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How Stocks Work

Updated: Mar 17, 2020

A stock is a financial asset that companies sell to raise money. When you invest in a company by buying its stock, you own a portion of that company and can profit from its success. The more of a company’s stocks you own, the bigger the portion of the company you own. Your profit comes from two sources: dividends and stock price increases.

Every quarter, many companies reward investors by giving a portion of their profits to shareholders. This divided chunk of profits is called a dividend. The more shares you own, the more dividends you receive. Dividends provide you with more cash that you can invest and grow. Invested capital grows exponentially, so a small increase in the capital you initially invest can make a big difference. Reinvested dividends are an important source of profit for many long-term investments.

You also profit when the stock price increases. Stocks trade like items at an auction, and a transaction only goes through when a buyer and seller agree on a price. The stock price moves when buyers and sellers are willing to exchange the stock for a different price than before. That price fluctuates according to supply and demand for the stock, which reflects investors’ sentiment.

When investors become more optimistic about the company’s future value and/or stock price, demand for the stock surges. Shareholders notice that their stock is in high demand, so they feel justified in charging a higher price for it. If investors want the stock badly enough, they will pay these higher prices. On the other hand, if investors become more pessimistic, demand drops and shareholders have to lower their prices to attract buyers. Thus, price movements indicate changes in investors’ sentiment about the company’s future value and/or stock price. As a result, stock prices are not random. They result from the buy and sell decisions of millions of investors. But despite being non-random, stock prices are difficult to predict.

A company’s stock price also reveals what investors in the market are willing to pay to own the company by buying all of its shares. This valuation is also known as the company’s “market capitalization,” or market cap. It tells you how much the market thinks the company is worth. You can calculate it by multiplying the current stock price by the total number of stocks the company has issued. That’s known as the number of outstanding shares, which includes shares owned by large banks and company insiders. When the company’s stock price changes, its market cap changes too.

Investors are forward-looking, buying and selling based on their expectations for the future value of the company and its stock. Despite being overdramatic, investors do a decent job of anticipating businesses’ successes. That’s why stock prices are a leading economic indicator. They forecast economic activity, rising before businesses grow and falling before businesses decline. So predicting stock prices requires us to forecast the forecaster, no easy task. Over the long-term, U.S. investors have expected U.S. businesses to increase in value, so most stocks have increased in value over the long run.

As a stock investor, you do not own the company’s assets. Just because you own 1/10,000 of a company does not mean you can claim one of its 10,000 jets. You only get a portion of the company’s assets if it fails and liquidates its assets. You do have the power to influence a company’s managerial decisions by voting in shareholder meetings. That power is minimal unless you are one of the company’s largest shareholders. If you own more than half of a company’s shares, you become a major shareholder and have more managerial power. Usually the founder is the major shareholder.

A stock is also called an equity security. “Equity” means the stock entitles its holder to some ownership of the company, and “security” means it is a financial instrument that has a negotiable monetary value. The stock market refers to all the exchanges where people can buy and sell publicly-traded stocks and other securities.

Watching the Market

Investors can track the overall stock market by looking at a stock market index, which calculates the average performance of a particular group of stocks. That group usually represents a country, stock exchange, sector, or size category. The three most popular market indices are the Standard & Poor’s (S&P) 500 index, the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite (NASDAQ). Surprisingly, most professional investment firms fail to beat these indexes over the long-term. During the 15 years ending in 2018, more than 90% of money managers underperformed the major indexes.

The Standard & Poor’s 500 index (S&P 500) tracks publicly traded companies with the 500 biggest market caps listed on the New York Stock Exchange (NYSE) or the NASDAQ. This index does not weigh each company equally; bigger companies have a bigger weight and a stronger influence on the index. Investors get a holistic view of the stock market by watching this index.

The Dow Jones Industrial Average (DJIA) tracks 30 of the most important publicly traded companies listed on the NYSE or the NASDAQ. These companies have the biggest market caps and the most frequently traded shares. The DJIA places a slightly heavier emphasis on industrial companies, giving investors a less holistic view of the entire stock market than the S&P 500.

The NASDAQ Composite tracks all the stocks on the NASDAQ stock exchange. This exchange focuses on new tech companies, even some that don’t have headquarters in the United States. The NASDAQ Composite gives investors an idea about how the information technology sector is doing, but not the overall general market.

As a group, stocks alternate between long uptrends, called bull markets, and shorter and more violent downtrends, called bear markets. Since 1926, the average bull market is 9.1 years long and sees stocks rising 471%. The average bear market is 1.4 years long and sees stocks falling 41%. 75% of stocks increase in bull markets and 75% of them decrease in bear markets. As mentioned, despite being non-random, stock prices are difficult to predict.

Who's Trading?

There are tons of shareholders of U.S. stocks, and they all fall into two categories: institutional investors and individual investors.

