Saturday, January 21, 2012
Understanding Stocks
Welcome to the Stock Market
You may be surprised, but the market is not as difficult to understand as you might think. By the time you finish reading this chapter, you should have enough knowledge of the market to allow you to sail
through the rest of the book. The trick is to learn about the market in small steps, which is exactly how I present the information to you.
The Stock Market: The Biggest Auction in the World
Think of the stock market as a huge auction or swap meet (some might call it a flea market) where people buy and sell pieces of paper called stock. On one side, you have the owners of corporations who
are look-ing for a convenient way to raise money so that they can hire more employees, build more factories or offices, and upgrade their equip-ment. The way they raise money is by issuing shares of
stock in their corporation. On the other side, you have people like you and me who buy shares of stock in these corporations. The place where we all meet, the buyers and sellers, is the stock market.
We’re not talking about livestock! Actually, the word stock originally did come from the word livestock. Instead of trading cows and sheep, however, we trade pieces of paper that represent ownership—shares— in a corporation. You may also hear people refer to stocks as equities or securities. Most people just call them stocks, which means supply. (After all, the entire stock market is based on the economic theory of supply and demand.)
When you buy shares of stock in a corporation, you are com-monly referred to as an investor or a shareholder. When you own a share of stock, you are sharing in the success of the business, and you actually become a part owner of the corporation. When you buy a stock, you get one vote for each share of stock you own. The more shares you own, therefore, the more of the corporation you control.
Most shareholders own a tiny sliver of the corporation, with little control over how the corporation is run and no ability to boss anyone in the corporation around. You’d have to own millions of shares of stock to become a primary owner of a corporation whose stock is publicly traded.
In summary, a corporation issues shares of stock so that it can attract money. Investors are willing to buy stock in a corporation in order to receive the opportunity to sell the stock at a higher price. If the corporation does well, the stock you own will probably go up in price, and you’ll make money. If the corporation does poorly, the stock you own will probably go down in price, and you’ll lose money (if you sell, that is).
Stock Certificates: Fancy-Looking Pieces of Paper
Stock certificates are written proof that you have invested in the cor-poration. (Some people don’t realize that you invest in companies, not stocks.) Although some people ask for the stock certificates so that they can keep them in a safe place, most people let a brokerage firm hold their stock certificates. It is a lot easier that way. To be technical, there are actually two kinds of stock, common and preferred.
we will always be talking about common stock, because that is the only type that most corporations issue to investors. Remember, not all companies issue stock. A company has to be what is called a corporation, a legally defined term. Most of the large companies you have heard of are corporations, and, yes, their stocks are all traded in the stock market. I’m talking about corporations like Microsoft, IBM, Disney, General Motors, General Electric, and McDonald’s.
You Buy Stocks for Only One Reason: To Make Money
The stock market is all about making money. Quite simply, if you buy stock in a corporation that is doing well and making profits, then the stock you own should go up in price. (By the way, the profits
you make from a stock are called capital gains, which are the difference between what you paid for a stock and what you sold it for. If you lose money, it is called a capital loss.)
You make money in the stock market by buying a stock at one price and selling it at a higher price. It’s that simple. There is no guarantee, of course, that you’ll make money.
Even the stocks of good corporations can sometimes go down. If you buy stocks in corporations that do well, you should be rewarded with a higher stock price. It doesn’t always work out that way, but that is the risk you takewhen you participate in the market.
New York: Where Stock Investing Became Popular
Before there was a place called the stock market, buyers and sellers had to meet in the street. Sometime around 1790, they met every weekday under a buttonwood tree in New York. It just happened that the name of the street where all this took place was Wall Street. (For history buffs, the buttonwood tree was at 68 Wall Street.)
A lot of people heard what was happening on Wall Street and wanted a piece of the action. On some days, as many as 100 shares of stock were exchanged! (In case you don’t think that’s funny, in today’s market, billions of shares of stock are exchanged every day.)
It got so crowded in the early days that 24 brokers and merchants who controlled the trading activities decided to organize what they were doing. For a fixed commission, they agreed to buy and sell shares of stock in corporations to the public. They gave themselves a quarter for each share of stock they traded (today we would call them stock-brokers). The Buttonwood Agreement, as it was called, was signed in 1792. This was the humble beginning of the New York Stock Exchange (NYSE).
