Understanding the stock market

If growth is your long-term investing objective, you’ll likely want to allocate a portion of your portfolio to stocks. And if, like most Canadians, you own shares of an equity mutual fund or exchange-traded fund, have an employer pension plan, or contribute to the Canada Pension Plan (CPP), you already invest in the stock market, if only indirectly. However, managing your own portfolio of individual stocks is different. You have to pick the stocks, do your research, and buy and sell stocks on your own.

If you’re new to investing in stocks, it can be a bit intimidating, with new systems and terminology to navigate. That’s where some know-how and the right tools come in handy.

What is the stock market?

The stock market is a marketplace system where stocks, commodities and exchange-traded funds are bought and sold (also known as “traded”). The stock market is made up of a number of “stock exchanges”, where sellers of a stock can connect with buyers of a stock. Examples of stock exchanges include the Toronto Stock Exchange (TSX), New York Stock Exchange (NYSE) and the Nasdaq.

What are stocks?

Companies sell stocks (also known as “equities” and “shares”) in order to raise money to run their business, to fund growth and expansion, or upgrade their equipment and technology. The portion of the company’s balance sheet that is funded by shareholders is called shareholders’ equity.

In exchange for providing the money, you, the shareholder, receive an ownership stake in the company, which includes a claim to its future earnings. The first time a company issues shares to investors is called an initial public offering (IPO). After that initial sale to the public, the shares can easily be traded—bought and sold—among investors. Stock exchanges and brokerages exist to facilitate those transactions and maintain an efficient, fast, accurate and cost-effective market for stocks and related securities.

How is a stock valued?

The value of a company’s stock (or its shares) is dictated by a wide variety of things, including the value of its assets, level of debt, creditworthiness, location, brand and reputation. External factors can also affect the value of a company’s stock. These include geopolitical events, regulatory change, interest rates, currency rates, or simply investors’ opinions about the company, its industry, or the financial markets in general.

The more optimistic (“bullish”) investors feel about a company’s potential to grow its earnings, the more they are willing to pay for a share of those future earnings. But when investors feel pessimistic (“bearish”) about a company’s prospects, the stock price falls.

If the company performs well, the value of its stock tends to increase. If the company doesn’t do well, if its earnings or profits decline, the value of its stock tends to decrease. Like all investments, stocks entail risk. If the company’s share price declines below the price you paid to purchase its shares, and you then sell the stock, you’ll realize a loss on your investment.

If you invest in a company’s shares, you hope the company is successful and profitable, so that you’ll receive a return on your investment. You can get a return in two ways:

• If the company grows its earnings and profits, shareholders may be willing to pay more for itsshares. If you sell your shares for more than you paid for them, you’ll realize a capital gain.
• The company may also distribute a portion of its profits to shareholders in the form of dividends.

Common versus preferred stocks

There are two main categories for stocks: common stocks and preferred stocks. Common stocks are the most (pardon the pun) common, and generally entitles stock owner to vote at a shareholder meeting and receive dividends paid out by the corporation. In contrast, preferred stock owners do not have voting rights, but have a larger claim on a company’s assets and earnings.

Categories of stocks

All companies earn money differently. Some are fast-growing, while others take a slow and steady approach. Their stocks tend to be grouped into three basic categories:

Growth stocks

Companies that are growing faster than the overall market and have substantial growth prospects in the foreseeable future. Generally, they don’t pay dividends in order to channel earnings towards expansion (think about those up-and-coming technology companies).

Value stocks

Companies that seem undervalued and relatively cheap, given their solid fundamentals (for example, sales, earnings, dividends). Value investors look for underdogs and invest before others move in and drive up the stock price.

Income stocks

Companies that have a track record of paying a regular dividend. Think about those slow and steady companies with solid cash flow—like a utility (people need to keep the lights on).

Stock market indices

When discussing stock market performance, analysts and market commentators are usually citing the performance of a stock index, which measures the performance of a group or basket of stocks that are intended to represent the performance of either a stock market, exchange or a smaller area (industry, segment).

Stock indices can be used as a benchmark to help investors and analysts compare the performance of an individual stock against its industry, peer group or the wider market. Some of the more widely known indices include the Dow Jones Industrial Average, which measures the performance of 30 major companies listed on U.S. stock exchanges, and the S&P 500 Index, which measures the performance of 500 large companies listed on U.S. stock exchanges. Other prominent indices include:

• S&P/TSX Composite Index – measures the performance of Canadian stocks, comprising approximately 250 companies.
• Nasdaq Composite Index – measures the performance of over 3,000 companies listed on the Nasdaq exchange.
• MSCI EAFE Index – measures the performance of 21 indices in Europe, Australasia  and the Far East.