Stock markets can be daunting, especially for beginners. Yet the banks of flashing green and red numbers that depict rapid share price moves and look impenetrable to the untrained eye represent where many of us invest much of our life savings and pensions.
Share prices are driven up and down by a vast amount of information that changes rapidly and requires expertise to understand.
But whether you are already investing in stocks and shares or you are a beginner looking to take the first step towards building wealth, it is worth taking the time to understand how stock markets work and how we can use them to make money.
What are stock markets?
A ‘stock market’, or ‘stock exchange’, is a market like any other. But instead of fruit, vegetables or houses, the buyers and sellers trade shares in companies principally, although other financial instruments such as derivatives may also be traded.
One share, or ‘equity’, gives the holder a part ownership in a company, and therefore the right to receive a portion of its profits and vote at annual general meetings.
One share only represents a very small part of ownership though: the ‘public’ companies listed on stock markets each issue millions, or even billions, of shares.
Stock markets exist to raise money for companies to use for commercial purposes. By buying shares, or equities, offered on an exchange, investors can take a slice of the profits and any increase in the value of companies, which will be reflected in their share prices.
The heart of the exchange has traditionally been a physical trading floor where traders buy and sell stock, calling out prices and using hand signals to communicate in an ‘open outcry’ method. While this system is still used on some stock and commodity exchanges, it is increasingly common for trades to be executed on computers. The New York Stock Exchange still facilitates both open outcry and electronic trading, however.
A stock exchange is designed to bring buyers and sellers together to create efficient markets. The parties involved in a stock exchange are:
- Participants – investors including banks, insurance companies, pension and other funds, and private individuals
- Stockbrokers – A broker and sometimes investment adviser that is authorised to access a stock market and place buy and sell orders on behalf of investors
- Designated market makers – Companies or individuals that quote the buy (bid) and sell (offer) prices on stocks
- Trader – Executes buy and sell orders from participants
Stock markets around the world list thousands of companies but their general performances are represented by flagship ‘indices’. These indices often track the combined performance of a group of the largest companies’ shares. For example, the FTSE 100 tracks the performance of the largest 100 companies listed on the London Stock Exchange. There are many other indices that cover other groupings of stocks, too, such as the FTSE 250, Russell 2000 and the MSCI Europe Index.
How do stock markets work?
Share prices float freely on the stock market, driven by demand and supply. If a company looks to be doing well its share price will rise on the expectations of higher future profits. But if its cash flows are threatened, perhaps because of negative market conditions, new competitors, strikes, a recession, tax rises or a war, then its share price will fall.
Interest rates can also impact share prices. If the central bank raises the base rate and the interest rises on bank accounts then investors might be tempted to switch their investments out of equities, reducing demand and pushing down their prices. If interest rates fall, shares generally become more attractive.
Share prices can fluctuate a lot during a stock market’s trading hours. A share’s price reflects whatever the market thinks it is worth at any given moment. It is based on the consensus opinion of thousands of investors who react rapidly with fear or greed to the latest information.
These are often over-reactions, however, so the resulting volatility can be used to advantage by traders and other investors who are buying shares when they are out of favour and cheap and sell them when they are popular and fully priced. As the famous investor Warren Buffett says, you should be “greedy when others are fearful and fearful when others are greedy.”
Can you make money off the stock market?
Patience often pays off for those with the nerve to ride out stock market volatility: over longer periods, shares can deliver strong positive returns. These returns are sometimes a good hedge against inflation too because companies seek to raise prices for their goods and services in line with it so their profits rise. Such returns are hard to achieve by placing money in savings accounts.
But shareholders can lose money if the company does not do well or even goes bust. It is important, especially for beginners, to diversify their risk by investing in shares in several companies and not ‘put all their eggs in one basket’.
Investors can reduce risk by investing in several companies to create a portfolio of shares. However, for most investors, both beginners and experienced alike, it is much easier to reduce risk by investing in an investment fund, such as the unit trusts, open-ended investment companies (Oeics) and investment companies with variable capital (ICVCs) offered by Liontrust.
These pool together the investments of hundreds and even thousands of investors, who can see their investments diversified across a range of companies, sectors and countries to reduce risk.
How to buy shares in a company
General members of the public are not authorised to buy and sell shares at the stock exchange. Investors can buy shares by going to a broker or investment platform. There was a time when brokers had high street offices all over the country but now many of them offer their services online, as do investment platforms.
Brokers may charge a commission, either as a percentage of the trade value or a flat fee, on purchases and sales. This will be higher if they provide advice on which stocks to buy and sell and there will be an annual management fee if your shares are held on their electronic platform. Investment platforms may charge a set fee.
The prices at which shares are bought and sold are different. This difference is known as the bid-offer spread and can be more than 1% of a trade. A stamp duty of 0.5% is payable on stock purchases and if you buy shares on a foreign stock market then there will be a currency exchange fee.
As well as diversification, it can also be more cost-effective to invest in investment funds such as those offered by Liontrust. Economies of scale mean these funds can spread the cost of trading shares among a high number of investors.
If the fund is ‘actively managed’ then they will be run by professionals who are experienced in analysing market information to create a portfolio of stocks on behalf of their investors. They assess economic and market data daily and the accounts of individual companies, often meeting the senior management to gauge their thoughts on their companies’ prospects.
Explore the entire range of Liontrust funds here.
