By Troy MacMillan

April 29, 2016 | News

The Stock Market Part I

How Does The Stock Market Work?

If you are not familiar with the stock market it can seem an extremely complex place where fortunes are made and lost in the blink of an eye – an image that is only highlighted in the numerous movies relating to the subject.

In reality, the stock market is simply a place where buyers and sellers can come together to exchange shares in companies, with the shares representing a slice of ownership in the company in question. The more demand there is from buyers, the higher the price will go. The appeal of share ownership for investors relates to several factors:

  • First of all, there are the dividends that companies frequently (in most cases) distribute to shareholders. These dividends represent a portion of the company’s equity, and are usually related to the amount of profit the company has made in the previous period – the better the company does, the greater the likelihood of higher dividends. Some investors will look for companies that consistently produce high dividends in order to make their profits.
  • Next, there is the value of the shares. There are many factors that can influence share prices, but in general, the more valuable the company becomes, and the brighter it’s future success is perceived to be, the more it’s shares are worth. Investors who are looking to make their profits off buying and selling shares aim to find companies whose shares are currently undervalued but that are likely to increase in price in the short term in order to buy low and sell high.
  • The other benefit of share ownership relates to corporations law. If you are the owner of a small business or a member of a business partnership, you have unlimited liability for debts incurred by the business, meaning that if the business goes broke with huge debts, you are left to foot the bill. Companies on the other hand have limited liability, meaning that shareholders are only liable to lose the amount they pay for the shares they own. This allows for business ownership, without the possibility of losing personal possessions.

While the movies frequently feature a mass of screaming traders crowding the floor of a stock exchange (Australia’s principle exchange is the Australian Securities Exchange – ASX), the majority of trades are now done online. As an investor, you can either set up your own account or use the services of a stockbroker, who will make the trades on your behalf. There is a fee attached to each trade you make (DIY online is cheapest, while brokers will charge higher fees, but will also use their experience to recommend suitable shares). When starting out in the stock market, it is important to understand the nature of these fees, as they can dramatically alter the success of a small trade. Let’s consider this example:

You are looking to start investing in shares with a small investment of $1,000. You decide to buy 196 shares in Company A at $5 each, with a fee of $20 (fees vary between providers). The following week the shares have increased by five per cent to $5.25 and you decide to sell. 196 shares at $5.25 equals $1,029. Minus the $20 fee for selling and you are down to $1,009. So for a five per cent increase in almost two hundred shares, you earn a $9 profit, which doesn’t account for any time you’ve invested or allow for the likelihood that shares are just as likely to go down as up. Online trading fees are normally charged as either a minimum amount or as a percentage of the trade,  so even with larger amounts, you will still need to be mindful of the overall cost of frequent trading rather than just the share price itself.

In the next article, we will look at the different types of dividends that shareholders can receive for the shares they own, with the concluding article detailing the difference between seeking high yield shares for profit, and buying and selling shares for profit.

If you are unsure how to proceed with investing in stocks, or have any doubts about the strategy that is best for you, please consult with a qualified advisor to ensure you have the greatest chance of success.

Words by Troy MacMillan.