Stock markets match buyers and sellers of shares that represent partial equity of a company. By purchasing a security, an investor obtains a fraction of the overall value of a company, and has a claim on future earnings in the form of capital gains and dividends. When the owner of a security then sells their holdings, they are selling to another investor who then obtains the partial ownership of the company and can participate in the capital appreciation of the stock or in its dividends. Trading in shares is largely based in New York City at the New York Stock Exchange (NYSE) and the NASDAQ (National Association of Securities Dealers Automated Quotations) however trading can occur anywhere, by phone, computer, or mobile device.
IPOs and Underwriters
The stock markets around the world are where companies generally go to raise capital. A company would need to raise capital for any number of reasons, like expanding a factory or increasing investment in a business line. When a company first issues shares to the public it is called its Initial Public Offering (IPO). A company usually hires an Investment Bank such as Goldman Sachs to underwrite their IPO, so that the IPO may be marketed, and the company assured of the total share amounts to be issued and total dollar amount to be raised. Typically an underwriter may also guarantee a price floor for an IPO, agreeing to buy shares if the IPO trades below a previously agreed upon level on the first day of trading.
Once the IPO date passes, the price of a stock is largely out of the hands of the underwriters, and instead depends on the supply and demand for the securities in the stock markets themselves. For instance, if a company has 1 million shares trading at the NYSE, and there are more buyers for those shares than sellers in the market, the share price will rise. Conversely, if there are more sellers than buyers in the market, prices will fall. This is what is known as price discovery, where the action of buyers and sellers combine to set a market price for a security.
What to Buy
There are literally thousands of public stocks trading on the major exchanges like the NYSE and NASDAQ. Investors have the option of buying individual stocks, but many investors choose to invest in mutual funds or exchange traded funds that track a certain sector, or aim to match the return of the market itself. A notable example of a market tracking ETF is the S&P 500 Index ETF, which is one of the most liquid and traded ETF instruments in the world. Investors have largely come to accept ETFs as a major, or even majority part of their portfolios for a number of reasons.
First, when investing in an individual stock an investor has investment risk in that specific company. If that company misses earnings, the price in the market could go down significantly. With a Mutual Fund or ETF, an investor need not worry about the risk of a specific company, because the fund may hold dozens or even hundreds of stocks. Diversification decreases risks, but may also cap investment returns as invested capital is divided among the constituents of the mutual fund or ETF. However, this is often an acceptable trade-off for the lower risk of holding a diversified portfolio.
There are also significant differences between mutual funds and ETFs, which can affect investment results. For example, mutual funds don’t confer direct ownership to the buyers of their funds, but instead pool the assets of investors to buy stocks. Mutual Funds may also have higher fees than comparable ETFs.
There are many mutual funds and ETFs competing for your investing dollars. Due diligence is a must when considering any stock investment, whether the stock of an individual company or when buying mutual funds or ETFs.
When to Buy
Timing the best period to add to your portfolio is an extremely difficult task. Most active managers have difficulties buying securities at the best times, when prices are lowest. And many active managers don’t even attempt to time their buys. Instead, they focus on company fundamentals like earnings quality, dividends, sales, and cash flow, to aid in the selection of companies, and the timing of purchases.
Individual investors are confronted with a similar difficultly when timing their own buys. One strategy that has grown in popularity and is widely used by individual investors, is dollar cost averaging. In this approach, an investor will not buy a security all at once, but may stagger their buys. They can achieve this by investing a fixed dollar amount during a specific time period. For example, an investor may purchase $1000 of stock monthly, regardless of price or market condition. Dollar cost averaging can bring down the average price of holdings in a portfolio and can also help investors get in the habit of methodical investing.
Ups and Downs – the Bull and the Bear
The stock market of course can go up or down, and long periods of rallying markets can quickly turn into difficult times of sharp losses. But it’s important to note that pullbacks are common, and that the market has rallied back after every pullback it’s ever experienced. For example, from 1980-2021 despite average intra-year drops of over 14%, annual returns were actually positive 31 of 41 years. In these cases, an investor just needed to wait until the end of the year for the markets to fully recover. Even though there were ten years in which the market did not recover it’s losses by the end of year, the market has eventually rallied back from all of these pullbacks.
An investor should have a plan to take advantage of the Bull and Bear periods of the stock market. Dollar cost averaging can help prevent investing at bottoms or tops, and can be an appropriate strategy in both up and down markets. An investor should also know what they hold and have goals for each position in their portfolio. They should also be prepared to part with an investment if it doesn’t perform as expected.
Buying when the market is down, and selling when the market has been rallying, is difficult to do in the real world. Emotions often get in the way of the best investing choices. That’s why it’s imperative to have an investing plan, and invest regularly. Doing this, an investor can take advantage of downturns while also participating in rallies, and can ensure the highest returns over time.