How Stocks and the Stock Market Work
Brain, Marshall, and Dave Roos. "How Stocks and the Stock Market Work" 06 July 2011. HowStuffWorks.com.
24 October 2011.
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?
Investing Image Gallery Traders work the floor of the New York Stock Exchange on June 22, 2011- Spencer Platt/Getty Images
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 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 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.
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
investors paid a total of $750,000 for shares in the pizza restaurant, they could expect to earn $75,000
annually. 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 return.
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 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.
Paying Dividends
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.
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 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 York to visit
the New York Stock Exchange. You can call a stock broker who does business with the NYSE, or you can buy
and sell stocks online for a small fee.
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 in the next section.
Corporations
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.
Let's talk more about the relationship between shareholders and corporations in the next section.
Shareholders
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
General Motors (GM) holds its annual shareholders' meeting in Detroit in June 2011.Dan Akerson
shareholders. Corporations can choose to
public
/Getty Images
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 exchange.
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 employees.
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 gain.
We'll take a closer look at the market forces behind stock prices in the next section.
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 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 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 fee.
As with many other industries, the Internet has revolutionized stock trading, giving anyone with an online
trading account the power to execute their own stock purchases and sales for as low as $7 a trade.
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.
A trader at the Chicago Board of Trade watches as the Dow Jones Industrial Average, S&P 500 and NASDAQ
Composite Index all fall upon news of soaring gas prices in July 2008.
Scott Olson/Getty Images