How to Make Money in the Stock Market
When it comes to building wealth, the stock market is one of the most common avenues. Thousands of companies provide value to their customers and a profit to their shareholders every quarter. How does someone get into the stock market and make money?
Stocks represent ownership of a company. Stocks are sold in the form of shares which give the owner equity in the firm and voting rights. These shares also include a share of corporate earnings in the form of a dividend. In the not-too-distant past, these shares were bought and sold by floor traders at the NYSE and other exchanges. Now stock markets are almost entirely electronic.
Companies issue stock in their companies to raise money for their operations. They are essentially selling a share in the company in return for funds. The price of shares is determined by the forces of supply and demand in the market. For every transaction in the stock market, there must be a buyer for every seller and vice versa. Just as with any other asset, when there are more buyers than sellers, the price of that asset will tend to rise. When there are more sellers than buyers, the price of that asset will tend to decrease.
There are several ways of making money in the stock market. Buying options, selling options, and shorting stocks are some examples. But when it comes to simple stock market investing, there are essentially two ways to make money: dividends and appreciation.
This is probably the most familiar way of making money in the stock market--simply buying low and selling high. Of course, the tricky part is that you can never really tell what low is in terms of future price. What is low today will look pretty high if the stock drops another 10%. Buy and hold is a long-term strategy that pays little attention to short-term fluctuations. On average, buy and hold investors do very well. They avoid the fees from buying and selling that come from active management plus they can defer capital gains taxes until they actually sell their stock and pocket their gains.
Dividend stocks are stocks that distribute a portion of the company’s profits to its shareholders. These dividends are usually paid quarterly. Older, more established companies are more likely to pay a dividend than younger, growing companies. This is because established companies require less capital investment, so they are better able to share their profits with their shareholders. Companies that are focused on growth will want to reinvest any profits back into the company and many of them are not yet making a profit anyway.
Reinvesting your dividend back into the stock is a great way to build up your position in a dividend stock. By buying more stock, you will be entitled to a larger share of the dividend payout in the future. This can be automated with a dividend reinvestment plan.
Risk is a reality in the stock market. Risk and opportunity are two sides of the same coin. When markets have been beaten down, it represents a great buying opportunity. Here are some methods to control risk in the stock market.
Recognizing the cyclical nature of the stock market can help you manage risk. Being able to see when the stock market is at the high end of its cycle helps you put their valuations in perspective. When the stock market or a particular stock is flying high, valuations will be higher. At the bottom of the cycle, a stock's valuations will be low. Buying stocks at low valuations decreases risk. This is one reason why value investing has historically been very successful.
Diversifying your investment portfolio means avoiding the proverbial “putting all your eggs in one basket.” If you put all your money on an oil stock and the bottom falls out of the oil industry, that’s not going to be good for your portfolio. But if you spread your capital around between the oil industry, the tech sector, construction, and other uncorrelated sectors, your portfolio will be much better able to absorb any issues that may arise in one of these sectors.
Stop losses are perhaps the most important risk management tool of all. Using stop orders, you can prevent further loss of capital by triggering a sell order when your stock falls to a certain price or hits a specified percentage of loss. Someone practicing a long-term buy and hold strategy may not be all that concerned with a 20% loss of their portfolio. Imagine you have a stock that drops 50% of its value. Would you be comfortable taking that loss, or would you want to limit your loss to 10% or 20%? Stop loss orders allow you to do this automatically without the need to constantly be watching your portfolio.
Options are contracts that allow the bearer to buy an asset at a particular price. Options have an expiration date, after which they become worthless. Selling call options can offset the loss of your investment if it goes south. Options are an advanced topic and can be very risky if you don’t understand them.
The stock market is made up of great companies that allow anyone to hold a share in the company in return for funds. This equity in the company is sold in the form of shares and these assets follow the laws of supply and demand just as any other asset. The two primary ways of making money in the stock are through dividends and appreciation. Dividends are a share of the profits that a company gives to its shareholders. Appreciation is simply the rise in price that a stock can enjoy over time. Understanding market cycles, diversifying your portfolio, using a stop loss, and selling options are a few ways that investors can manage their portfolio risk.