Investing in Stocks – What Beginners Should Know

Most Germans don’t ever invest in stocks. While it is common in other countries for private investors to invest in stocks, a fear of risk prevails in Germany. However, due to the stagnating low-interest rates, this attitude is gradually changing. In the study “Stock Culture in Germany” in January 2017, 58% of the participants were playing with the idea of purchasing stocks.

The study also shows that Germans’ knowledge of the stock market is moderate at best. For example, one-third of the participants didn’t know that a share represents a form of participation in a company. However, the basics of the stock trade aren’t difficult to understand. We will introduce you to the world of the stock market and explain the most important terms.

What are stocks?

Stocks are shares in a limited company (Aktiengesellschaft, AG). Whoever purchases a stock thus owns a small part of the company. The buyer becomes a shareholder and thus a joint-owner of the limited company. The stock purchase is linked with the right to vote on the company’s orientation at the annual general meeting (also known as shareholder’s meeting). The stock purchase is also frequently linked to a dividend. The dividend is part of the profit of a stock corporation that is distributed to shareholders.

In order for a share to be acquired and traded by the public, the company must have already made an initial public offering (IPO). The sale of shares is an opportunity for the company to generate capital. As a result, it can continue to grow and make new investments. However, only companies that have already reached a certain size usually aim for an IPO, since this step involves considerable costs and administrative paperwork.

What is the stock exchange?

The stock exchange is a marketplace on which securities are traded. In addition to shares, these include bonds and other financial products such as warrants or derivatives. It also offers the exchange of currencies and commodities (oil, coal, grain, gold, silver, etc.). All of these are considered easily exchangeable goods (also known as "defensible goods"). Objects of value, such as real estate or machinery, which are difficult to exchange, are excluded from stock exchange trading.

The prices of securities are determined according to the principle of supply and demand in fixed trading hours and are shown as stock exchange prices. The stock exchange functions a bit like an old marketplace where fruit and vegetables are offered, except that the prices of securities fluctuate more than food prices in one day. Exchange traders are also known as brokers. They process purchasing and sales orders on behalf of various customers.

What stock exchanges are there?

A distinction is generally made between "real" stock exchanges with classic exchange floor trading, where traders call and bid wildly back and forth on the one hand, and electronic stock exchanges that only exist digitally on the other. The most famous and largest “real” stock exchange is the New York Stock Exchange (NYSE) on Wall Street in Manhattan. Other important markets are the London Stock Exchange (LSE), the market in Japan’s capital Tokyo Stock Exchange (TSE), the Chinese market Shanghai Stock Exchange (SSE), and the Hong Kong Stock Exchange (HKEX).

In Germany, Frankfurt am Main is the seat of the German Stock Exchange. It ranks among the ten biggest stock exchanges in the world and plays a central role in Europe along with the trading centers in London and Paris. Next to the trade center in Frankfurt, there are stock exchanges in Munich, Hamburg, Düsseldorf, Hannover, Berlin, and Stuttgart.

The largest electronic stock exchange is also located in New York. It is the US technology stock exchange Nasdaq, where tech companies like Apple, Facebook, or Microsoft are traded. The largest electronic stock exchange in Germany is Xetra and is located in Frankfurt am Main. As with the Nasdaq, stock trading takes place exclusively via computer systems.

What is a share index?

The share index is a key figure of selected share prices. Stock indices are designed to reflect the development of a particular market. Each country has a benchmark index to reflect the development of the local economy. But there are also share indices that cover sub-segments of the economy, such as industry, transport or technology.

The benchmark index of the US stock exchange Wall Street is called Dow Jones Industrial Average (DJIA), or Dow Jones for short. This index was created to measure the development of the American stock exchange by reflecting the development of the 30 largest US companies. The benchmark index of the German stock exchange is the Deutsche Aktienindex (DAX). It reflects the market trend of the 30 largest German companies.

