How Stocks and the Stock Market Work 12/17/13

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How Stocks and the Stock Market Work
by Marshall Brain and Dave Roos
Brow se the article How Stocks and the Stock Market Work
Introduction to How Stocks and the Stock Market Work
Investing Im age Gallery
For a new investor, the stock market can feel a lot like legalized gambling. "Ladies and gentlemen,
place your bets! Randomly choose a stock based on gut instinct and water cooler chatter! If the
price of your stock goes up -- and who knows why? -- you win! If it drops, you lose!" Isn't that why so
many people got rich during the dot-com boom -- and why so many people lost their shirts (not to
mention their retirement savings) in the recent recession?
Not exactly. But unfortunately, that's how many new investors think of the stock market -- as a
short-term investment vehicle that either brings huge monetary gains or devastating losses. With
that attitude, the stock market is as reliable a form of investment as a game of roulette. But the
more you learn about stocks, and the more you understand the true nature of stock market
Traders w ork the floor of the New York Stock Exchange on
June 22, 2011. See m ore investing pictures.
Spencer Platt/Getty Images
investment, the better and smarter you'll manage your money.
The stock market can be intimidating, but a little information can help ease your fears. Let's start
with some basic definitions. A share of stock is literally 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
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earnings are all of the money the company brings in from selling its products and services.
Why would a company want to share its assets and earnings with the general public? Because it
needs the money, of course. Companies only have two ways to raise money to cover start-up costs
or expand the business: It can either borrow money (a process known as debt financing) or sell
stock (also known as equity financing).
The disadvantage of borrowing money is that the company has to pay back the loan with interest. By selling stock, however, the company gets money with fewer
strings attached. There is no interest to pay and no requirement to even pay the money back at all. Even better, equity financing distributes the risk of doing business
among a large pool of investors (stockholders). If the company fails, the founders don't lose all of their money; they lose several thousand smaller chunks of other
people's money.
Perhaps the best way to explain how stocks and the stock market work is to use an example. For the remainder of this article, we'll use a hypothetical pizza
business to help explain the basic principles behind issuing and buying stock. We'll start on the next page with the reasons why a restaurant owner would issue stock
to the public.
The interesting thing about issuing stock is that
even if the company is profitable, shareholders
won't necessarily receive a check in the mail each
year with their cut of the loot. Only a few
companies, usually long-established firms, hand
out annual profit shares called dividends. Most
new companies are considered growth stocks,
meaning that the company reinvests all profit to
fuel growth and expansion. In the case of growth
stocks, the investment only increases in value as
the stock price rises. And stock prices only rise if
more people are interested in buying shares in
the company.
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Selling Shares
Let's say that you've always dreamed of opening a pizzeria. You love pizza, and you've done your homework to
figure out how much it would cost to launch a new pizza business and how much money you could expect to
earn each year in profit. The building and equipment would cost $500,000 up front, and annual expenses
(ingredients, employee salaries, utilities) would cost an additional $250,000. With annual earnings of $325,000,
you expect to make a $75,000 profit each year. Not bad.
The only problem is that you don't have $750,000 (building + equipment + expenses) in cash to cover all of
those costs. You could take out a loan, but that accrues interest. What about finding investors who would give
you money in exchange for a share of the ownership of the restaurant?
This is the logic that companies use when they make the decision to issue stock to private or public investors.
They believe that the company will be profitable enough that investors will see a good return. In this case, if
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investors paid a total of $750,000 for shares in the pizza restaurant, they could expect to earn $75,000 annually.
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That's a solid 10 percent return.
As the owner of the pizza restaurant, you can set the initial price of the company, as well as the total number of
shares of stock you want to sell. Interestingly, the price of the pizza business doesn't have to correlate with the
actual value of the assets or the company's current profitability. You can set the price so that it reflects the future value of the investment. For example, if you set the
price at $750,000, investors could expect a 10 percent return. If you set the price at twice that much, $1,500,000, investors would still get a respectable 5 percent
If you issue a lot of shares, that would lower the price of each individual share, perhaps making the stock more attractive to lone investors. Another consideration is
ownership. Each person who buys a share of stock essentially owns a piece of the company and has a say in how the company is run. We'll talk more about
shareholders in a later section. But for now, it's important to understand that, as the owner, you may wish to buy a majority of the available shares yourself so that
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you remain in majority control of the company.
