What is the stock market in simple terms and how it works
Do you want to teach your children to use their savings as efficiently as possible? Then you need to teach him from an early age about the intricacies of investing and working in the stock market. But you need to do it clearly and simply, without coercion. Here we will not only explain to you how to teach a kid about the stock market but also tell you how it works. Not every adult has a clue.
To get your child interested in the new world of money, start learning easily. Do not overload the child’s thinking with complex terms, technical assessment of the stock market, and analysis of the companies that work on it.
Just show your child the simplest things you do and watch how he reacts to new information. If your child likes to participate in trading, sell and buy valuable assets-continue to tell him about the peculiarities of working in the stock market.
What is the stock market, and what is it for?
The stock market is a market where transactions are made to buy and sell securities (stocks, bonds, mutual funds). Securities can grow up in price so that you can earn money this way. All trading operations take place on the stock exchange. This is a specialized trading platform that gives all participants the opportunity to safely enter into transactions at prices that are relevant at a given time.
Tell your child about the participants who work on the exchange, and invite him to choose a profession that he likes. Basically, the exchange employs intermediaries between direct sellers and buyers: brokers, banks, investment companies, and private investors.
Certain types of securities can be sold and bought off-exchange. However, without intermediaries, such transactions still do not pass. Also, OTC trading is associated with high risks since no one controls direct transactions. Tell your child about this so that he understands that investing personal money in securities is safer and safer only on the stock exchange.
How the stock market works
It is essential to explain to your child that the stock market is not a lottery. You can’t accidentally become rich here. You need to have a deep understanding of what to do. The basis of the securities market is the stock exchange, where recently it is possible to trade not only securities but also precious metals, currencies, credit agreements, and contracts. Also, in the stock market, you can buy and sell assets that are created on the basis of other assets (for example, options and futures).
There are dealers, brokers, and licensed management companies. Traders, institutional and private investors also trade on the exchange, but only through the above-mentioned companies that provide intermediary services. To start cooperation with an intermediary, you only need to open an account with this company.
Issuers are participants of the stock market that are engaged in the issue of securities. These may be companies that issue bonds and shares. Also, the state itself or its entities that issue bonds can act as an issuer.
Dealers, management companies, and brokers are market participants who have broader rights. They open access to the financial objects of the exchange for investors and traders. Such companies may enter into transactions on their own behalf and on behalf of the clients whose interests they represent.
The main task of the exchange is to maintain a high level of stock market liquidity. A market is considered liquid if a large number of transactions are made on it. This leads to a smooth price movement and minimal spreads (the difference between the purchase and sale price over the same time period). The main aim of investors is to get profit from lucky investing.
When the market liquidity is low, there is a panic among the bidders. There are doubts that they will not be able to sell or buy assets at the most attractive price. The exchange’s earnings are generated by the commissions it receives from all market participants. Therefore, if a lot of participants work on the exchange and a lot of transactions are carried out, the exchange will receive a large profit (for example, the New York Stock Exchange).
What do the prices on the stock exchange depend on?
First of all, it depends on the size of supply and demand. Higher demand leads to higher prices, and low demand leads to lower prices.
Demand increases at times when investors and traders want to buy assets at a lower price and then sell them at a higher price. At these moments, market participants expect stock prices to rise. The supply in the market appears during periods when investors and traders expect prices to rise in order to sell assets more expensive later.
To explain to the child why the quotes at one time can change up or down, you need to tell him about the reasons for the change in the expectations of traders and investors about the issuing company.
The most important reason for the change in prices on the market is the planned profit of the issuing company. The stock market immediately reacts to information about the company’s performance, which it displays and publishes in its financial report. When the profit exceeds investors, analysts, and traders’ expectations, it causes a positive reaction from all market participants. They have the opportunity to buy shares of the company, then sell them at a higher price.
The opposite situation occurs when the company’s report shows a profit that is lower than the analysts’ forecast. The market begins to fluctuate; all participants evaluate the likely risks. After all, if the interest in a particular company and its shares falls, the price will also decline in the near future. As a result, market participants begin to quickly sell assets at the current price in order to buy them later, but cheaper.
What securities are traded on the stock exchange?
On the American stock exchanges, you can buy and sell different types of investment instruments. The main ones are bonds, stocks, mutual funds.
In the United States, there are the following types of bonds:
- municipal bonds;
- government bonds of the country;
- Treasury bonds of the country;
- corporate bonds.
There is a distinction between investment-grade and non-investment-grade bonds. The latter are also called speculative or high-yield (high-yield) securities. The level of investment quality depends on whether the bond has a credit rating or not.
In the United States, there are bonds with a constant and floating coupon, as well as coupon-free securities. Coupon payments are not made for the latter type of bonds. But investors still make a profit on them, but only at the expense of a discount.
For example, when bonds are placed with a nominal value of $1,000, investors can buy them for only $700. However, at the time of repayment, the issuing company is obliged to pay the owners of the securities their nominal value.