It wasn’t long before the brokers and merchants moved their offices to a Wall Street coffee shop. Eventually, they moved indoors permanently to the New York Stock Exchange Building on Wall Street.
Keep in mind that a stock exchange is simply a place where people go to buy and sell stocks. It provides an organized marketplace for stocks, just as a supermarket provides a marketplace for food.
Even after 200 years, the name Wall Street is a symbol for the U.S. stock exchanges and the financial institutions that do business with them, no matter what their physical location. If you go to New York,
you’ll see that Wall Street is just a narrow street in the financial district of Lower Manhattan. Therefore, the stock market, or Wall Street, is really a convenient way of talking about anyone or anything
connected to our financial markets.
Three Major Stock Exchanges
After the NYSE was formed, there were also brokers trading stocks who weren’t considered good enough for the New York Stock Exchange. Traders who couldn’t make it on the NYSE traded on the
street curb, which is why they were called curbside traders. Eventually, these traders moved indoors and established what later became the American Stock Exchange (AMEX).
There is also a third major stock exchange, the National Association of Securities Dealers Automated Quotation System (Nasdaq), which was created in 1971. This was the first electronic stock exchange;
it was hooked together by a network of computers. (Yes, they did have computers back then.)
Competition is good for the stock market. It forces the stock exchanges to fill your orders faster and more cheaply. After all, they want your business. There are stock exchanges in nearly every country in the world, although the U.S. market is the largest. U.S. stock exchanges other than the three major ones include the Cincinnati Stock Exchange, the Pacific Stock Exchange, the Boston Stock Exchange, and the Philadel-phia Stock Exchange (the Philadelphia Stock Exchange is our country’s oldest organized stock exchange). Other countries with stock exchanges include England, Germany, Switzerland, France, Holland, Russia, Japan, China, Sweden, Italy, Brazil, Mexico, Canada, and Australia, to name only a few.
A few years ago, in order to compete more effectively against the NYSE, the National Association of Securities Dealers (NASD), which owns the Nasdaq, and the AMEX merged. Although the two exchanges are operated separately, the merger allowed them to jointly introduce new investment products. This is interesting, but it doesn’t really affect you as an investor. In the end, it doesn’t really matter from which exchange you buy stocks.
Joining a Stock Exchange
It’s not easy for a corporation to be listed on, or join, a stock exchange because each exchange has many rules and regulations. It can take years for a corporation to meet all the requirements and join the exchange. The stock exchanges list corporations that fit the goals and philosophy of the particular exchange.
For example, the companies that are listed on the NYSE are some of the best-known and biggest corporations in the United States—blue-chip corporations like Wal-Mart, Procter & Gamble, Johnson & Johnson, and Coca-Cola. The Nasdaq, on the other hand, contains many technology corporations like Cisco Systems, Intel, and Sun Microsystems. In addi-tion, stocks that are traded “over the counter” (OTC) are located on the Nasdaq. By the way, there are over 5000 stocks traded on the three U.S. stock exchanges and another 5000 smaller companies traded over the counter.
Corporations: Convincing People to Buy Their Stock
Once a corporation goes public and allows its stock to be traded, the trick is to convince investors that the corporation will be profitable. Corporations do everything in their power to attract money from investors.
Bigger corporations spread the word through print and televi-sion advertising. Smaller corporations might rely on word of mouth, emails, or news releases. The more people there are who believe in a corporation, the more people there will be who will buy its stock, and the more money the people on Wall Street will make. Now do you understand why everyone is always saying such good thing about the market? If you’re lucky, you’ll also make a few bucks if you invest in a profitable corporation.
Now that you have some idea of what happens in the back rooms of the stock brokerage, I’m going to take you upstairs. First, I will intro-duce you to the three types of people who participate in the market: individual investors, traders, and professionals. By the time you finish this book, you should have a better idea of where you fit in.
Individual Investors
Investors buy stocks in corporations that they believe in and plan to hold those stocks for the long term (usually a year or longer). Investors generally choose to ignore the short-term day-to-day price fluctuations of the market. If all goes according to plan, they find that the value of their investment has increased over time.