We'll talk more about stock prices later. In the meantime, let's talk about stock exchanges -- the clearinghouses where the world's biggest companies sell shares by
the millions each day.
A Stock Exchange
Let's get back to our pizzeria example. If you want to launch one and are interested in recruiting a
pool of investors, where would you find these people? You could place an ad in the paper or online,
or you could simply contact friends and family. But what if some of your initial investors decide a
year later that they want to sell their shares? They would each have to go out and find a new buyer,
which might prove difficult, especially if the company isn't performing very well.
A stock market solves this problem. Stocks in publicly traded companies are bought and sold at a
stock market (also known as a stock exchange). The New York Stock Exchange (NYSE) is an
example of such a market. In your neighborhood, you have a "supermarket" that sells food. The
reason you go the supermarket is because you can go to one place and buy all of the different types
of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the
The New York Stock Exchange in New York City.
Spencer Platt/Getty Images
dairy farmer and the baker. The NYSE is a supermarket for stocks. The NYSE can be thought of as
a big room where everyone who wants to buy and sell shares of stocks can go to buy and sell.
Modern stock exchanges make buying and selling easy. You don't have to actually travel to New
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York to visit the New York Stock Exchange. You can call a stock broker who does business with
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the NYSE, or you can buy and sell stocks online for a small fee.
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There are three big stock exchanges in the United States:
NYSE - New York Stock Exchange
AMEX - American Stock Exchange
NASDAQ - National Association of Securities Dealers
If these exchanges didn't exist, buying or selling stock would be a lot harder. You'd have to place a classified ad in the newspaper, wait for a call and haggle on a price
whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly.
Stock exchanges have an interesting side effect. Because all the buying and selling is concentrated in one place, and since it's all done electronically, we can track
the constantly fluctuating price of a stock in real time. Investors can watch, for example, how a stock's price reacts to news from the company, media reports,
national economic news and lots of other factors.
For example, all publicly traded companies need to issue quarterly earnings reports through the Securities and Exchange Commission (SEC). If those earnings are
lackluster, shareholders might decide to sell some of their stock, which would lower the stock price. But if the newspaper reports an overall increase in the popularity
of pizza, more people might buy shares and the price would go back up.
But before we delve too deeply into the intricacies of stock prices, let's talk about corporations. Even if you own your own pizza business, you can't sell stock in the
company unless you become a corporation. We'll discuss that on the next page.
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Any business that wants to sell shares of stock to private or public investors needs to become a corporation
first. The legal process of turning a business into a corporation is called incorporation.
If you start your pizzeria with your own money (even if it's borrowed from the bank), then you've formed a sole
proprietorship. You own the entire restaurant yourself, you get to make all of the decisions, and you keep all
of the profits. If three people pool their money together and start a restaurant as a team, then they've formed a
partnership. The three people own the restaurant themselves, sharing the profit and decision-making.
A corporation is different, and it's a pretty interesting concept. A corporation is a "virtual person." That is, a corporation is registered with the government, has its own
Social Security number (called a federal tax ID number), can own property, sue and make contracts. (It can also be sued.) By definition, a corporation has stock
that can be bought and sold; all of the owners of the corporation hold shares of stock in the corporation to represent their ownership. One characteristic of this "virtual
person" is that it has an indefinite and potentially infinite life span.
There is a whole body of law that controls corporations. These laws are in place to dictate how a corporation operates, how it's organized, and how shareholders and
the public get protection. For example, every corporation must have a board of directors. The shareholders in the company meet every year to vote on the people who
will "sit" on the board. The board of directors makes the decisions for the company. It hires the officers (the president and other major officers of the company), makes
the company's decisions and sets the company's policies. Consider the board of directors as the virtual person's brain: Even if a corporation has a single employee
who also owns all of the stock in the corporation, it still has to have a board of directors.
Another reason that corporations exist is to limit the liability of the owners to some extent. If the corporation gets sued, it's the corporation that pays the settlement.
The corporation may go out of business, but that's the worst that can happen. If you're a sole proprietor who owns a restaurant, and the restaurant gets sued, you're
the one being sued. "You" and "the restaurant" are the same thing. If you lose the suit, then you can lose everything you own in the process.
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Let's talk more about the relationship between shareholders and corporations in the next section.
