HOW THE STOCK MARKET WORKS
Most people have zero clue about how the stock market works. They don’t really understand what stocks are, how to buy them, or how owning stocks can increase their wealth over time. This is a significant failing of our educational system. Luckily, Confident Money is here to help you fill in this gap with this stock market primer.
When you buy a corporation’s stock, you are buying a small portion (or a “share”) of that corporation. You become one of that corporation’s many owners. We buy corporations so that we will make a profit in the future. This process is called “investing.” The purpose of investing is to make a profit in the future. If you buy something where there is no expectation of a future profit, the purchase is neither investing nor an investment.
A stock entitles you, as one of the corporation’s owners, to share in the profits and assets of your new company. Payment of the company’s annual profits to its owners are called “dividends.” The more shares you own, the more dividends you receive, should the corporation’s board decide to pay dividends to its stockholder this year.
Stock Exchanges Stocks are bought and sold on a stock exchange. The broader term for the stock exchange is simply “the stock market.” Individual investors or other corporations are free to buy and sell stocks on these designated, controlled stock exchanges that are located in nearly every country in the world. A variety of different investments (often called securities) can be bought and sold on these exchanges as well—such as bonds. All stock exchanges are electronically connected through the secure Electronic Communications Network or ECN.
You Profit Owning Stocks In Two Ways
1. Some corporations pay out a portion of their annual profits in payments called “dividends” to their owners. This is considered your share of the profits for a particular year. However, not every corporation feels this is a good use of their profits.
2. Stocks typically become more expensive over time. When something becomes more valuable from the time you bought it, to the time you sold it, the extra value is called “appreciation.”
Why Stock Prices Fluctuate
Stock prices are based upon all investors’ evaluation of the company based on the publicly available financial information about the company and other variables.
A partial list of factors that impact stock price:
• The economy’s direction
• Profits made by the company in the past
• The company’s profitability compared to similar companies
• News about the company
• Direction of our world economy
• Investor psychology
• Changing technology
• Corruption scandals
• Changes in government policy
Where Stocks Come From
Stocks are initially created by the corporation’s owners (usually the founders or first investors who began the company) who decide they need to raise more money to fund their company’s expansion. In order to fund it, the corporation decides to sell partial ownership of itself to the public in an Initial Public Offering (IPO stocks). Their hope is that even though they are selling partial ownership, the expansion will make the corporation much more valuable for everyone.
The amount of shares initially issued are determined by the owners and an investment bank at the time the shares are issued. An investment bank buys all of the new stocks and gives the corporation some money up front to get started on their expansion—called underwriting. The bank then sells the stock on the stock exchange to make back their money and maybe even create a profit.
Types of Stock
There are primarily two types of stocks available for purchase:
1. Common stocks give the owner a voting right in how the corporation is run.
2. Preferred stocks do not allow voting privileges, but the owner receives dividends before common stockholders receive a share of the profits and first shot at assets should the company be dissolved.
Investing Risk Is Present in Every Stock
An investor faces two basic types of risk:
1. Systematic risk - A general downturn in our economy that generally drags down nearly all stocks/corporations lower in value
2. Non-systematic risk - A company or a particular industry performs poorly because of changing economic conditions, incorrect strategies, or a poorly run corporation.
How to Reduce Investing Risk
One of the ways to reduce investor risk is to own a wide variety of stocks and different investment types.
The term “corporation” in this context means the company has become its own “legal person” and has the right to take out loans and enter into contracts entirely independent of its owners. The significance of this legal designation is that it protects the owners from any liability stemming from the corporation’s actions. For example, if a corporation were to go broke or even be sued out of existence in civil court, the owners are not personally liable for any loss, debts, or civil damages.
The Best Winning Stock Investment Strategy
Your winning strategy will be to buy and hold stocks for a long period of time. Prices might fluctuate wildly in the short term, but in the long term, people who buy and hold stocks win! Stocks have historically gone up over the long run—just like everything else in life. This buy-and-hold strategy eliminates the need to figure out which stocks will be short-term winners or the need to decide when the stock prices are at their highest point in a price run-up or a “bull” market. Luckily, the simplest strategy that requires the least amount of effort from you is the clear winner.