Basic Stock Market Explainer

(via Howstuffworks.com, “How Stocks and the Stock Market Work”)

Stock Markets

share of stock is a share in the ownership of a company. When you buy a share of stock, you’re entitled to a small fraction of the assets and earnings of that company. Assets include everything the company owns (buildings, equipment, trademarks) and earnings are all of the money the company brings in from selling its products and services.

Companies share their assets and earnings in this way in order to raise money. Companies that need money to cover start-up costs or expansion costs can go one of two ways:

  • Debt financing: borrowing money — selling bonds.
  • Equity financing: selling stock.

Bonds and stocks are both securities, with the major difference between the two being that stockholders have an equity stake in the company (they are owners), whereas bondholders have a creditor stake in the company (they are lenders). A security is just a way of packaging something up (ownership, debt, mortgages, future grain prices, you name it) so that it is tradable.

If the company goes the way of debt financing, it must pay back the loan with interest. This can be a traditional loan from a bank, or (especially when large sums of money are involved) a loan through the selling of bonds on which they have pay back the purchase value plus an agreed upon interest, after an agreed upon period of time (once the bond “matures”).

If it sells stock, there is no interest to pay (not to mention no loan to repay). Equity financing distributes the risk of doing business among the entire pool of investors (the stockholders). If the company fails, the losses are distributed among thousands of shares.

Stocks are bought and sold at stock markets or exchanges. The New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and National Association of Securities Dealers (NASDAQ) are the three biggest stock exchanges in the US.

Corporations

A business that wants to sell stock (whether to private or public investors) has to become a corporation first. The legal process is called incorporation. A corporation is a “virtual person,” and has certain rights that go along with this — it is registered with the government, can own property, sue (or be sued) and make contracts. All the owners of the corporation are the shareholders — the shares are representations of their ownership.

Every corporation has a board of directors, elected by shareholders. The board makes decisions for the company — hiring officers, setting policies.

Corporations limit the liability of the owners — if the corporation gets sued, the corporation itself pays the settlement. The shareholders and owners are protected to a certain extent by this limited liability.

Not all corporations have public shareholders – they can choose whether to be privately or publicly held. In a privately held company, the shareholders are a much smaller group of people, who buy and sell shares among themselves (shares that are not valued by public markets). A publicly held company is owned by thousands of shareholders who trade their shares on a public exchange, and is subject to restrictions and regulations that do not apply to private companies.

Companies often choose to issue stock to the public to raise a large quantity of investment capital. This is done quickly through an initial public offering (IPO).

If the corporation chooses to pay an annual dividend, then shareholders will receive a cut of the profits every year. Very few young companies issue dividends, however. In this case, shareholders are banking on the fact that the right corporate management will help the company grow and generate even more profit. It’s this potential for future success that will help determine the stock price on the open market.

Stock Prices

Stock prices rise and fall based on free market forces. It is these ever-shifting market forces that make short-term movements of the stock market so difficult to predict. And that is precisely the reason why short-term stock market investing is so risky.

We know, for example, that prices rise and fall primarily because of changes in supply and demand. In a free market system , the price of any commodity will rise as demand for it increases, as long as there’s a fixed amount of the commodity in circulation. The same is true for stocks. If there are a fixed number of shares in circulation, then the price of the stock will rise as more people want to buy it, and fall as more people want to sell it.

The inherent risk of the stock market is that any number of forces — logical or otherwise — can push prices up or down. In recent years, we’ve witnessed the boom and consequent bust of two large stock market bubbles that formed around the Internet sector in the early 2000s and the housing market six years later. In both cases, commodities became overvalued, and investors poured money into unprofitable or unsustainable markets. When the truth came out, investors rushed to sell, sending stock prices through the floor.

These free market forces are what Adam Smith so poetically dubbed, “the invisible hand of the marketplace.” Specifically he was referring to the self-regulating nature of the market, whereby individual ambition benefits society, even if the ambitious have no benevolent intentions and are only trying to maximize their own profits. The degree to which this concept of the invisible hand is true is one of the points of contention between difference economic worldviews.

What are those mysterious numbers called the Dow Jones Industrial Average, the S&P 500 and the NASDAQ Composite Index that are always reported on the evening news? These aren’t individual stock prices, but broad market averages designed to give you a general idea of how companies traded on the stock market are doing. 

What these averages tell you is the general health of stock prices as a whole. If the economy is doing well, then the prices of stocks tend to rise en masse in what is known as a bull market. If it’s doing poorly, prices as a group tend to fall in what is called a bear market. A bear market is generally defined as a sustained decline of more than 20 percent of the Dow Jones Industrial Average.

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