Part 1 of 2:
As European traders began exploring the New World in the 16th century, they faced a problem we still deal with today: their goals and dreams far outstripped their finances.
Sailing across the Atlantic was expensive, especially when they had no idea whether they’d find goods that were profitable enough to pay for the trip. The solution was to raise capital from investors, promising a share of the (presumed) profits in return.
The idea of making an investment today in return for a share of future profits was the essence of the modern stock market. Seeing how well the idea worked for explorers, industrialists also began using the same idea to raise the capital to build factories and other businesses.
As Europeans settled in the New World, they raised the capital they needed to industrialize America the same way. On May 17, 1792, 24 supply brokers signed the Buttonwood Agreement outside 68 Wall St. in New York, underneath a buttonwood (also known as a sycamore) tree. On March 8, 1817 the group changed its name to the New York Stock and Exchange Board and moved from the street into 40 Wall Street.
And thus the world’s largest stock exchange, now synonymous with Wall Street, was born.
But what is the stock market? What are stocks? What are you buying when you buy a share of stock, or a mutual fund that owns stocks? How do stocks fit into your long-term investment strategy? We’ll answer those questions and many others in this two-part series about understanding the stock market and using it to achieve your financial goals.
What is a Stock? What is a Public Company?
In broad terms, companies are defined by who owns them. Your local pizzeria, independent bookstore, or gift shop is almost certainly privately owned. The couple that started the pizzeria, and maybe one or two of their children, own it. You can’t just walk in and tell the owners you plan to buy part of their business.
A public company, on the other hand, is publicly owned, which generally means that anyone can buy part of that company. Buying stock means you’re actually buying a piece of that company. Rather than saying, “you own 0.001% of this company,” companies will sell shares. Apple, for example, currently has over 17 billion shares of stock publicly available.
If you buy 100 shares of Apple, you’re now a part owner. This has three benefits:
- As an owner, you can vote on certain company issues (which typically occurs annually)
- If the company is profitable, owners share in the profits
- If the company returns some of its profit to shareholders in the form of dividends, you’ll get some money
In the case of Apple, which paid a dividend this summer of $0.205 per share, you would have received $20.50 as a dividend for owning 100 shares. Dividends, if the company pays them, generally happen every quarter.
If you decide you no longer want to own Apple stock, you can sell all or some of your shares on the stock market. Conversely, you can buy more shares and own more of Apple if you wish.
Why Do Companies Sell Stock?
Companies typically sell stock, known as “going public,” for three basic reasons:
- They want to raise money to expand their company
- Their founders want to convert some of the equity they have in the company into cash
- They want to reward and motivate employees by giving or selling them shares in the company
Generally, the first time a company sells stock is called an Initial Public Offering, or IPO. Many IPOs are splashy, high profile affairs, with lots of buzz when a well-known company decides to go public. Often, companies will offer some of their shares of stock during their IPO and sell additional shares later, depending on demand.
Popular IPOs are almost always over subscribed, which simply means that there’s a greater demand for shares than the company has available. If you’re excited about buying shares in a company but can’t get any during the IPO, don’t worry: as shares begin to be bought and sold in the stock market, you’ll have an opportunity to buy the shares you want.
How Does the Stock Market Work?
The stock market exists to bring buyers and sellers together. Before the advent of computers, sales and purchases were made in person in the stock exchange. Now, although the stock exchange still exists as a physical building, billions of shares are bought and sold electronically every day. Buying and selling is also called trading; you’re trading your money for shares of stock, or vice versa.
Without getting too technical, stock markets make money by pocketing the difference between what a seller charges for shares of stock and what a buyer pays. The difference between what a seller is asking for a stock (the ask) and what a buyer pays (the bid) is called the spread.
If you’ve ever traveled and exchanged some of your American dollars for, say, Euros, chances are the bank or exchange booth you used had a sign showing the prices for buying or selling various currencies. That spread between what the bank would pay for your dollars, versus what it would charge if you were buying dollars, works the same way as the spread for buying or selling stock.
