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Basics of Stock Market Investing

Posted By Jim On 08/06/2012 @ 7:03 am In Investing | 3 Comments

Until a few years ago, the stock market was a mystery to me. I understood how it worked but I was always concerned about taxes, not getting ripped off, and the sums of money it seemed to take to “make” anything in the market. This was way before the huge market gyrations of the last few years, especially the pops and drops during the “Great Recession,” and I didn’t commit myself to learning until a few years into personal finance blogging.

I thought it would be valuable to put together an article on the basics of stock market investing. This won’t explain everything about the market, that’s just too difficult, but hopefully it’s a good start that will be the basis for additional research. Let me know if you see anything missing and I can add it.

Types of Stock

There are several types of “stock” but the general idea behind “stock” is that it represents ownership in a company. Stock is counted, bought, and sold in units of measure called “shares.” So you would buy a hundred shares of a stock, or sell a hundred shares of stock.

Stock comes in two main flavors: common stock and preferred stock. When people talk about buying and selling stock on the stock market, they’re usually talking about common stock. Common stock usually are voting shares, so you can vote in the annual meetings for major decisions and for the board of directors, but they aren’t always voting shares. If the company distributes dividends, common stockholders generally receive those as well. Sometimes a company will have different classes of common stock and it’s up to the investor to research what rights each class has.

Preferred stock isn’t traded on the open market, typically carries no voting rights, but often has priority over common stock for purposes of dividends and in the event the company goes bankrupt. There are different varieties of preferred stock but biggest difference between these and common stock is that they usually aren’t traded on the open market. There are exceptions, usually in utility companies and real estate investment trusts (REITs) areas.

Buying & Selling Stock

Let’s limit our discussion to common stock for the purposes of buying and selling. The first thing you will need to invest in the stock market is a stock broker. I’ve done a quick comparison of some stock brokers [3] on the basis of commissions, fees, minimums, and other important details that may be helpful. Ultimately, who you decide will depend on what you want to do. For now, let’s talk about the mechanics.

There are two types of transactions you can do – you can buy shares of a company or you can sell shares of a company. When you’ve decided on the action you want, the next step is to decide whether you want to place a market order or a limit order. A market order is where you tell the broker you want shares of a company at whatever price the market is selling them at. You lose predictability but you gain speed, because the trade will execute as soon as they find someone willing to sell you shares at the market price.

A limit order is where you tell the broker you want shares of a company at a specified limit price (“I want 100 shares of BRG at $5 a share”). If someone is willing to sell the stock at that price, the trade is made. Otherwise it sits there until someone is willing to sell, the order expires (you can set orders to be active until the end of the day or active until fulfilled), or you cancel it.

In the case of sell orders, there’s another rule you can add to the action. You can specific a stop price, which is the price at which the order activates. In the case of a trailing stop loss order [4], you want a market sell order to be executed once the price falls under a specified price.

ETFs and Mutual Funds

If you aren’t interested in investing in individual companies, you might want to try a fund. A mutual fund is a basket of different companies that satisfy the fund’s stated mission. For example, an index fund is a mutual fund that seeks to mimic a stock market index (these S&P 500 index funds [5] mimic the S&P). A mutual fund can have anything as its goal. The Vice Fund [6] is a mutual fund that invests at least 80% of assets in alcohol, tobacco, gaming, and defense/aerospace companies.

Mutual funds aren’t traded in real time. If you place an order before close of business, you get the closing price that day. If you place an order after close of business, you get the closing price the following day. I don’t want to get too detailed into mutual funds but I do want to mention that you need to do your research because not all funds are created equal, even if their stated goals are. Do your homework or you may overpay for an underperforming product.

ETFs stands for exchange traded funds and they are mutual funds that are traded in real time, just like stocks. Many were created relatively recently to fulfill a market demand. People wanted to actively trade mutual funds and so companies started offering mutual fund-like products that could be traded in real time.

Options

I don’t dabble often in options and I only want to briefly mention them in a primer on stock market investing because you’ll likely run into these creatures from time to time. Put and call options are contracts you can purchase (or sell) that give you the right, but not the obligation, to buy or sell a stock at a particular strike price. A put option is a contract that gives you the right to sell the underlying stock at a certain price. A call option is a contract that gives you the right to buy the underlying stock at a certain price.

Dividends

A dividend is a payment offered by a company to its shareholders of record. Sometimes the dividend is in the form of shares of stock, more often it’s a direct cash payment. Dividends are taxed at the long term capital gains tax rate.

Depending on your broker, you can opt to have the dividends reinvested into your position or paid out to you in cash. Reinvesting your dividends can be a powerful way to grow your position cheaply as long as the reinvesting can be done for free. Regardless of whether you reinvest or take the dividends, you still owe taxes on the amount paid out.

Taxes

Whenever you sell a stock for a profit, you are subject to capital gains tax. Short term capital gains tax is your marginal tax rate [7] and applies to sales of a stock you’ve owned for less than a year. Long term capital gains tax is a separate rate, based on your tax bracket, and is often lower than your marginal tax rate. It applies to stocks you’ve owned for over one year. As for reporting taxes, your brokerage will send you a tax form that you can use to fill out your tax return. It’s pretty straightforward and since the information is also relayed to the IRS, you better get it right or you can expect a letter in the mail.

That pretty much covers the basics. Were there any big pieces that I missed?

(Photo: proimos [8])


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[1] Tweet: http://twitter.com/share

[2] Email: mailto:?subject=http://www.bargaineering.com/articles/basics-stock-market-investing.html

[3] quick comparison of some stock brokers: http://www.bargaineering.com/articles/compare-stock-brokers

[4] trailing stop loss order: http://www.bargaineering.com/articles/what-is-a-trailing-stop-loss-order.html

[5] S&P 500 index funds: http://www.bargaineering.com/articles/cheapest-sp-500-index-funds.html

[6] Vice Fund: http://www.google.com/finance?q=vicex

[7] marginal tax rate: http://www.bargaineering.com/articles/federal-income-irs-tax-brackets.html

[8] proimos: http://www.flickr.com/photos/proimos/5899300483/sizes/s/

Thank you for reading!