In your quest for financial wellness, you have probably heard countless times the importance of investing as part of a well-rounded financial plan. While this is true, most articles don’t tell you how to invest wisely, what role investments play in your wealth-building journey or even what the Market can tell you.
We understand that you want to invest in a way that’s aligned with your goals and values. But you can’t do that without a clear understanding of what the financial market is, how it operates, and strategies to approach it. In this four-part series, each piece will provide a more holistic understanding of investing and how it works with your financial plan.
Today, we’ll be defining and demystifying the market to give you a more comprehensive view of how investing works.
Breaking It Down
The first thing to define is what we mean when we talk about “the market.” In most news stories and media outlets, it is often referring to the activity of the U.S stock market. But the financial market as a whole is far more comprehensive and includes any medium through which securities can be traded.
While the stock market is one facet, it is far from the only one. Other types include bonds, derivatives, foreign exchange, and commodities. Each of these serves a different purpose, either gaining capital or offsetting risk. They are public which makes them a great place to set transparent pricing and knowledge about trading.
Most of what you will need to know about your investments centers around the stock market.
What is the Stock Market?
It is a subset of a financial market where successful corporations seek expansion (a.k.a cash) through investors. Stocks are shares of ownership in a particular public company that are sold to investors, and profits happen when the company does well and increases its earnings. This is the bare bones of how the stock market functions.
What does it mean for you when it is doing well or is floundering (like during the global pandemic)? For the general state of these activities, we turn to two tough animals: a bull and a bear. Each of these represent a different phase of the market and economy.
The Bull Market
Bull indicates rising stock prices. But beyond this, a bull market is a term often reserved for rising prices over long stretches of time — like what was seen before the global pandemic crash in March.
While there is no set criteria to trigger a bull market, it’s often associated with the rule of 20:
- 20% rise in stock prices
- This rise proceeds a 20% fall in prices
- The rise precedes another 20% drop
These are hard to predict and there’s no prescription for how long they last; it could be months or even years. We experienced the largest bull market run in history from 2009 to March 11, 2020. These market conditions happen when the economy is strong, there is a solid gross domestic product, decreased unemployment, and overall optimistic investor morale.
The Bear Market
Bear indicates falling stock prices — a day all investors know will come but hate when it does anyway. Although there are no hard and fast rules, they are often marked by at least a 20% drop in stock prices. A market correction, on the other hand, is more in line with a 10% drop in prices. In bear markets, the economy tends to slow down along with a spike in unemployment numbers.
How did these animals become an economic metaphor for market health? It has to do with each animal’s preferred method of attack: a bull plunges its horns in the air, a bear swipes its paws downward. Interesting tidbit for your next Zoom family party.
Understanding Market Volatility
You may hear talk about market volatility and wonder what that really means. Market volatility measures the fluctuation of stock prices. If the volatility is low, there is little change; but when volatility is high, big changes can be expected.
How is volatility measured?
Since volatility is a matter of statistics, it’s usually measured by the standard deviation or variance between the returns of a specific security (stock, bond, etc.) or market index across a certain time frame. Time is a crucial factor when it comes to volatility as the volatility of something can be measured in days, weeks, years, etc.
So when talking about volatility on a larger scale, we are really talking about risk. If a security has higher volatility, it is often a riskier asset than one with lower volatility. Since volatility looks at the statistical return of a specific asset or index, it’s important to understand how it works and what influence it may have on your risk tolerance and portfolio management.
Introducing Market Indexes
An index helps indicate market movement by tracking a certain basket of securities. These securities are monitored for performance and intended to represent a certain part of the market. Each index has different weighting systems to measure progress.
Indices are a great way to get a sense of what the market is doing. While there are several indices out there, the two most popular are the DOW and the S&P 500.
The Dow Jones Industrial Average (DJIA) index tracks 30 blue-chip stocks representing the major market sectors like IT, pharmaceuticals, finance, chemical, and more. The only sectors it doesn’t represent are utilities and transportation (which have their own index).
The DJIA is a price-weighted index, meaning overall performance is primarily determined by the price of the stocks within the index. This type takes the price of all stocks in the index and divides it by the number of companies to get the index’s value. This means a higher-priced stock gets more weight than a lower-price stock, making a change in stock prices an important determinant of its performance.
The S&P 500
Unlike the DOW which tracks 30 stocks, the S&P 500 tracks 500 stocks across all economic sectors. To enter this index a company has to meet specific criteria:
- It must be a U.S company
- It must reach market capitalization of at least 8.2 billion (as of 2020)
- 50% of the stock must be available to the public
- Four consecutive quarters of positive earnings are required
- Possesses positive liquidity
The S&P 500 is weighted differently than the DOW. It tracks the market capitalization of all companies in the index. This just means the index tracks the total value of a company (in terms of the market) measured by stock price and number of shares.
Which Is More Reliable?
Indices are designed to represent the market as a whole, making a comprehensive view important. The S&P 500 tracks more securities and also looks at the total market value of each company (as opposed ascertaining true value with just the stock prices). These factors make it more reliable than the DJIA, giving investors a better overview of market activity.
The Bottom Line
The financial market is a fascinating arena and an excellent way to help you reach your goals. But before investing, it’s important to know how the system works so you and your financial advisor can create a portfolio that truly reflects your needs.
Look for Part Two of our series where we delve into types of investing strategies!
Need help with your investment plan? Give us a call today.
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This is not an offer to sell any type of security, and there is no investment currently available through Abacus. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell this security. This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Information was based on sources we deem to be reliable, but we make no representations as to its accuracy. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
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