One of the most profitable buy-and-hold investors of our time, Warren Buffett, likes to say that he is not buying a stock, he is buying a business. He buys stocks for the best price he can and holds them as long as he can—forever, if possible. (When asked when he sells, Buf-fett once said, “Never.”)
Keep in mind, however, that Buffett buys stocks in conservative (some would say boring) corporations like insurance companies and banks and rarely buys technology stocks. Buffett became a billionaire using his long-term buy-and-hold investment strategy (a strategy is a plan that helps you determine what stocks to buy or sell).
Investors who bought shares of stock in Caterpillar (CAT), Lock-heed Martin (LMT), and Minnesota Mining and Manufacturing (MMM), for example, saw the value of their investments increase over time, especially during the latter half of the 1990s. Actually, there was never a better time to be an investor than during the 1990s. You bought shares of a corporation you knew and believed in, then sat back and watched the value of the shares increase by 25, 50, or 100 percent. (This is as good as it gets for investors!)
Short-Term Traders
Unlike investors, short-term traders don’t care about the long-term prospects of a corporation. Their goal is to take advantage of the short-term movements in a stock or the market. This means that they may buy and then sell a stock within 5 minutes, a few hours, a few days, or even a week or month on occasion. When you are a trader, you are pri-marily focused on the price of a stock, not on the business of the corporation.
There are many kinds of short-term traders. Some of you may have heard the term day trader, which refers to a very aggressive short-term trader. For example, a day trader might buy a stock at $10 a share with a plan to sell it at $10.50 or $11, usually within the same day. If the stock goes down in price, he or she will probably sell it quickly for a small loss.
In other words, day traders buy stocks in the morning and sell them for a higher price a few minutes or hours later. Generally, they move all their money back to cash by the end of the day. Keep in mind that it’s extremely hard to consistently make money as a day trader. Only a small percentage of people make a living at it.
Professional Traders
Professional traders use other people’s money (and sometimes their own) to make investments or trades on behalf of clients. Professionals include individuals who work for Wall Street brokerages and stock exchanges, but they also include institutional traders like pension funds, banks, and mutual fund companies.
There is no doubt that institutional investors that have access to millions of dollars influence not only individual stocks but the entire market. Some of these institutions have set up computer programs that automatically buy or sell stocks when certain prices have been reached. (On days when the market is up or down hundreds of points, the stock exchanges limit how much institutional investors can buy or sell.)
If you want to be a professional Wall Street trader, you can also apply to become a member of one of the exchanges. At current prices, it will cost you several million dollars to buy a seat on the NYSE, and all you get for this is the freedom to trade stocks directly on the exchange floor. (For that kind of money, you’d think they’d let you play golf and swim! For a few million dollars less, you can trade directly from the comfort of your own home.) Some people with seats rent them out to professional traders and thus bring in extra income.
How Wall Street Keeps Score
Wall Street has several ways to keep track of the market. One of the eas-iest ways to find out how the market is performing each day is to look at a newspaper, television, or the Internet. Typically, people look at the Dow Jones Industrial Average (DJIA), the most popular method of determining whether the market is up or down for the day.
The Dow Jones Industrial Average
In 1884, a reporter named Charles Dow calculated an average of the closing prices of 12 railroad stocks; this became known as the Dow Jones Transportation Average. His goal was to find a way to
measure how the stock market did each day. He then wrote comments about the stock market in a four-page daily newspaper called a “flimsie,” which later became the Wall Street Journal.
A few years later, the company Charles Dow helped start, Dow Jones, launched the Dow Jones Industrial Average, consisting of 12 industrial stocks. If you know about averages, you know that you basically
add up the prices of the stocks in the index and divide by the num-ber of stocks to create a daily average. By watching the Dow, you can get a general idea of how the market is doing. It also gives us
clues to the trend of the market, whether it is going up, down, or sideways. (The trend is simply the direction in which a stock or market is going.)
The original 12 stocks in the Dow were the biggest and most popu-lar companies at the end of the nineteenth century—for example, American Tobacco, Distilling and Cattle Feeding, U.S. Leather, and
General Electric, to name a few. Guess which stock still remains in the index? (If you guessed General Electric, you are right. The other corporations either went out of business or merged with other
corporations.)
