8. Start now

• 9. Avoid short-term trading

• 10. Keep investing over time

How the stock market works for beginners

The stock market is really a way for investors or brokers to exchange stocks for money, or vice versa. Anyone who wants to buy stock can go there and buy whatever is on offer from those who own the stock. Buyers are expecting their stocks to rise, while sellers may be expecting their stocks to fall or at least not rise much more.

So the stock market allows investors to wager on the future of a company. Together, investors set the value of the company by what price they’re willing to buy and sell at.

While stock prices in the market on any day may fluctuate according to how many shares are demanded or supplied, over time the market evaluates a company on its business results and future prospects. A business growing sales and profits will likely see its stock rise, while a shrinking business will probably see its stock fall, at least over time. In the short term, however, the performance of a stock has a lot to do with just the supply and demand in the market.

When private firms see which stocks investors favor, they may decide to fund their business by selling stock and raising cash. They’ll conduct an initial public offering, or IPO, using an investment bank, which sells shares to investors. Then investors can sell their stock later in the stock market if they want to or they can buy even more at any time the stock is publicly traded.

The key point is this: Investors price stocks according to their expectations of how the company’s business will perform in the future. So the market is forward-looking, with some experts saying the market anticipates events about six to nine months away.

Risks and benefits of investing in stocks

The stock market allows individual investors to own stakes in some of the world’s best companies, and that can be tremendously lucrative. In aggregate, stocks are a good long-term investment as long as they’re purchased at reasonable prices. For example, over time, the S&P 500 has generated about a 10 percent annual return, including a nice cash dividend, too.

Investing in stocks also offers another nice tax advantage for long-term investors. As long as you don’t sell your stock, you won’t owe any tax on the gains. Only money that you receive, such as dividends, will be taxable. So you can hold your stock forever and never have to pay taxes on your gains.

However, if you do realize a gain by selling the stock, you’ll owe capital gains taxes on it. How long you hold the stock will determine how it’s taxed. If you buy and sell the asset within a year, it will fall under short-term capital gains and will be taxed at your regular income tax rate. If you sell after you’ve held the asset a year, then you’ll pay the long-term capital gains rate, which is usually lower. If you record a loss, you can write that off your taxes or against your gains.

While the market as a whole has performed well, many stocks in the market don’t perform well and may even go bankrupt. These stocks are eventually worth zero, and they’re a total loss. On the other hand, some stocks such as Amazon and Apple have continued to soar for years, earning investors hundreds of times their initial investment.

So investors have two big ways to win in the stock market:

• Buy a stock fund based on an index, such as the S&P 500, and hold it to capture the index’s long-term return. However, its return can vary markedly, from down 30 percent in one year to up 30 percent in another. By buying an index fund, you’ll get the weighted average performance of the stocks in the index.
• Buy individual stocks and try to find the stocks that will outperform the average. However, this approach takes a lot of skill and knowledge, and it’s more risky than simply buying an index fund. However, if you can find an Apple or Amazon on the way up, your returns are likely going to be much higher than in an index fund.

Bottom line

Investing in the stock market can be very rewarding, especially if you avoid some of the pitfalls that most new investors experience when starting out. Beginners should find an investing plan that works for them and stick to it through the good times and bad.

— Bankrate’s Logan Jacoby contributed to an update.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.