Stock market 101
The stock market, a daunting institution with not the best reputation. What do you know about the stock market? And I mean actual facts, not information that came from Wolf of Wallstreet or the big short. If you’re not coming up with anything, then you’ve arrived at the right place, because I am going to give you a crash course in stock market 101.
Why do I need to learn about the stock market?
Good question. The stock market and those who work on Wall Street are often portrayed as evil. Why? Because it makes for interesting stories and good movies. And because they do bear a serious responsibility in the financial crash of 2007 – 2008.
But that’s not to say you can’t use the stock market to your advantage. The growing popularity of brokerage apps only proves that more and more people are finding their own way to the stock market. And why shouldn’t they? There is only one certainty when it comes to finance and that is that you will lose money when you keep everything in the bank. Yes, you might lose money on the stock market, but it’s a might. Inflation is a given fact, and your money will only lose its value as it's sitting there idle. So get your money off its lazy as and let it work for you.
While some horror stories about ordinary people losing everything on the stock market are true, there are several ways to make sure your investments are as safe as possible. There is never a guarantee though, so always do your own research, too.
So why do I need to learn about the stock market? So that you can make educated decisions about what to do with your money. In that way, you can start your own path to FIRE and tap into the magic of compound interest.
What are stocks?
Stocks, also known as shares or equities, are little pieces of ownership of a certain company. When you buy a stock, you are, in essence, a partial owner of that company. Why would you want to be a partial owner of a company? Because it gives you certain benefits that could earn you a return on your investment.
Companies need money for expanding their business. When they want to launch a new product, hire more people or open a new factory, they need to raise capital. Companies can raise capital by issuing or selling shares of stock. When people buy these stocks, the company receives money. In return, the company promises certain benefits to their loyal stockholders, thus giving them a chance to make money on their investment.
How can I make money from stocks?
There are generally two different ways you can earn money from stocks:
Dividends: it is possible that the company you purchased stocks from pays out dividends. A dividend is a piece of the company’s profit. Companies pay out dividends to reward loyal stockholders. Mind you, not all companies do this! Especially, tech companies refuse to pay out dividends, claiming they rather re-invest their profit in the company's growth instead of paying out stockholders. But there are a lot of companies that do pay out dividends. Good dividend yields are usually between 2% to 6%.
Capital appreciation: capital appreciation is a fancy word for capital gains. When a company’s stock price goes up, so does the value of your shares. Of course, when a company’s stock price goes down, so does the value of your shares. It is up to you whether you buy more stocks during a price fall and try to “buy the dip” or sell your stocks to avoid any more losses. It all depends on how strong your belief is in the company.
How can I buy stocks?
Do you know those movies about Wallstreet with the aggressive alpha males all yelling into the phone? That’s how Hollywood portrays the stock market. Luckily, you don’t have to get on the phone with one of those guys. Nowadays, it’s easier than ever to buy and sell stocks yourself. There are dozens of apps that give you access to all kinds of products on the stock market, including stocks. Examples for my American readers are Fidelity, Webull, or Robinhood (infamous from the GameStop debacle). When you are based in Europe, you can turn to DEGIRO, Saxo Bank, or Questrade. Changes are your local bank will have an app too, but be sure to check the brokerage fee, because they can get quite high when you go with a local bank.
Now that you’ve set up your brokerage account, it’s time to invest in some stocks. It’s good to know that you don’t need a lot of money to start investing. For example, if you are a big Elon Musk fan and want to buy a share of Tesla, you don’t need to put down 900 dollars, which is the current price of a Tesla share. Thanks to fractional shares, it is possible to own half a share or even a quarter of a share. In this way, it is possible for everyone to own a bit of Tesla, if they want to. Do mind that not all shares can be bought as fractional shares, so always do your own research into the stocks you wish to buy and what options you have.
Stocks can be traded at any point during the day. That’s where the name day trader comes from: a day trader is someone who buys and sells stocks on a very short timeframe, usually within a day. They make a profit by estimating if a stock will be worth more or less in the next hour or day. Day trading is all about timing the market, a mythical concept that is very, very hard to achieve. If you ask me, don’t bother with it. Some people claim they got their fortune by day trading, but most people lose money or barely break even with the market. I don’t think it’s worth all the effort, but I’m not a financial advisor, so do your own research first if you think day trading might be something for you.
Wall Street history fact: the name Wall Street has a history meaning. A long, long time ago, New York was called New Amsterdam. The Dutch gave it that name after colonizing the island in the first half of the 17th century. Unfortunately, it wasn’t a peaceful time back then. Pirates and the British constantly attacked New Amsterdam, so the Dutch started building a defense wall. Any guess as to where that wall was located? The wall is long gone now, but its legacy is still remembered in the street being named after it:
Wall Street.
