Demystifying stock markets

Unit Trusts, the beginner’s charm
15 May 2020

Demystifying stock markets

When you hear the names Warren Buffet, George Soros or even Peter Lynch, what comes to mind! I hope it’s not a blank screen. If you guessed the stock market then a big high five to you! These men have made a killing on the stock exchange and have earned billions from it. There is a huge fortune to be made on the stock market but as with all things, you must be prepared to put in the hard work in order to become an expert who can maximise on the opportunities.

The stock market is a sophisticated market where people can buy and sell ownership in companies. You might be familiar with how trading markets worked in the early hundreds. If someone came to the market to sell their sheep, the head auctioneer would announce the minimum selling price and the bidding would begin. Whoever was willing to bid the highest price got the sheep. While this might be a very simplistic example, this is the easiest way I can get you to understand how the stock market works.

Now, in the real world, companies are listed on the stock market in order to raise capital. This capital can then be used to finance internal growth, expansion by opening branches in more locations, mergers and acquisitions just to mention a few. The listed company is divided into small units called shares and investors have the option of buying into those shares. The buying price of the shares is usually called the bid and the selling price is commonly known as the offer price. The difference between the two is called the spread. As with all things, offer prices are usually lower than bid prices because we all love a good deal. Once a match is found between a bid and an offer, the trade is completed and a transaction is concluded. The more transactions get concluded for any particular share, the more liquid we say it is. It is always better to invest in a liquid stock than a non-liquid one.

When you buy a share you make a commitment to share in the profits and losses of the company and God forbid, every investor hopes only for profits. In return for taking on the risk to invest in the company, shareholders are compensated through dividends or the appreciation in the value of the shares they bought. Capital gains are as a result of the increase in the value of the shares over time. The best deal for any investor is to have a stock the pays good dividends while it’s share price is also increasing over time.

It would be naïve for one to think that it’s all plain sailing on the stock market. Companies go through cycles of great profits and sometimes of great losses. If the losses are insurmountable, the company has no option but to close. As a result, investing in stocks comes with the risk of loss of capital and due to the unpredictability, they are generally considered high risk. The more volatile a stocks performance is, the higher the risk and for the higher risks, most shareholders would demand a higher return to compensate them for this. So now that you know how the market works, you can probably challenge Warren Buffet with a stock portfolio of your own.

 

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