What is the Stock Market?

The Stock Market can be an intimidating place. The recent financial crisis which decimated so many people’s retirement accounts is still fresh on everyone’s mind. Economists and Financial Experts are all over the news talking in jargon that 90% of Americans don’t really understand. They use acronyms, terms and ratios that are confusing and overwhelming. It makes the Stock Market seem inaccessible at best. I have heard people commonly refer to the Stock Market as gambling (my wife is one of them) or a fool’s game. Many people have told me that the Stock Market is a game for the rich, that lower and middle class folks don’t stand a chance.

I am trying to dispel some of those misconceptions because I believe the best way for someone to claw their way out of the lower or middle class is by taking advantage of the Stock Market. It can help you put your kids (or yourself) through college. It can ensure that you can live comfortably in retirement or help purchase your first home. There are risks. I won’t deny that but there are simple ways to minimize them. It is far easier than it looks but it is not intuitive. You need someone to walk you through it, someone that can translate the jargon and explain financial concepts in simple terms.     

Let’s start from the beginning;

What is the Stock Market?

The Stock Market, for the most part, is a secondary market. That means that when you purchase a company’s stock you are not buying it from the company but from someone else. You are buying stock second or third or 23^rd hand. Stocks for the most part are used goods. Think of the Stock Market like a giant swap meet but instead of crafts, clothes and used furniture people are haggling for stocks, bonds, mutual funds, commodities and other more obscure financial products.

What is a Stock?

Each share of stock represents a miniscule portion of company ownership. Many companies have sold millions or even hundreds of millions of shares. When I write that you own a portion of the company I do not mean that in some abstract sense. You literally own a portion of the company. You have voting rights (each share is a vote) on company matters. You can attend and be heard at company shareholders meetings. Some companies even give you a cut of the profits called a “dividend” for each share of the company you own (I will write about that in great detail another time). All of this participation is strictly voluntary.

So why own Stock?

The goal of every company is to make money for the owners. As a stock holder, that’s you. Ever considered opening a business but decided it was just too risky. Maybe you just didn’t have enough cash on hand to make it happen. Well, why not just buy into a well established company with great leadership and a product line that anyone born after 1975 can’t seem to live without; Apple (AAPL). Or how about a fast food company that has stores in 119 countries world-wide but is still an American icon; McDonald’s (MCD).

These two companies are highly respected organization and while their stock price may go up and down over the weeks, months and years the general trend is up and they will be around for a long, long time. It is important to remember during those down days that you do not gain or lose money until you purchase and then sell your stock. It may worry you to the point of giving you hives but you are not out of the game until you sell.

SIDE NOTE: I would suggest that any new investor stick to this type of large, well known, highly established companies that would make headlines if they were in trouble. I am not saying it is a fool proof investing plan or a plan at all really but you will avoid a lot of risk by simply choosing companies that you know and are familiar with. I mean, if a few of McDonald’s near you boarded up their windows you would notice.

How does owning stock make you money?
There are two primary ways that a stock can make you money. The first way is stock appreciation. You have probably heard the phrase "buy low, sell high" before. It refers to buying stock at one price and selling it at a higher price. It is a very simple concepts that we all are familiar with but it is easier said than done.

The second way a stock can make you money is through a dividend. A dividend is basically profit sharing. The company distributes cash to its owners based on the number of shares they hold. The distributions generally happen four times a year (quarterly) at a set annual rate. For intance, Windstream Corporation (WIN), offers $1.00 per share, broken into quarterly distributions of $0.25. This is often represented as a percentage of the stock price called the dividend yield. Windstream's price is currently about $13.00 a share. To get the yield take the dividend and divide it by the stock price and multiply it by 100 like so: ($1.00 / $13.00) X 100 = 7.7%. That means if you purchase the stock at $13.00 a share and you keep it for a year you will earn a 7.7% return without selling the stock.

SIDE NOTE:  Dividends can be altered or suspended at any time. Buying a stock with a dividend does not guarantee the yield. Also of note, this percentage changes as the stock price changes. If the dividend stays the same but the stock price drops the yield increases.    

What is a Bond?

When you purchase a bond you are purchasing debt or in more familiar terminology, you are loaning money. There are many kinds of bonds. You can buy them from the United States Federal or State governments, another country’s government or a corporation. Bonds have far less risk than stocks but the potential for reward is capped by the interest rate. Just like any loan, when a bond is purchased it has an interest rate and a specified duration. For instance a 2 year treasury note right now will earn you around a 2% guaranteed annual return (unless the US government collapses). Stocks do not come with a guarantee but the potential gain is unlimited. Most bonds do not really come with a guarantee but the risk of a government or company defaulting on a loan is generally pretty remote because the impact is to the company or governments well being is often catastrophic. The more likely a company or government is to default the higher the interest rate they will offer for their debt.

What is a Commodity?

In a word, Stuff. Commodities are everything from oil and gold to coffee and grain. This stuff, or more often the paper contracts that represent the purchase or the option to purchase this stuff is bought and sold daily.

What is a Mutual Fund?    

A mutual fund is a collection of stocks, bonds, commodities and other financial products crafted and managed by a financial professional. When you buy shares of a mutual fund you are purchasing a portfolio of financial products that when combined are supposed to meet an objective. An example of a common objective would be to match the performance of a particular index, say the S&P 500. That portfolio is not static. It is professionally managed which means the mix of stocks, bonds, commodities etc can and often will change. The point of a mutual fund is for a bunch of individual investors to pool their money together so they can achieve a level of diversification they couldn’t on their own. They also have access to investment products and opportunities that are only available for larger investors. The down side of course is that there are fees associated with the professional management.         

I managed to avoid discussing the mechanics of purchasing stock or methods for stock valuation yet again. I am starting with baby steps so that this can be a comprehensive resource for all levels of traders. Trust me, I am as anxious as you to discuss the nuts and bolts of stock valuation. I hope you found this primer helpful. I will spend more time on all of the topics discussed above in the future so if I did not get to your specific question, come back at a later date (or you could ask me by commenting below).