What are mutual funds?
Stocks are only one part of the stock market. There are a dozen more financial products available nowadays. Not every financial product is as easy to understand, so I’m going to stick to the basics for now.
Stocks are easy to understand but riskier. Putting all your money into one or two stocks is like putting all your eggs in the same basket. It’s not really safe. Investing in the stock market is never truly safe, but you can make it as safe as possible.
So how do you spread your risk in the stock market? There are lots of ways, but let’s start with mutual funds. Mutual funds are basically a basket full of all different kinds of stocks. You can go really broad with an all-world kind of fund, or focus on technology stocks or clean energy stocks. With a technology fund, you can buy a little piece of Apple, Amazon, Tesla, and dozens of other technology companies all in one go.
The more you focus on one market segment, the more risk. Things can turn out great if the market for those particular stocks goes up, but it can also become catastrophic if the market for those stocks goes down. By diversifying your portfolio, you manage the risk.
Managing your risk also means managing your gains. Yes, there is a slight chance you might get super-rich with the next Tesla or GameStop, but changes are a lot bigger than you lose all your money if you start thinking like that. Investing in a fund balances out the wins and the losses. The worst losses are softened by some wins, but the biggest wins are also reduced by some losses.
Mutual funds are actively managed by your bank or other fund managers. Those people know a lot about stocks and the stock market (or at least they pretend to), and the goal of a mutual fund is to beat the market. Each day, they pick the right stock and try to time the market to make as much profit as possible. It takes a lot of work to research all those stocks and follow up on the daily movement of the stock market, so mutual funds usually have a higher running cost. This means that a part of your gains will go to your bank or fund managers as payment for their work.
A big difference between mutual funds and stocks is that mutual funds are only traded once per day after the markets close.
What are index funds?
Another popular financial product available on the stock market is index funds. An index fund is not the same as a mutual fund. The difference lies in how the fund is managed. A mutual bond actively buys and sells stocks (or other financial products, depending on the fund), but an index fund tracks a market index. An index fund will only change its composition when the underlying index the fund tracks changes, for example, when Tesla entered the S&P 500 index.
There are a lot of financial markets in the world, and nearly every one of them has an index and an index fund. The S&P 500 or Nasdaq 100 are examples of market indices. The S&P 500 consists of the 500 biggest US publicly traded companies. The Nasdaq 100 is similar, except it consists of the 100 largest companies traded on the Nasdaq stock exchange, which relies heavily on the technology sector.
When you buy an index fund that tracks the S&P 500, you invest in all the companies that are included in the S&P 500. Because the index fund tracks a particular index, it is unnecessary for banks or fund managers to actively manage the fund, hence the difference with a mutual fund. Therefore, investing in index funds is known as passive investing: once you buy the index fund, you don’t have to do anything else.
Because index funds are so easy to manage, you don’t need to go to a bank or a fund manager to invest in them. You can just buy them yourself in the same way as you would buy a stock, except that index funds can only be bought and sold once per day, at the price set at the end of the trading day. A big advantage that is tied into the simplicity of index funds is that the management costs, also known as expense ratios, are a lot lower than the expense ratios of mutual funds. This can save you a lot of money in the long run.
What is an ETF?
ETF stands for Exchange Trade Funds. ETFs are a kind of index fund, but there are some key differences. The major difference between ETF’s and index funds is that ETFs can be traded at any point during the day. In this way, they behave the same as stocks. During the day, prices can go up or down and you can buy in or sell out whenever you like. Index funds can only be bought and sold at the end of the trading day and at that exact price.
Another key difference between ETF’s and index funds is the minimum investment required. A lot (not all!) ETFs can be bought as fractional shares. If the ETF doesn’t allow you to buy fractional shares, you can still buy your way into the ETF with just one share. Index funds rarely have that option. They require a minimum initial investment of several thousands of dollars, much higher than the price of just one share. This is one reason why ETFs are so popular with retail investors because they don’t have to save up a sizeable sum upfront to cross some magical minimum investment threshold.
ETFs and index funds in general, are very popular with people pursuing FIRE. There are several reasons for this. The first one is simply how easy it is to buy an ETF. You don’t need a financial advisor or a fund manager, only a brokerage account. The second reason is the low expense ratio of ETFs. Minimizing costs is a huge part of the FIRE journey. A third reason is that it is very easy to achieve a healthy diversification of your portfolio with ETFs. Remember: diversification is key to being as safe as possible in the stock market. The conclusion is that investing in ETFs is a great way to passively invest in the stock market, and that’s what FIRE is all about: creating enough assets or passive income so you can retire early.
