Melissa believes the stock market is where your money goes to grow. She loves researching new stocks to build her dividend portfolio.
Learning the Stock Market's Terminology
When new investors step onto Wall Street, it may seem like another country. Investing in the stock market brings you into a self-contained world with its own lingo and customs that may be confusing if you've never encountered them before. Baffling terms like "bull market" and "IPO" may send you running for the hills (or Google). But like any foreign country, you can stick around for a while, learn the language, and find a way to thrive in the stock market. I am a relatively new investor, but I want to share what I've learned so far to help others get started. Here are some terms and definitions that will help you begin your investment journey.
What Is a Stock?
A stock is an asset that gives you ownership of a small fraction of a company. When you own stock in a company, the money that you've invested into buying it will grow and shrink based on the profits and growth of the company. You are basically making a bet on the company's future. Units of stock are called shares, and the more shares you hold, the more you are invested in the company.
Being a shareholder means that you don't actually own the company, but you may have the right to vote in shareholder meetings that the company holds, and you have the ability to buy or sell your shares as you wish. If you cannot afford the share price of a full stock, some companies sell fractional shares that allow you to buy in for a cheaper price.
Common Stock, Preferred Stock, and Dividends
Common stock allows you to participate in shareholder meetings and lets you receive dividends if the company pays them, which are monthly, quarterly or annual payments made to shareholders from the company's profits.
Dividend-paying stocks, particularly dividend aristocrats with a long history of consistent payouts, are a great way to create a steady income for yourself. The more shares you hold, the more your income grows. You can also choose to reinvest these dividends to buy more stock with a DRIP (Dividend Reinvestment Plan), speeding up your account's growth. However, not all companies pay dividends towards shareholders, putting the money towards company growth instead.
Preferred stockholders usually don't vote in shareholder meetings, but they have a better claim on the company's earnings and assets, and are considered first if the company goes bankrupt. They tend to receive a fixed dividend that pays out perpetually, and receive it before common stockholders.
What Is a Bond?
With a bond, you are lending your money to a company for a time, and you will be paid in interest, usually for a fixed rate, although variable interest rates are becoming more common. When a bond matures after a certain time period, the borrowing company is required to pay back your principal, or the original amount that you loaned them. You can also buy bonds from most governments, so that your bond is not tied to a particular company's success.
Bondholders will be prioritized before stockholders in the event of a bankruptcy, so holding bonds is considered to be less risky than holding stocks. However, stocks may have a higher potential for growth based on the movement of the market.
What Are Options, Calls, and Puts?
Options are a type of asset where you make a contract with a company that gives you the right to buy or sell shares over a period of time. Call options allow you to buy shares, and put options allow you to sell shares. Think of it like a down payment for a purchase you will make later in the case of a call, or insurance against a bad event in the case of a put.
Options don't represent ownership in a company like stocks do, instead they represent other assets and get their value from them, making them derivatives. Options are considered less risky than stocks because you can potentially back out of fulfilling the contract before its date of execution. They give you the option to perform the action or change your mind. Options can expire after a certain amount of time, so your ability to buy or sell will only last for a certain time.
What Is the Difference Between an Exchange-Traded Fund and a Mutual Fund?
Funds track a group of stocks or an index measuring a certain market instead of focusing on the performance of just one company like stocks do. When you invest in a fund, you are taking on less risk because even if one stock in the fund decreases the others may not be affected.
Exchange-traded funds, or ETFs for short, are baskets of stocks that can change prices throughout the day as individual stocks within the fund rise and fall. Mutual funds are managed by a professional money manager and will only change in price at the end of the day. Mutual funds require more documentation, and the fund manager will get a cut of the price, making the price higher than you would see with an ETF. However, they are considered less risky over the long run since their price is more stable and they are being overseen by someone else who stands to benefit from you making money.
What Is a 401(K), and What Is the Difference Between a Traditional 401(K) and a Roth 401(K)?
A 401(k) plan is a company-sponsored retirement plan for their employees that allows them to purchase stocks, bonds, and other funds with a certain percentage of their paycheck. Employers may match employee contributions to this fund, allowing you to grow your money faster. There is the traditional 401(k) and the Roth 401(k).
