Stock Market Basics: What Beginner Investors Should Know

Investing, Investing Strategy, Investments
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If you’re not well-versed in the basics of the stock market, the words and numbers spewed from CNBC or the markets section of your favorite newspaper can border on gibberish.

Phrases like “earnings movers” and “intraday highs” don’t mean much to the average investor, and in many cases, they shouldn’t. If you’re in it for the long term — with, say, a portfolio of mutual funds geared toward retirement — you don’t need to worry about this lingo, or about the flashes of red or green that cross the bottom of your TV screen. You can get by just fine without watching the market much at all.

But if you’re interested in trading stocks, you need to start with some basic knowledge about how the stock market works.

Stock market basics

The stock market is made up of exchanges, like the New York Stock Exchange and the Nasdaq. Stocks are listed on a specific exchange, which brings buyers and sellers together and acts as a market for the shares of those stocks. The exchange tracks the supply and demand — and directly related, the price — of each stock. (Need to back up a bit? Read our explainer about the ins and outs of stocks.)

But this isn’t your typical market, and you can’t show up and pick your shares off a shelf the way you select produce at the grocery store. Individual traders are typically represented by a broker — these days, that’s often an online broker. You place your stock trades through the broker, which then deals with the exchange on your behalf.

The NYSE and the Nasdaq are open from 9:30 a.m. to 4 p.m. Eastern, with premarket and after-hours trading sessions also available, depending on your broker.

Stock market indexes

When people refer to the stock market being up or down, they’re generally referring to one of the major market indexes. A market index tracks the performance of a group of stocks, which either represents the market as a whole or a specific sector of the market, like technology or retail companies.

You’re likely to hear most about the Standard & Poor’s 500, the Nasdaq composite and the Dow Jones industrial average; they are often used as a proxy for the performance of the overall market. Investors use indexes to benchmark the performance of their own portfolios. You can also invest in an entire index through index funds and exchange-traded funds, which track a specific index or sector of the market. Read more about ETFs here.

Bull markets vs. bear markets

Neither is an animal you’d want to run into on a hike, but the market has picked the bear as the true symbol of fear: A bear market means stock prices are falling — thresholds vary, but generally to the tune of 20% or more — across several of the indexes referenced earlier.

Younger investors may be familiar with the term bear market but unfamiliar with the experience: We’ve been in a bull market — with rising prices, the opposite of a bear market — for over eight years. That makes it the second-longest bull run in history.

It came out of the Great Recession, however, and that’s how bulls and bears tend to go: Bull markets are followed by bear markets, and vice versa, with both often signaling the start of larger economic patterns. In other words, a bull market typically means investors are confident, which indicates economic growth. A bear market shows investors are pulling back, indicating the economy may do so as well.

The good news is that the average bull market far outlasts the average bear market, which is why over the long term you can grow your money by investing in stocks.

The importance of diversification

The above statement is true about a diversified portfolio — the S&P 500, which holds 500 of the largest stocks in the U.S., has historically returned an average of around 7% annually, when you factor in reinvested dividends and adjust for inflation. That means if you invested $1,000 30 years ago, you could have around $7,600 today.

That long-term growth would have happened despite several bear markets, which you can’t avoid as an investor. What you can avoid is the risk that comes from an undiversified portfolio. Individual stocks frequently fizzle to a lifetime loss of 100%, according to a recent working paper by Arizona State University professor Hendrik Bessembinder.

If you throw all of your money into one company, you’re banking on success that can quickly be halted by regulatory issues, poor leadership or an E. coli outbreak. To smooth out that company-specific risk, investors diversify by pooling multiple stocks together, balancing out the inevitable losers and eliminating the risk that one company’s contaminated beef will wipe out your entire portfolio.

But building a diversified portfolio of individual stocks takes a lot of time, patience and research. The alternative is the aforementioned ETF or index fund. These hold a basket of investments, so you’re automatically diversified. An S&P 500 ETF, for example, would aim to mirror the performance of the S&P 500 by investing in the 500 companies in that index.

The good news is you can combine individual stocks and funds in a single portfolio. One suggestion: Dedicate 10% or less of your portfolio to selecting a few stocks you believe in, and put the rest into index funds.

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Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.