In the United States, ordinary and preferred shares are traded on the stock market. The owners of ordinary shares receive dividends on them and have the right to vote, while the owners of preferred shares only receive dividends. At the same time, the owners of preferred shares are in a higher priority position. After all, they have an advantage over the owners of ordinary securities when paying dividends.
The main feature of ordinary shares is the ability to divide them into certain classes (class A, class B, class C, etc.). Depending on which class of shares the investor owns, the number of votes in the voting directly depends. For example, one Class B ordinary share gives the owner 50 votes, while one Class A share gives only one.
At the moment, in the United States, the law does not restrict companies in the classification of shares. There are also no restrictions on the number of votes that can be assigned to shares of different classes. These parameters are determined by the issuing company.
In the United States, all stocks are conditionally divided into:
- Income stocks — these securities regularly pay dividends. Therefore, their purchase is only due to the cash flow.
- Growth stocks are issued by companies whose profits increase faster than the market average. However, dividends on such shares are rarely paid. Therefore, they are bought only with the prospect that the company’s capital will grow in the future.
- Value stocks have low multipliers of P/BV and P/E. Their purchase by investors is explained by the prospect of their market revaluation.
- Blue chips are produced by large companies with a good reputation. They usually pay dividends regularly.
- Penny-stocks — the value of such shares does not exceed $1. They usually cost a few cents. They buy cheap shares with the expectation that their value will grow significantly in the future.
In the United States, there are several types of funds:
- Equity funds are invested in highly liquid stocks of different classes.
- Bond funds invest in securities that do not fall into the class of cash equivalents.
- Money market funds invest in liquid securities that are classified as cash equivalents in accounting.
Funds with an end date (target-date) — the closing date of the fund is fixed. These include various securities that are primarily focused on long-term prospects.
The purchase of securities through mutual funds is carried out only with the help of a broker. The fact is that most of these organizations are listed on the stock exchange (for example, NASDAQ has almost 35 thousand). But each of the listings can only be purchased through a broker.
ETF (index funds): what they are and how they work
ETFs (exchange-traded funds) are funds similar to mutual funds. An important difference between mutual funds and index funds is the way they are purchased. For example, the purchase of a unit in a mutual fund is carried out directly from the management company or through a broker. At the same time, the share price is fixed at the end of the trading day, and the price corresponds to the price of net assets that fall on one share. At this cost, the investor can buy or sell a different number of shares.
The purchase of units in an ETF takes place on the open market. This is the risk of making a purchase at a higher price, which will not always correspond to the internal price of the unit. In addition, there are a lot of stock indexes in the United States, and the rules for forming an index follow a complex pattern. For example, on the stock exchange, you can find indexes on shares from the NASDAQ 100 offer, against which call options are sold. This indicates the active management of the company’s investment portfolio.
What does a kid need to start investing in the stock market
To teach a child to properly manage his or her personal money and increase it with the help of investments, parents need to make a lot of effort. Children need to start learning financial literacy from an early age (9-12 years). When your child is in school, open a bank account for them. At the same time, the child must also be present at the bank when opening a deposit so that your kid can participate in the process of creating his/her first account. Then every month, together with the child, make reports: how much money was deposited to the account and how much interest was accrued on this amount.
You need to explain to your child that it is safer to invest in the assets of companies with a clean reputation. The names of the companies must be familiar to your child, so it will be easier to convince him. Also, invite your child to invest in different companies. It will help him understand the principle of diversification.
To start with, you can choose companies such as Amazon, Procter & Gamble, FBS Data Systems (a company that helps with real estate transactions), Advoco (a company that manages PepsiCo and Starbucks assets), and Apple. The brokerage account can be replenished not only by parents but also by the children themselves, using personal money given to him for his birthday and other holidays.
Inflation is a concept that a child should know about already at the initial stage of investing. They must realize that investing doesn’t just help them make money. Investments should be made with one goal in mind so that inflation does not take away all the accumulated money. At the same time, it is essential to give the child freedom of action, but in moderation. For example, he can be allowed to manage only 20% of the investment portfolio. This will help the child to understand the responsibility for their actions and actions.
You can tell your child the story of the famous US entrepreneur and investor — Warren Edward Buffett. One of the wealthiest people in the world made his first purchase at the age of 6. With his pocket money, he bought several cans of Coca-Cola for 25 cents and then successfully sold them to his family members, but at 50 cents per can. At the age of 11, Warren Buffett began trading on the stock market, following his father’s example. This story will be a vivid example and an incentive for your future successful investor to learn financial literacy.
The stock market is one of the most attractive investment objects for investing free money. Despite the risks, the market gives traders and investors an excellent prospect of getting a good return on their investments.
If you want to grow your child into a successful investor, then teach them complex terms, concepts, and financial transactions from an early age. You only need to do it with interest — show the child that this way of generating income is interesting to you. Looking at their parents, children often follow in their footsteps quite successfully.
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