The Stock Market
3.1 STOCK MARKET BASICS
Objectives
Corporate Stock
Investing in stock is often viewed as one of the best ways to build up your
personal wealth and reach long-term financial goals.
Today, around 50% of Americans own corporate stock in a public
corporation.
A Public Corporation is a company whose stock is traded openly on a
stock market.
When you buy a share of stock, you are buying an ownership interest in
that company and you become a Stockholder or Shareholder of the
corporation.
As an investor, you buy shares of stock in the hope of earning a return on
investment (ROI).
Buying and Selling Stock
Generally you buy and sell stock by placing your order with a stockbroker.
A Stockbroker is a person who handles the transfer of stocks and bonds
between buyer and seller (every trade has a buyer and seller).
Stockbrokers can be full service or discount brokers. They work for
Brokerage Firms (Companies that specialize in investment research and
trading).
Full Service Brokers – Provides investment advice based on research and
analysis. More expensive than discount brokers.
Discount Brokers – Only execute trades without providing research,
analysis and advice. Much less expensive than full-service brokers.
Placing an Order
Once you have decided to buy or sell stock, you can place your order over
the phone or through an automated system over the internet.
Three basic kinds of orders:
Market Order – Buy or sell a certain number of shares at the best current
available price. You assume your order will be executed ASAP.
Limit Order – Buy or sell when the stock reaches a certain price. If the
specified price is not reached, no trade is executed. Primary advantage is it
guarantees the trade will be made at a particular price.
Stop Order – Your order to buy or sell at a specific price changes to a market
order when the specific price is reached. Does not guarantee a particular
price.
Filling an Order
Stock Exchange – An auction market where orders to buy and sell
stock are sent and carried out. (The largest is the New York Stock
Exchange (NYSE) located on Wall Street in NYC.
Using computers, your order goes (in minutes) from your broker to
the appropriate stock market. If listed on the NYSE, a Specialist there
will handle your order. A Specialist acts as an agent matching buy
and sell orders. Sometimes the Specialist will by or sell from his own
account to maintain an orderly market.
In the NASDAQ and over-the-counter markets, a Dealer handles
buying and selling.
Institutional Investors
Institutional investors do approximately 75 to 80% of stock market
trading. These include banks, bank trust departments, mutual fund
companies, pension funds and insurance companies.
Usually they are large companies with professional staffs dedicated
to investment decisions.
Because of the size of their purchases, they have a great deal of
influence on stock prices.
The Stock Market
3.2 OWNING STOCK AND EARNING RETURNS
Objectives
How Stockholders Earn Returns
Remember…As an investor, you buy shares of stock in the hope of earning
a return on investment (ROI).
If the company does well, stockholders can potentially profit in two ways.
Dividends – a portion of company profits that is allocated to stockholders
on a regular basis (usually paid out quarterly).
For example, If you own 100 shares of XYZ Bank and they pay an annual
dividend of $1 per share, you would receive $100 per year ($25 per
quarter) in dividends representing your share of company profits.
You must hold the stock in order to earn dividends and NOT ALL publicly
traded companies pay dividends to shareholders.
How Stockholders Earn Returns
Capital Gains – Besides dividends, the other way that stockholders
could profit is through Capital Gains. This is an increase in the value
of the stock over time.
For example, if you bought 100 shares of XYZ Bank at $5 per share
and the corporation did well driving the stock price up to $10 per
share a year later, you could sell your 100 shares for $1000. Since
your initial investment was $500 (100 x $5), you would have a
Capital Gain (profit) of $500.
You must sell the stock in order to earn Capital Gains and sometimes
you sell for less than your investment (Capital Loss).
Common vs. Preferred Stock
Common Stock usually pays a variable dividend (sometimes no dividend)
and gives the stockholder voting rights. Common stockholders vote on
major policy decisions (issuance of additional stock, sale of company).
Board of Directors (elected by stockholders) decide on dividends.
Most shares purchased are Common shares.
Preferred Stock pays a fixed dividend but has no voting rights. Less risky
than common stock.
If company fails, preferred shareholders are paid before common
shareholders.
Stock Categories
Stocks are often classified into different categories to fit investment
objectives. Some stocks may fall into more than one category.
Income –Have a consistent history of paying high dividends. Popular
choice for retirees.
Growth – Companies that reinvest their profits into the business so
that it can grow. These companies may pay little or no dividends.
Blue Chip – Large, well-established companies with a solid record of
profitability.
Stock Categories (cont.)
Emerging – Young, often smaller corporations that could be on their
way to high profitability. (Uncertainty/Risk).
Cyclical – Stocks that are much more affected by ups and downs in
the economy.
Defensive – Stocks that remain relatively stable during an economic
decline.
Valuing Stock
A stock’s Market Value is the price for which the stock is bought and
sold in the marketplace.
Market Value of a stock reflects the price that investors are willing to
pay for a stock based on current company performance, track record
and future expectations.
Stock Prices increase or decrease over time based on investor supply
and demand at various prices in the market.
Stock Analysts review detailed information about companies and
rate stocks (buy, hold, sell). Stock prices can be heavily influenced by
these ratings.
Interest Rates and Market Conditions
When interest rates are low, people who would normally put money in
savings accounts and CDs look for more profitable places to invest their
money. As interest rates rise, people tend to move their money to safer
investments.
Generally, when interest rates fall below the rate of inflation, people buy
more stock and stock prices rise.
The Stock Market goes through periods of rising and falling prices.
A Bull Market is a prolonged period of rising stock prices and investor
optimism.
A Bear Market is a prolonged period of falling stock prices and a general
feeling of investor pessimism.