By 1928, the Dow Jones Industrial Average was increased to 30 stocks, which is the number of stocks in the index today. (By the way, this index is sometimes called the Dow 30.) These 30 stocks are a
cross section of the most important sectors in the stock market. (A sector is a group of companies in the same industry, such as technology, utilities, or energy.) Over time, the Dow changed from an equal weighted index to one in which different stocks have different weights. This means that stocks with a higher weighting affect the Dow index more than stocks with a lower weighting.
For example,
since American Express is weighted high in today’s market, if this stock is having a bad day and falls by several points, the Dow could end up down for the day.
It’s easy to find out how the Dow did each day—it’s reported in the media. Since more than half of the public is invested in the stock mar-ket, there is a lot of interest in what the Dow does each day.
Therefore, when we talk about the Dow Jones being up or down each day, we’re really talking about a representative group of 30 stocks, the Dow 30. Even if the market is down for the day, the stock you own could be up, or the other way around.
Other Indexes
Although the Dow (operated by the Wall Street Journal) was the first index to keep track of stocks, hundreds of other indexes have been cre-ated to track almost everything from transportation to utilities to technology stocks. Some sophisticated investors keep an eye on many of these indexes, but most people watch just three.
The next most popular index (after the Dow) is the Nasdaq Composite Index, which tracks the more than 5000 stocks listed on the Nas-daq. On television or on the Internet, when you see the Dow listed, you will almost always see the Nasdaq below it.
The third index that many people watch closely is the S&P 500. If you guessed that this contains 500 stocks, you are right. These are 500 stocks that Standard & Poor’s Corporation (S&P) has selected to represent the overall stock market. They are usually the largest stocks and include a lot of technology stocks. Other popular indexes are the Russell 2000 index and the Wilshire 5000. You’ll learn later that you can invest directly in them, since they trade just like stocks.
If you were a professional money manager, your goal each year would be to beat the major indexes. What does this mean? It means that if the Dow is up 15 percent this year, you would try to get 15 percent or more. The bad news is that it’s very hard for people, even professional investors, to beat the indexes. In 2001, it was reported that 50 percent of the professional money managers don’t beat the
indexes each year. In 2002, it was reported that only 37 percent of the professional man-agers beat the indexes.
It’s All About Points
To measure how much you make or lose in the stock market, Wall Street uses a system of points that represent dollars. For example, if your stock went from $5 a share to $10 a share, we would say that
your stock went up 5 points. That’s how we keep score on Wall Street, but accountants and market analysts make it seem a lot more complicated than it is.
The same type of scoring is done with the major indexes like the Dow, the Nasdaq, and the S&P 500. If the Dow went from 10,000 to 10,100, you would say the market went up by 100 points. If your
stock went from $10 a share to $11 a share, you made a point, not a dollar.
Note: Although it’s okay to tell people how many points you made or your percentage gain, it’s not polite to tell people the exact amount of money you made on a stock deal. Even if you made $5000 in 5
min-utes, it’s best to keep it to yourself. To be polite, stick to the point sys-tem and avoid talking about money.
How Much Is It Going to Cost?
If you can figure out the following calculation, then you will under-stand how to buy or sell stock. Just as in an auction, every stock has a price. This price changes frequently—every few seconds for some
stocks. Let’s say that a stock you’re interested in, Bright Light, is cur-rently trading at $20 a share. You decide you want to buy 100 shares. The math goes like this: 100 shares multiplied by $20 a share
will cost you $2000. That means you must pay $2000 if you want to buy 100 shares of Bright Light (plus commission, of course).
This is so important that I’ll give you another example. Let’s say you want to buy 1000 shares of a stock that is selling for $15 a share. How much will it cost you? The answer is $15,000. One more
example: Let’s say you want to buy 100 shares of a stock that costs $5 a share. The answer is $500.
How Much Did You Make?
Let’s say you decide to buy 1000 shares of a stock that costs $15 a share. It will cost you $15,000. If the stock goes to $16, you have made 1 point. If the stock goes to $17, you have made 2 points. Here’s
the important part: If you have 1000 shares of a stock and you made 1 point, you made $1000 in profit. If the stock goes up 2 points, you made $2000 in profit. So the more shares you own, the more
money you’ll make (or lose).
(More examples? If you own 100 shares of a stock and it goes up 1 point, you made $100. If you own 100 shares of a stock and it goes up by 5 points, you made $500.)