Other important share indexes are the American Nasdaq Composite (all Nasdaq companies), NYSE Composite (all NYSE companies), and S&P 500 (the 500 largest US companies), the Japanese Nikkei 225, the British FTSE-100, the French CAC-40, the Chinese Shanghai Composite, the Russian RTS, the European benchmark index Euro Stoxx 50, and the global benchmark MSCI World (more than 1,600 shares of the 23 largest industrialized countries). All these indexes reflect the economic development of their respective region or industry.

What is a securities deposit?

When an individual wants to enter the stock exchange, he or she cannot simply go to a stock exchange. The times in which one buys shares and stores them as slips of paper at home are long gone. Nowadays, almost everything runs electronically. Therefore, there is no way of getting around setting up a securities deposit first. Trade orders are passed on to professional brokers, who buy or sell the stocks for private investors.

In order to open up a deposit, one can either go to a bank branch office or go online. Within a short amount of time, one can set up a securities deposit through online banks or online brokers. To open the account, one needs a form of identification (an ID in person or a post-identification procedure for online servers). When selecting the provider one has to consider whether one wants to save costs or whether one values personal consultation. However, you should always be cautious when receiving consultation, as many consultants work on a commission basis.

If you don't want to put savings at risk as a beginner, you can also open a sample portfolio. These simulate the purchase and sale of stocks. This way, you can pretend to invest in the stock exchange and track the development of selected securities. This can help reduce anxiety and also to learn the basic procedures of the stock exchange.

Investors can thus learn which transaction costs occur when and how they reduce return, for example. In addition, beginners can also get an overview of the purchasing behaviors of stock exchange experts, as they also run sample portfolios and make their transactions accessible to a broad public. The experts compete against each other to prove their competence and thus gain as many new followers or customers as possible.

What investment strategies are there?

Before starting to invest in stocks you should find out what type of investor you are. Then you should set yourself clear goals. What do you want to achieve with your investment? Do you want to make as much profit as possible at the cost of higher risk? Or do you want solid participation in established companies that, though they do not offer high returns, bear only moderate risks? Are you out for short-term success or do you invest in the long term?

The investment strategy depends on these questions. The security-oriented investor pursues diversification. He or she spreads portfolio risk in order to minimize potential losses if prices collapse. The profit-oriented investor, on the other hand, pursues value investing. He searches for undervalued shares, which he acquires at good conditions and keeps until they have reached their true value. However, this strategy requires extensive financial knowledge and steady nerves, since one has to keep the shares even in difficult times.

Which risks does the stock exchange entail?

Equity investments are investments with entrepreneurial risk. This means you are successful when the company is successful. Should the company not be successful, however, you can make losses. Since no one knows the future, no one can say where the stock exchange will be tomorrow, in a month, or in the following year. Thus all equity investments are characterized by speculation.

Empirical values of market development and the analysis of financial data help reduce uncertainty and predict the market to some extent. From this perspective, brokers do have at least a head start in terms of information. If you’re the first to know that a company won’t reach its goals you can sell your shares first and the other way around.

Stocks are considered tangible assets because they represent a share (however minuscule) in a company with machines, real estate, and employees who produce a product or service. In contrast to some complicated financial instruments, the investment has a real value. Moreover, the likelihood that an established company goes bankrupt and that the shares thus lose their value is unlikely.

Having an investment strategy in order to sidestep the greatest stock exchange dangers is recommended. You shouldn’t just “start buying,” instead, start with a plan. Investors can avoid greater losses with stop-loss orders, which are orders placed with a broker to sell a security when it reaches a certain price. That way, investors can protect their shares against extreme price drops.

Beginners should steer clear of cheap stocks, which are called penny stocks, as well as complicated financial products like derivatives, warrants, contracts for difference (CFDs), and leveraged foreign exchange transactions. The likelihood of loss is much higher with these than with shares of established companies.

Finally, one should follow this basic rule with every financial investment: Only invest as much money as you can lose in good conscience! Thus, beginners should refrain from buying shares on credit.