First and foremost the stock market is just a vehicle for achieving your financial dreams. You can use it to create an income to live on (great for those with no job such as the unemployed and retired), or you can use it to grow your money for some future expense such as your child’s college, your dream home, or even for your retirement.

Whichever way you choose to invest you’ll need a basic understanding of how stock market investing works. In the rawest sense, you are basically buying an ownership interest in a company. If that company does well, so do you (and vice versa). When you buy a share you become a shareholder and are entitled to share in the profits (through dividends if the company pays them) and attend shareholder meetings where you can vote on company matters and be heard.

However, I doubt you want to become an investor in the stock market for those things. Most people invest because they want their money to grow for them and multiply. This certainly can be done and the stock market offers many ways, which brings us to rule 3 of our stock market investing basics.

When it comes to investing, you can invest in stock through a mutual fund, by yourself, or through the aid of a broker. Of these ways I recommend you invest on your own.

Brokers love to recommend you move from one stock to another, because they make big commissions when you do. Mutual Funds rarely beat the markets because of rules placed on them. The only one you can count on is you, so learn to become a great investor.

This now brings us to rule 4 of my stock market investing basics, how do you know when you are a good investor?

You use a benchmark, that’s how. The stock market offers many benchmarks, but the three most popular are the Dow, the NASDAQ, and the S&P 500. These are indices whose prices are based upon the stocks they track. For example, the S&P 500 tracks 500 stocks. If those 500 stocks go up on average, the S&P 500 index goes up.

Your goal as an investor is to beat the market! What that means is that your investing return should be greater than the return of the major indexes. It is in this way you can tell if you, are someone else, is a great investor.

If someone says, “I made 50% this year.”, that does not necessarily make them a great investor. While it may sound good, if the markets went up 80% that year, this guy did horrible and under performed the market.

Risk vs. Reward. Every investment offers risk, the more risk you take, the more return you should get.

How much risk do you want to take? Risk comes in many sizes. For example, a penny stock has a much greater chance of being worth 0 than a big company such as Microsoft or Wal-Mart. However, a penny stock could easily rise 100%, 300%, or more.

A proper rule of thumb is that your drawdown should be no more than 50% of your annual gain.

Look on the internet and you will find claims that the stock market averages a 12% annual gain (before taxes and inflation). In order for the stock market to be labeled “little risk” it should never drop (drawdown) more than 6% (50% of annual gain).

We see drops in the S&P of 10% or more once or twice a year. We see drops of 20% or more every 7-10 years. This makes the stock market a risky investment (drops more than 50% of it’s annual gain).

If your trading strategy achieves 100% annually, then you should expect drops of 50% or less to be normal. Any more and it’s too risky.