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It takes economists and hedge fund managers years to know everything there is to know about the stock market. Beyond the classic tagline of “buy low, sell high” is a seemingly infinite number of financial terms and complex relationships between multiple economic factors that make up the stock market. Whether you’re simply curious as to how this important socioeconomic mechanism works or is someone looking to invest in a company’s stock, here are five things you should know as you dive deeper into the stock market:
Prices are Relative
The stock market, or any artificial market for that matter, revolves around fluctuating values and prices. These prices, however, are not absolute. It changes frequently and sometimes quite violently. For instance, knowing the price of gold right now doesn’t mean you know its intrinsic value, much less be able to trade it profitably.
Market participants will have different opinions and valuations on any given asset, which is what makes prices move. If company ABC’s stock price moves down this morning, it’s not necessarily because of any fundamental changes in the company’s value, but rather the opinions of people buying and selling ABC stocks have changed.
Risk is Unavoidable
The stock market is regarded by many as a safe wealth-growing tool compared to other asset classes, like options contracts and cryptocurrencies. However, as with any financial product, stocks have an inherent degree of risk that must be acknowledged and planned for. The risk of the capital loss is high if an investor does not have a risk management plan or has one but is inadequate.
Investors who do try to eliminate risk will find themselves holding onto losing positions until the losses become too great to bear, in which case their broker liquidates it automatically to cover the position in a mechanism known as “margin call”.
Indicators are Lagging
Technical indicators are a popular means by which investors base their entry and exit levels. Commonly used technical indicators include, but are not limited to, Stochastics, Relative Strength Index, Bollinger Bands, Fibonacci retracement levels, and Ichimoku Clouds. Although these indicators help give meaning and identify price patterns, they tend to be lagging indicators, meaning that a stock’s price has already made the move before the indicator produces an actionable signal.
There is technically nothing wrong with this fact, but most investors wrongfully use these tools as the holy grail system with which their positions are solely based on. As a result, they often sustain losses from inaccurate signals.
Capital Preservation Should Come Before Capital Appreciation
That means that managing risk should be your main priority, and only after capital safety is assured should you look for ways to grow it. It again comes down to managing how much money you lose over time through stock market investing. Every investment should have a predetermined dollar risk and reward ratio.
For instance, a 1:2 risk-to-reward ratio means that, for every $1 you invest in the stock market, you stand to gain $2 back. Long-term investment strategies usually go for at least a 1:1 risk-to-reward ratio while short-term strategies involve negative RR ratios. As a general rule of thumb, only engage in short-term investing or speculation if you absolutely know what you’re doing.
Diversification Works
Have you ever heard of the phrase, “Don’t put all of your eggs in one basket”? While it’s flexible enough to be used in many scenarios, it is often thrown around in the context of investing. Diversification is dividing your available funds into multiple assets instead of a single one in order to distribute and, consequently, mitigate risk.
With most brokers now offering lower or even zero commissions per order executed, diversification comes as a more useful approach as it lowers risk without the multiple commission fees eating up your potential profits. When diversifying, limit your stock picks to segments or industries that you are familiar with and whose underlying company you understand from a macro and microeconomic level.
These are five important universal concepts every stock market participant should understand. While it’s equally important to memorize and familiarize yourself with jargon, such as bears vs bulls, ETFs, and drawdowns, the five things above help give you a bigger picture view of the market and how it works.