A basic introduction to the stock market for new investors and traders

Article summary

The stock market can be a viable option for investors looking for a potentially profitable alternative to regular bank savings and fixed deposits. In this article, we will break down the basics of the stock market, the difference between trading and investing, and the potential risks involved.

A lot of us have money in a bank account that earns interest at a steady but relatively low rate. But what if there's a way to make our savings grow faster?

Lately, more people are looking at the stock market as a place to invest their money. Though the stock market can be unpredictable—while there's a chance to earn more, there's also a risk of losing money—with the right knowledge and planning, it can be a way for smart investors to enjoy great returns. But before you dive into the world of bulls and bears, it's important to understand the pitfalls and opportunities, especially for new investors and traders.

In this article, we'll explain the stock market in easy terms to help you get started with your investment journey.

What is a stock?

When you buy a stock, also known as a share or equity, you're purchasing a tiny part of a company. This makes you a shareholder of the company. So, if the company does well, your stock value rises. But if the company faces challenges, your stock value might decrease in worth. For the sake of simplicity, we'll use the term 'stock' throughout.

Understanding the stock market and stock exchanges in India

When we talk about the stock market, we're referring to the system where stocks of companies, bonds, and other securities are bought and sold. It's like a massive, virtual marketplace where investors or traders buy or sell stocks.

Now, where does the actual buying and selling happen? In exchanges, that’s where!

Exchanges: These are the physical or digital places where all the buying and selling of stock happens. Literally, stocks change hands at an exchange. Exchanges help ensure that when you want to buy or sell a share, there's someone on the other end of the deal. And more importantly, they make sure that the prices you see are genuine and fair.

In India, we have two main exchanges:

Bombay Stock Exchange (BSE): Established in 1875 in Mumbai, it's one of the oldest and largest places for trading stocks in the country.

National Stock Exchange (NSE): Started in 1992 in Mumbai, it's a more recent addition but has quickly become a key place for trading, especially with its digital focus.

Overseeing all of this is the Securities and Exchange Board of India, or SEBI. Think of SEBI as the referee of the stock market. SEBI is the government body that ensures that everything runs smoothly, transparently, and fairly for everyone involved in the stock market.

Why do companies issue stocks?

Let’s say you want to start a café but don’t have enough money. Instead of borrowing and paying interest, you ask friends to invest in your café, and in return, they get a small share of the café. Similarly, companies issue stocks to raise money. This can help them expand, launch new products, or clear debts.

There are different reasons why a company may issue stocks, some of them are:

• Expansion and growth: Companies might need more funds to open new branches, enter new markets, or increase production. Issuing stocks provides the necessary capital without taking on debt.
• Acquisitions: If a company wants to buy another business, they might issue stocks to fund the acquisition.
• Research and development: To stay competitive, companies often need to invest in research and new technologies. Issuing stocks can provide the funds for this.
• Reduce debt: If a company owes a lot to lenders, it might sell stocks to get money and pay off some of what they owe.
• Public visibility and credibility: Being listed on a stock exchange can raise a company's profile and potentially help attract more customers and business partners.
• Liquidity: People who started the company or invested early might want to sell some shares and get some money. Selling stocks to the public makes this easier.

Types of stocks

One of the most important decisions you need to make as an investor in the stock market is choosing the stocks to buy. There are different types of stocks that have different characteristics, risks, and rewards. In this section, we will explain the two most common types of stocks:

• Common stocks: When you buy common stock, you're essentially buying a piece of a company, as a small share of ownership. With common stock, you may get a portion of the company's profits (known as dividends) at fixed time intervals if the company does well. And depending on the number of stocks you own, you may also get more voting rights in certain company decisions, like electing board members or approving major business moves.
• Preferred stocks or preference shares in India: Think of these as VIP tickets. If a company makes a profit and decides to share it, preferred stockholders get their share first, before those with common stocks. However, they usually don't get to vote on company decisions.

How do you make money from stocks?

When you invest in stocks, there are mainly two ways you can earn money:

• Capital appreciation: Capital appreciation is essentially the growth in the value of your stock over time. For instance, if you buy a stock at INR 100 and its price rises to INR 150 because the company does really well, you've made a profit of INR 50 for each stock.
• Dividends: Some companies share a part of their profits with their stockholders. This share is called a dividend. For example, if a company you've invested in has had a good year, they might give you INR 5 for every stock you own. Not every company gives out dividends, but those that do typically distribute them regularly.

Trading vs. investing: What's the difference?

Trading is like competing in a 100 meter sprint Traders aim to make quick profits by buying and selling stocks within short time frames, sometimes even within the same day. For instance, a trader might buy shares in the morning when the price is low and sell them in the afternoon when the price rises, making a profit from the difference.

Investing, on the other hand, is like running a marathon. Investors buy stocks with a long-term perspective, in the belief that over a long period of time, the company will grow significantly in value. They might invest in a promising startup, hold onto the shares for years, and watch their investment grow as the company expands and becomes more profitable.

Let's examine these differences more closely.

Both approaches have their merits and risks. The choice between trading and investing depends on your individual financial goals, risk appetite, and market knowledge.

What are market indices?

Before you invest in the stock market, it is critical to know how the stock market is performing overall. That’s where market indices come in. Market indices are like scorecards for the stock market that show how a selected group of stocks is performing, thereby giving us an idea of the market's overall health. For instance, in India, when people talk about the Sensex (from BSE) or the Nifty (from NSE), they're referring to market indices. These particular indices track the performance of top companies, helping us understand whether the market is generally going up, down, or staying steady.

Risks associated with the stock market

The stock market is not a risk-free investment. It can be volatile and unpredictable, and you may lose some or all of the money you invested in a particular stock. Some of the risks associated with the stock market are:

• Market risk: This is when the value of your stocks drops because of larger market issues, like economic slumps, political shake-ups, or even natural disasters.
• Company risk: Here, the stock value dips due to problems within the specific company you've invested in. Maybe they're dealing with bad management, facing stiff competition, or struggling with legal troubles.
• Liquidity risk: There is always a risk that you will not be able to sell your stocks quickly or easily when you want to, due to low demand or limited trading volume.
• Inflation risk: Imagine if the money you have now is worth less in the future because everything's gotten pricier. That's inflation risk. It's the danger that your stocks won't grow fast enough to outpace rising costs.

The stock market offers promising returns, but it comes with its share of risks. If you're new to this world, start with small investments, take the time to understand the ins and outs, and gradually venture deeper as you gain confidence and knowledge.

Wrapping up: Key points to remember

• Thinking of making your money work harder? The stock market might be an option, but remember it's not without risks.
• Buying a stock is like owning a tiny bit of a company. If the company does well, so does your money. But if it doesn't, the value of your tock nosedives as well.
• There's a difference between quickly buying and selling stocks (trading) and holding onto them for a longer time (investing). Know which suits you best!