What If No One Wants to Buy or Sell Your Stock?
This is actually a very good question. It’s like having a house sale that no one goes to. To solve this problem, the stock exchanges have set up a system in which there is always someone on the other side
of a trans-action. In other words, there will always be a buyer or seller for you. You may not get the best price, but at least you know that there is someone who is willing to sell you the stock or buy it from you if you own it.
On the NYSE, there is one person, a specialist, who acts as the intermediary for each stock. The specialists “make a market” for every stock listed on the exchange. This means that the specialist keeps track of and fills all of the orders for a particular stock that comes in, some-times using his or her own money if no one else wants to buy or sell the stock. Does this sound like a fun job? Handheld computers make the job a lot easier. Before computers, the specialists used to fill the orders by hand. Once orders increased from hundreds to billions of shares, computers were installed to handle the orders.
You might wonder how the specialists get paid, since they are using their own money to fill the orders. First of all, because specialists know the stock so well, they are able to buy it at the lowest possible price and sell it to you at the highest possible price. It doesn’t sound really fair, but that’s how they make their money. They also get a cut on every trade they make. They claim this is to compensate them for the risk they take when they use their own money to buy or sell.
If you are investing in only a few hundred shares, or even a few thousand, it’s not worth your time to worry too much about the pennies the intermediaries make on each trade. It’s the million-share traders who try to save money on each trade. By the way, those pennies add up to thousands of dollars every day for the specialists. They make money whether the market goes up or down.
At the Nasdaq market, the computerized stock exchange, buyers and sellers are matched with the help of an intermediary called a mar-ket maker. Unlike the arrangement at the NYSE, where only one specialist is assigned to a stock, at the Nasdaq you can have multiple market makers for a stock. The more popular the stock, the more mar-ket makers will be assigned to the stock.
For instance, a stock like Microsoft could have as many as 30 market makers, while a $1 stock might have only one market maker. There is, however, at least one market maker assigned to each Nasdaq stock. Keep in mind that all of this happens behind the scenes within seconds. Because billions of shares are traded each day, your orders end up being routed by computers. It is nice to know, however,
that there will always be someone who is willing to buy or sell shares of your stock.
Why Stocks Are a Good Idea
There are a number of reasons why you should buy stocks. According to researchers, stocks have beaten every other type of investment over any 10-year period during the last 75 years. They are a good
buy even after a market crash or an extended bear market. According to research conducted by Jeremy Siegel, best-selling author of Stocks for the Long Run (McGraw-Hill, 2002), over the long term stocks gained an annual-ized 8 percent after inflation after the market has fallen by over 40 per-cent or more. (Inflation is the expansion of the money supply. As a result, the price of goods and services go up, which lowers or erodes the amount you can buy with your money.) In the short term, stocks are riskier than fixed-income assets, but in the long run, says Siegel, stocks outperform every other investment.
According to many experts, stocks have returned an average of 11 percent annually for the last 75 years, handily beating inflation as well as bonds, money market accounts, and savings accounts. In addition, it’s cheaper to buy stocks over the long term, especially if you buy and hold. And according to the experts, the odds are quite good that the market will continue to go up just as it’s done in the past (although there are no guarantees).
Risk: The Chance You Take When You Buy Stocks
A lot of people enter the stock market without a clear idea of the risks. (Too many people look up at the stars without looking out for the rocks below.) Let’s be clear: when you invest or trade in the market, there is a chance that you could lose some or all of your money. It’s even possible to lose more money than you put in. The goal for many investors and traders, therefore, is learning how to recognize and minimize risk. Keep in mind, however, that you can’t completely eliminate risk, but you can learn to manage it.
There are all kinds of risk. First, the entire stock market could go down in price because of outside events like war, recession, or terrorism. Second, even if the stock market as a whole goes up, there are a number of reasons why your stock could go down. Third, even if you avoid the stock market and put your money in a savings account (or under your mattress), there is the risk that your money will be worth less because of inflation. And finally, if you do not invest in the market, there is the risk that you will miss out on some very profitable buying opportunities. Therefore, whether you invest in the market or not, there will be risks. By the time you finish this book, you’ll be able to decide for yourself whether the risks you take are worth the rewards you’ll make.
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