Traditional 401(k) accounts let you put in money now, which will be taxed later when you withdraw it. Roth accounts take taxes as you put money in so you can withdraw the money tax-free later. Since it's unknown what taxes will be like in the future, it is wise to put some money in both.
401(k) plans are an easy way to participate in the market, but they are also somewhat subject to the market's whims. Diversify your portfolio with different types of assets to have the best cushion against this volatility.
What Is an IPO?
An IPO is an initial public offering, where a company who previously only issued private shares makes their shares open to the public. This can help companies access more money than they had previously, and allows the public to get in on a new opportunity for growth. Since public companies are required to post quarterly reports, the company and shareholders alike will also benefit from increased transparency, and the company also has more leverage in acquisition deals. Private shareholders are often given share premiums, so they stand to profit as well.
To hold an IPO, companies must prove to the Securities and Exchange Commission (SEC) that they meet legal requirements, and they may advertise their decision beforehand to gauge public demand and figure out their initial share price. A lot of focus in the media has been put on unicorn IPOs, private startup companies with a value over 1 billion dollars that decide to go public.
What Is the Difference Between a Bull Market and a Bear Market?
A bull market means that market prices are trending upwards by 20%, so investors may be more confident in the market and will be more likely to buy stocks. To take advantage of a bull market, investors will buy a stock early and sell it when its price rises higher for a profit. This is called taking a long position, which means they will buy the stock and hold onto it, believing it will "go long" and increase over time.
A bear market means that market prices are trending downwards by more than 20%. To take advantage of a bear market, investors may use strategies like short selling a stock. With a short position, sellers believe that stock will "go short" or decline in price. Short sellers borrow a stock and sell it on the market for a higher price, and then buy it back later after the price has decreased, pocketing the difference. This can be a risky strategy, as shown by the Gamestop craze in January 2021, since the price of a stock can theoretically go up to infinity, leading to huge losses. Most investors during a bear market become conservative with their money, and are less likely to buy during this time.
Both bear markets and bull markets can occur in short cycles or be part of a long term trend. For example, a recession may cause a long term bear market, while a strengthening economy can result in a bull market.
What Is a Speculative Bubble?
A speculative bubble happens when the price of an asset rises sharply due to hype and sentiment rather than the actual value of the asset. A period of growth or price appreciation leads investors to overhype the stock and have high expectations for its success. More investors pile on as the price skyrockets, fearing the possibility of missing out on the opportunity to become rich. Eventually, however, the bubble will pop, and prices will drop to match the stock's actual value, which can leave some unlucky investors at a loss, holding an empty bag.
An example of a speculative bubble is the Gamestop craze of early 2021, where stock prices surged up to $400 and above before suddenly dropping sharply.
What Is a Stock Market Crash?
The stock market is considered to have crashed when prices drop suddenly and sharply by the double digits over a couple of days. This can signal economic trouble ahead for the world and a long bear market, causing people to panic over their lost money.
Crashes can become even worse when investors panic-sell their stocks en masse, trying to minimize their losses. Crashes can also have long-term effects on the way investors maneuver in the market, keeping them behaving more conservatively with their money. Methods such as trading halts can be triggered to protect the market in the event of a crash, and large companies can also protect against plunges by buying large amounts of stocks to counteract the "Sell, sell, sell!" panic mentality going on.
Some famous stock market crashes include the crash of 1929, which kicked off the Great Depression, and the 2008 housing market crash that caused the Great Recession.
Hopefully these definitions have helped to demystify the stock market for you. As general advice, buy when stocks are low, sell when they are high, and never invest more money than you're willing to lose, Put your money into companies that you believe in, and your money will be put to good use. Enjoy the thrill of the highs and weather the storm of the lows. The stock market is a world full of adventure and potential profits, so do what you can to get started with investing! There's money to be made!
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2021 Melissa Clason
Liz Westwood from UK on February 21, 2021:
This is an interesting and useful explanation of stock trading terminology.