Learn the stock market in 7 easy steps. Get spreadsheets & eBook with your free subscription!

Step 2/7. How the Stock Market Works.

The saying goes that knowing is half the battle, and the same is true with investing in the stock market.

By yearning to educate yourself about how to invest and build wealth, you as the reader are already halfway to your goal.

My job as your teacher is to build a foundation of educational wisdom that can be broadly used to earn money and understand any stock market strategy presented to you. I hope this guide is as entertaining and easy to follow as can be. Here’s a look again at the 7 categories of the guide.

1. Why to Invest?
2. How the Stock Market Works
3. The BEST Stock Strategy and Buying Your First Stock
4. P/E Ratio: How to Calculate the Most Widely Used Valuation
5. P/B, P/S: The Single Two Ratios Most Correlated to Success
6. Cashing In With a Dividend Is a Necessity
7. The Best Way to Avoid Risk, and Putting it all Together!!

In order to understand investing, you must understand how the general principles behind the stock market work. Before I started researching and reading about investing, the only things I knew about the stock market are what I saw on the news or heard on TV, and it was never positive.

The Stock Market is Overdramatized

I remember hearing about the disaster of the Facebook IPO (initial public opening, when the stock is first able to be bought by the public), the failures of Freddie and Fannie Mae and how stocks tumbled afterwards, and the great dot com bubble that burst in 2000.

With each stock market crash or failure, I remember hearing emotional stories about everyday people losing everything they had or big, greedy corporate leaders succumbing to the fall of their empire.

Because of my limited knowledge of the stock market, I pictured it as full of Gordon Gekko businessmen types (from Wall Street: Money Never Sleeps) with money spilling out of their ears and lives full of fast action and New York speed trading.

Hollywood depicts Wall Street as this extreme roller coaster ride where fortunes are won and lost every instant, when in reality this isn’t the case.

Yes, the stock market has ups and downs, there is risk involved, and some people do get burned badly, but the majority of successful investors take very boring and safe strategies straight to success, because they understand the basic principles and are educated with how to stay out of risky investments.

Reality: The Market Fluctuates

I feel like I must give the reader some perspective to the reality of the stock market, so you can understand that the big flashy news headlines and TV specials are extremely over-dramatized.

The S&P 500 is a list of the top 500 stocks in the U.S., and is widely accepted as the benchmark for all stock investments; analysts consistently compare performance to that of the S&P 500.

The S&P 500 is an index that you can think of that is similar to the DOW, which only has 30 companies.

Now, the worst one day loss for the S&P 500 in 2008 was only -9.03%. In total for the year, the S&P 500 lost -38.49%, which was the worst year the index has ever had.

If you think about these numbers for a little bit, anyone can clearly derive that investors lost less than half their worth during that year.

But as you can see from the graph below, the S&P quickly recovered lost ground after the ’08 fall and in fact, periods of time where the price falls are common. 

An important aspect of investing is knowing that stock prices do fluctuate up and down but when held over long periods of time, the chances of capital gains exponentially increases.

Reality: Media Covers the Extreme

As you can see, the majority of investors aren’t in fact losing their shirts and the media is choosing to cover extreme cases of people losing money in the stock market, simply because they make for good stories and good TV.

Those that did lose all their money weren’t diversified in their investments, bought stock in companies that were over leveraged, borrowed money to purchase stocks, or a combination of all three.

For those investors who didn’t sell their stocks in 2008, which would’ve been the worst time to bail out of your stocks, the market recovered and the “devastating losses” didn’t affect their portfolio.

Therein lies the importance of long term investing and riding out the storms.

Since its inception in 1957, the S&P 500 has returned on average annually 10.83%, when dividends are automatically reinvested. For those who need a reminder on how powerful a compounding 10% return can be, recall my $2 million example. In 40 years, this amount becomes $8,179,114.

Smart Investors Don’t Listen to Noise

So readers, please don’t forget that a stock is meant to be a long term investment.

It will pay you dividends that over time will compound and multiply, and if invested in a good company the share price will appreciate substantially as well.

As financial guru Dave Ramsey simply puts it, “The only people who get hurt riding a roller coaster are the ones that jump off.”

Once you gain the confidence to have convictions in your investments- knowing that they will recover when hit badly, you will easily be able to avoid selling your stocks at the worst possible time, when the market has a temporary crash and it seems like everyone else around you is doing it.

Before I introduce the more in-depth coverage of this guide, I feel I must explain how I derived these categories and why they are relevant to you.

The fundamental ideas and ratios are all well known and widely used by millions of investors around the world and countless investing gurus and authors.

In fact, if you get around to reading enough investing and stock market books you’ll realize they are all almost the same, and many of the various ways institutional investors evaluate a stock run parallel to other strategies.

Understanding this fact helps bring greater understanding to the process and you can feel confident in these metrics because a quick Google search will confirm their validity.

I am not reinventing the wheel here; instead I am utilizing my obsessive passion for investing research and presenting the most important concepts in an easy to follow guide not yet found on the web.

For those who complete the guide and advance as investors, the Value Trap Indicator formula can be accurately implemented to craft a stock picking strategy from the 7 steps learned here.

Step 3 will uncover the BEST stock strategy you will ever learn, and will show you that buying stock is easy. The first step to swimming is first getting your feet wet.

Once you climb that obstacle of learning how to transfer money into your investment account and easily buy a stock, you will find the confidence to continue educating yourself about investing to then make the right decisions with some real money.