What’s more important for most stockholders is how easy it is to buy or sell a particular stock. Millions of shares of Apple stock trade every day. You can buy or sell 100, 1,000 or 10,000 shares almost immediately. For small companies, that process might take longer.
In the stock market, the size of a company is based on its market capitalization, otherwise known as its market cap. A company’s market cap is a simple calculation: the price per share multiplied by the number of shares outstanding, which is the number of shares a company has made available to trade. A company with a share price of $50 and one million shares outstanding would have a market cap of $50 million. When analysts talk about a billion dollar company, they’re generally referring to the company’s market cap.
Currently, a large cap company is one with a market capitalization of $10 billion or more, and a small-cap stock would be a stock from a company with a market capitalization between $250 million and $2 billion. A mid-cap company would fall between those two extremes.
What Makes Stocks Rise or Fall?
In broad terms, stock prices are based on future expectations. If a company is profitable now and investors expect it to be even more profitable in the future, its stock price will rise. After all, investors are buying stock in the expectation of future earnings.
That doesn’t mean that the price of a stock will rise every day or rise steadily. In the short term, the market will react to how a company does compared to expectations. If the professionals who analyze companies expect Apple to sell 48 million iPhones this quarter and Apple only sells 44 million, chances are Apple’s stock price will drop the day those results are announced. Apple may still be profitable and growing, but falling short of analysts’ expectations may mean that the stock price will temporarily fall.
A surprise company announcement, a high-profile hire or departure, a hot new product or many other factors can cause a stock price to rise or fall in the short term.
Sometimes, too, a company’s stock price can be affected by what’s happening in its industry, or what just happened to a competitor. If Samsung announces disappointing phone sales or Dell predicts a slowdown in the computer market, Apple’s stock price may drop in response.
Those daily, weekly or monthly stock and market fluctuations aren’t where investors should focus. Investors should take the longer view, building a risk-appropriate portfolio aligned with long-term goals and an overall plan.
Bulls and Bears
Just as individual stocks rise and fall, so does the stock market overall. A market where many stocks are declining in value is called a bear market, while a rising market is called a bull market. Someone who is bullish is generally optimistic about the market’s future direction or the prospects for a specific company; someone who is bearish is pessimistic.
The general direction of the market is usually judged by one of two metrics:
The Standard & Poors 500 Index, referred to as the S&P or the S&P 500, is the value of the 500 (actually 505) largest stocks in the stock market. Those stocks represent approximately 80% of the total value of the stock market, making the index a reasonable proxy for the stock market overall.
The other common way of measuring the market is the Dow Jones Industrial Average, often just called the Dow Jones or the Dow. The Dow is based on the stock prices of 30 companies, and the Dow Jones Company substitutes new companies from time to time. Despite the name, many of the companies in the Dow are no longer what most of us would consider industrial.
Although the Dow is more often seen in the news headlines, the S&P 500 is a more accurate way of measuring market performance.
A third, less common, way of measuring the market is the Nasdaq, a global electronic marketplace that was created on February 8, 1971. Its 3,000 stocks primarily consist of technology companies. In the U.S., it is second in size to the New York Stock Exchange. Because the Nasdaq is so tech heavy, it isn’t as good an indicator of the overall direction of the market.
As you might imagine, there are public companies in many countries and stock exchanges all over the world. At last count there were over 60 stock markets in North America, South America, Europe, and Asia, with at least 16 boasting a market cap of over $1 trillion.
Because stock markets in Europe and Asia open hours earlier than U.S. markets, many U.S. investors look to them for early signs of general market trends that will affect the U.S. markets when they open.
However, U.S. investors don’t have to move to another country to invest in European, Asian, or South American companies. Many international companies trade on American stock exchanges; approximately 37% of the companies on the New York Stock Exchange are headquartered outside the U.S.
That’s the background of the origins and general make-up of the stock market. In Part 2, we’ll highlight different ways of using the stock market to reach your financial goals.