Institutional investors invest other people’s money. Examples include investment banks (like Goldman Sachs), money managers, insurance companies, and funds (like mutual funds, pension funds, and hedge funds). They have access to huge amounts of capital, so they can make huge purchases. The investment community calls these investors “smart money” because they hire countless analysts and industry experts to inform their decisions. They are the biggest players on the market, and account for the bulk of the trading volume every day. Mutual funds try to actively move money around into the best investments. Their results are generally underwhelming.

Then there are the individual investors, also called “retail investors.” If you are just managing your own money, you are a retail investor. The downside: retail investors generally have less information at their disposal than institutions. Now, the internet is reducing that information gap, and retail investors can make thoughtful decisions based on comprehensive research. However, institutions can still access information sources that individuals cannot, like corporate boardroom meetings or company executives.

These institutions have huge portfolios, and if they want to invest even a small portion of it in a particular company, they would have to buy thousands of shares. This can drastically increase the ratio of buy orders to sell orders for that company’s stock, causing significant price increases. As institutions keep buying shares, the share price usually increases.

As you’ll learn later, one way to profit from investments is by investing in financially strong companies that are starting to attract institutional investors. When one institutional investor bites, many follow suit, increasing demand and causing a sustained share price increase.

Not all institutions invest in companies for weeks, months, and years. Some institutional investment firms, like hedge funds, use high frequency trading (HFT) algorithms. HFT trades account for roughly 50% of the trading volume on the stock market every day. These algorithms hold stocks for minuscule time periods to earn minuscule profits. The short hold times allow them to make thousands of trades a second. For investors who plan on holding stocks for weeks, months, or years, HFT is usually not a big deal. A company’s long term growth easily dwarfs the price change that HFT can cause.

However, HFT can cause problems if you invest in a very cheap stock. If the share price is $2.20, a 10 cent drop caused by HFT is a 4.5% loss. This loss can make other investors sell, thinking they need to get out before the share price keeps crashing. These sell orders further drop the price, causing even more people to sell. This snowballing effect can actually crash the stock price. That risk is a strong reason to avoid trading cheap stocks like penny stocks.

Going Public

If a stock is "publicly-traded," the general public can easily buy or sell it. Publicly-traded stocks trade on stock exchanges like the New York Stock Exchange (NYSE) and the Nasdaq.

Most companies start out as privately-owned. To invest in it you must have discovered it yourself or know one of the insiders. But eventually, companies "go public" and decide to let the general public invest in them so they can raise more funds for expansion. Here's how they do it.

Let’s say Hi-Tek Cloud Services CEO Joe Chipman needs money to help expand the company. To raise money, Joe plans to sell ownership of a portion of his company to the public. He does it with stocks. Here’s how:

1. Joe decides to turn his private company, which the public can’t invest in, into a publicly traded one. This is called an an Initial Public Offering (IPO).

2. Joe must decide how much of his company he’s willing to give up for public trading. He decides on 10%.

3. He hires an investment bank like Goldman Sachs as an “underwriter,” which estimates how much the public will likely pay to own that 10%, and decides which stock exchange will list the stock and facilitate its trading.

Suppose the underwriter estimates the public will pay $100 million to own 10% of Joe’s company. The underwriter divides that value into chunks, called shares, that the public will be able to buy. A “stock” is just another name for a share.

The underwriter decides how much the public will likely pay for each share and the number of shares to offer. In our case, if it thinks the public will pay $100 for each share, the underwriter would decide to offer 1 million shares to the public.

They also decide which stock exchange gets to offer the stock to the public. The exchange is just a marketplace where people can buy and sell stocks. The most well-known are the New York Stock Exchange (NYSE) and the NASDAQ, which focuses on new technology companies.

4. To make a profit, the underwriter buys all the shares from Joe’s company for a price slightly lower than the price it plans to offer to the public on the stock exchange. For instance, the underwriter might buy all 1 million shares for $97 each, then sell it to the public for $100 each.

5. Joe’s company gets the $97 million from the underwriter. That’s how much money it raises through the IPO. In exchange for that fundraising, the original investors of the company lost a portion of their ownership. That ownership entitles them to a portion of the company’s profits.

6. Once the underwriter sells the shares to the public, the public trades those shares among themselves. This trading does not raise any money for the company, even if the share price increases. If the company wants more money, it must sell ownership of another portion of itself to the public, or it can sell bonds and other debt instruments.

Company executives that believe in their company’s growth potential often buy large amounts of stock, and they personally profit as the stock price increases. But that profit does not go back into the business unless those executives decide to surrender their profits and give it to the company.

And that’s how stocks work. A stock is also called an equity security. “Equity” means the stock entitles its holder to some ownership of the company, and “security” means it is a financial instrument that has a negotiable monetary value.

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