How does the stock market work?

Read up before trying your hand at investing in the stock market

Felicity Hannah - Virgin Money Living Mentor

by Felicity Hannah | Independent Money Mentor

Award-winning personal finance and consumer affairs journalist

Please forget you ever heard the phrase “playing the stock market”. It gives entirely the wrong impression because investing in the stock market is neither a playful gamble nor is it usually a rapid way to make some money.

When you’re considering investing in the stock market, you don’t want a seat-gripping, Wolf of Wall Street punt, you want a viable way to grow your resources. Less game of chance and more strategic investment opportunity.

Like a game, however, there are rules you can learn and skills you need to know before you dip your toe into investing.

What are stocks, anyway?

The term “shareholder” refers to someone who owns shares issued by a company. The more shares you own then the more of a company’s stock you own and the greater your interest in that company.

When a company decides that it wants to raise money, it may choose to issue shares. The company gets to keep the money it makes selling them and can use it to grow its business. After that initial sale, which you will see listed as an initial public offering (IPO) the shares can keep on being traded via an exchange like the London Stock Exchange (LSE). However, the company doesn’t make any cash from the shares being sold on; it just receives money from the initial sale. Anybody subsequently buying shares and selling them at a profit keeps that revenue themselves. 

Why would I want shares?

Many companies pay their shareholders a dividend. This is a share of the profit the company has made. Not all stocks pay them and it’s not unknown for even big, established companies to suspend payment of a dividend if its fortunes are looking uncertain.

You may decide to buy stocks that pay a high dividend if you’re hoping to generate an income from your investment.

The other way to make money is by buying stock in companies that you believe will become more valuable. The price of shares is determined by what other investors are willing to pay for it on the stock market so if you can spot an investment that is likely to grow in value then you can make a good return. In other words, if you identify a company that you think is about to become more valuable, you can buy their shares and later sell them at a profit. If, for example, a company is about to release a new product which you think will be successful then you could invest in shares before the product goes on sale in the hope of seeing your share of the profit increase. 

It is important to highlight that it is very difficult identifying which stocks will rocket in value and plenty of people have lost money trying to make a quick profit. Most people choose to invest for the long term and over time stocks typically trend upwards in value. Of course, that’s no guarantee that shares in one single company will do so. That’s why many investors diversify.

Can I spread my risk?

Some investors will choose to invest in specific companies that they have chosen for their potential. Others may choose to limit their risk by investing in a fund. A fund takes money from a number of investors and buys up shares in a wide range of companies, spreading the risk, thereby avoiding putting all your eggs in one basket.

What if I don’t understand all the terms?

If you don’t know what the FTSE or LSE actually are, let alone bonds or bears then don’t panic. The more you read about it all, the more you will understand. A good place to begin reading is our stocks and shares jargon buster.

One way to dip a toe in the stock market is to use a stocks and shares ISA. You may well be familiar with the cash ISA already. It is a tax-free wrapper that lets you save money. You can use the same kind of account to invest in stocks and shares.

Doing so can be a good way of familiarising yourself with the stock market, but through a familiar structure. And just in case you make a small fortune (over time!), it could be helpful to protect it from the taxman.

Before making financial decisions always do research, or talk to a financial adviser. Views are those of our mentors and customers and do not constitute financial advice.