Learn the stock market: understanding stocks
In this guide, we’ll help you understand stocks, what they are, and how they’re grouped, so you can enter the world of stock market trading and investing.
Understanding stocks & how they work
What are stocks?
Understanding stocks is simple. When you buy stocks and shares, you are buying a small piece of a company. This is called equity ownership and another name for stocks or shares is equities.
Buying them means you’re a shareholder and are now entitled to capital appreciation and dividends if the company pays them. Dividends are payments made to shareholders as a share in a company’s profits. However, not all companies pay them.
Essentially, you hold onto stocks in the hope they will increase in value. This is investing. You would physically own the shares you have bought.
Stock market trading, on the other hand, is trading on a stock’s price movements. This is done using financial products called derivatives, such as contracts for difference (CFDs) or spread betting. Here, you don’t own the underlying asset you are trading. Any profit made is generated from movements in share prices.
Another key part of understanding stocks is understanding asset sectors. To properly learn the stock market, you will have to learn what sectors equities are usually grouped into. Different sectors tend to move in different cycles, falling in and out of favour with traders and investors, and changing performance levels, throughout the year.
A lot of investors and traders diversify their portfolios by picking equities from across the sectors. This helps them mitigate their risk. We’ll take a look at portfolio diversification later on.
For now, we’ll look at the main sectors stocks are grouped into.
Consumer discretionary – Stocks that offer non-essential services. Think luxury goods, or consumer goods outside core needs. Examples of consumer discretionary stocks include:
Consumer staples – These are stocks in companies that produce products that are considered essential. Think items like food, drinks, agricultural products, tobacco, and pharmaceutical products. Non-durable household goods and personal products, including grocery stores and supermarkets are also included in this asset category.
Examples of consumer staple stocks include:
- Proctor & Gamble
Energy – These are stocks companies who produce energy. Oil & gas tends to dominate here, but this class also includes started to include renewable energy stocks, nuclear and coal power.
Examples of energy stocks include:
- Royal Dutch Shell
- Canadian Solar
Financials – Financials are stocks that cover financial services for retail and commercial customers. This includes banks, insurance companies, savings plans, investment managers, mortgage companies, and real estate.
Healthcare – Companies that deal with medical goods and services fall into the healthcare stocks sector. This includes hospital management firms, medical equipment, and medical products. It also includes research, development, production, and marketing of medical equipment, pharmaceuticals, and new biotechnology. Examples of healthcare stocks include:
Industrials – Industrial stocks cover a lot of different sub-sectors. In this case, we’re looking at aerospace, industrial machinery, and military & defence equipment. It includes cement, metal fabrication, pre-fab houses, and waste management. Industrials also include airlines and transport & logistics. Examples of industrial stocks include:
Materials – Companies in this sector are involved in the production or extraction of materials, as well as chemical production. Paper, containers and packaging also fall under the materials umbrella. Examples of Materials stocks include:
- Rio Tinto Group
- Anglo American
Technology – This sector includes IT businesses and companies that research, develop, produce, and distribute communication equipment such as cell phones, towers, cable, etc. It includes computer hardware and software, home entertainment, office equipment, data management, processing systems, and consulting services. Examples of technology stocks include:
Utilities – This sector distributes electricity, oil, gas, water, etc. Example of utility stocks include:
How are the different asset classes affected by different economic cycles?
Different asset classes behave differently depending on how the economy is performing. A good example of this is the difference between how consumer staples and consumer non-discretionary stocks behave.
In tough economic times, the share price of non-discretionary stocks will likely go down. That’s because consumers won’t necessarily have the spare cash to spend on luxuries. Conversely, the share price of staples might go up because their services or products are considered essential.
Utilities are also considered essential, so the share prices, in theory, should remain relatively stable. Until very recently, oil & gas stocks used to be very strong too. However, they are susceptible to volatility caused by market conditions. Oil prices crashed during the Covid-19 pandemic, and thus oil companies have seen their share prices fall in line with that. On the other hand, with governments investing heavily in renewable energy, green energy stocks are rising.
Essentially, the principle of supply and demand is at play here. More on that later.
Understanding stocks: Portfolio diversification
Diversifying your portfolio is a way of mitigating your risk. In practice, it basically means building a portfolio of stocks from different sectors. The theory goes that if a sector is underperforming, any losses created as a result can be offset by gains in stocks in other sectors that are performing well.
All investing and trading are risky. You can make a profit, but you can also make losses. Any steps to help lower your risk should be taken. Understanding stocks and learning how stock trading works will help you do just that. Remember to do careful research when picking equities to add to your portfolio.
Where do stocks get their value?
A stock’s value comes from the principles of supply and demand. High demand usually means a higher price; low demand usually means a lower price. Another factor that gives a stock value is the ROI it can give to investors and traders.
Investors might look at stocks with strong fundamentals. Other this smaller, under-appreciated businesses are the best companies to invest in, as they might have great growth potential. What you choose is up to you, but a blend of technical and fundamental analysis will give you a clearer view of the markets and help inform your choices.
There are some methods you can use to find out a stock’s valuation and whether it has been under or overvalued.
Which cap fits?
Away from asset classes, stocks can also be grouped according to their market capitalisation or market cap. This is a key part of learning the stock market.
This is how market cap is calculated:
- Total outstanding company shares x share price
There are no official market cap groupings. However, the market generally divides companies into the following groups.
||$200 billion or over
||$300 million – $2 billion
There are also micro and nano cap stocks, covering up to $300 million.
Mega and large cap stocks are generally thought to have less growth potential but are more likely to weather challenging market conditions. Smaller stocks may offer higher returns, but this is tempered by potentially high volatility.
A dividend is a portion of a company’s profits it can choose to return to shareholders. Dividend stocks are those that pay out this little reward.
Not all companies pay dividends, but those that too tend to be popular stock picks. You might consider them if you’re going for a long-term investment strategy. They may be some of the best shares to invest, so if you’re learning the stock market read up on dividend stocks.
Investing, trading & risk
Trading and investing are both risky. You can make money, but you can also lose it if stocks turn against you. Only pursue these activities if you can afford any potential losses.