Shareholders are the people who own shares of stock in a company. Collectively, the shareholders
are the owners of the company, since each share of stock entitles the owner to a say in how the
corporation is run. Shareholders elect a board of directors to make the company's major decisions,
such as the number of shares to be issued to the public.
Interestingly, not all corporations decide to have public shareholders. Corporations can choose to be
privately or publicly held. In a privately held company, the shares of stock are all owned by a small
group of people who know one another. They buy and sell their shares amongst themselves. A
publicly held company is owned by thousands of people who trade their shares on a public stock
General Motors (GM) holds its annual shareholders' m eeting
in Detroit in June 2011.
Dan Akerson/Getty Images
Trying to please thousands of anonymous shareholders is a difficult task for any corporation. So why
do they do it? The main reason that companies choose to issue stock to the public is to raise a
large quantity of investment capital quickly through an initial public offering (IPO). The
corporation might sell one million shares of stock at $20 a share to raise $20 million in a short
amount of time (that's a simplification, however -- the brokerage house in charge of the IPO will
extract its fee from the $20 million). The company then invests the $20 million in equipment and
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But what do the shareholders get out the relationship? 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. They're more likely to issue growth stocks, in which all of the profits are
reinvested. 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. And if the shareholder holds onto a growth stock for long enough, he could eventually sell it for a significant
We'll take a closer look at the market forces behind stock prices in the next section.
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Stock Prices
Stock prices aren't fixed. From the second a stock is sold to the public, its price will 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.
Market forces aren't a total mystery, though. 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.
Beyond supply and demand, the logic behind stock prices gets a little fuzzy. Since supply of stock is generally fixed, the riddle is to figure out what influences
demand. Why do people want to buy or sell a certain stock? Earnings and profit certainly play a large role. If your pizzeria posts record sales in the most recent
quarter, then it will probably attract more investors, pushing up the stock price. But earnings only tell half the story. There is local and global competition to consider,
the rising costs of pizza ingredients, the possible unionization of pizza delivery boys and more. Professional stock analysts and brokers (as well as amateur investors)
try to take all of these factors into account when trying to predict the future movements of a stock's price.
After all, it's the change in a stock's price over time that determines its ultimate value to shareholders. The key to investing is "buy low, sell high." You want to buy a
stock at $2 a share and then sell it when it's $20 a share. The safest way to buy low and sell high is to invest in a slow growth stock -- usually an established
company with a long track record of success like Coca-Cola or IBM -- and hold onto it for many years. This allows the stock price to weather short-term fluctuations,
but average steady growth over time. A much riskier investment strategy is to try to pick the "next big thing" and cash out quickly after the stock price skyrockets.
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.
One way to safely invest in the stock market is to find a stockbroker who understands your investment strategy and trades accordingly. Learn more about
stockbrokers and ways to measure market performance on the next page.
Stock Averages and Brokers
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. The Dow Jones Industrial Average is the sum of
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the value of 30 large American stocks -- think General Motors, Goodyear or Exxon-Mobil --divided by
the number of companies plus any stock splits. The S&P 500 is the average value of 500 of these
large companies. The NASDAQ Composite is the average of all stocks listed on the NASDAQ
exchange (more than 2,800) and includes both domestic and global companies.
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 [source: CNN Money].
As an investor, you have several options for buying or selling stock. There are dozens of companies
A trader at the Chicago Board of Trade w atches as the Dow
Jones Industrial Average, S&P 500 and NASDAQ Com posite
Index all fall upon new s of soaring gas prices in July 2008.
Scott Olson/Getty Images
that are authorized to trade with the major U.S. stock exchanges and even foreign exchanges like
the Tokyo or London Stock Exchanges. If you call an investment house like Merrill Lynch, Charles
Schwab or Morgan Stanley, they'll connect you to a stockbroker who can make your trades for a
As with many other industries, the Internet has revolutionized stock trading, giving anyone with an
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online trading account the power to execute their own stock purchases and sales for as low as $7 a
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Stocks that aren't listed on an exchange are sold Over the Counter (OTC). OTC stocks are
generally in smaller, riskier companies. Usually, an OTC stock is stock in a company that doesn't
meet the requirements of an exchange.
For lots more information on stock, the stock market and related topics, see the links on the next page.
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More Great Links
U.S. Securities and Exchange Commission (SEC)
New York Stock Exchange
Understanding and Controlling Your Finances - introduction to personal finance
CNN Money. "What is a stock?" Money 101.
Investopedia. "Stock Basics"