A Primer on Stocks and the Stock Market. Editor’s note: This is a guest post from Matt Alden S., publisher of Dividend Monk. The stock market can be a confusing and hectic place.
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Especially after witnessing recessions, bank- bailouts, and huge volatility, it can seem like it operates with no rhyme or reason. A crucial skill for any man is the ability to master one’s own finances.
It’s an important part of life to be able to understand exactly what he owns and why he owns it. But many men will admit they really don’t even know the basics of how the stock market works. Fortunately, behind all of the noise of computer trading and non- stop financial media, the basics of buying and selling stock are pretty simple. Advances in technology and increases in the speed of news distribution may have complicated it on the surface, but the same general ideas hold as true today as they did 1. This article provides an overview of what stock is, and how shares of stock are bought and sold on the market.
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A Share of Stock Is a Fraction of a Business. The ownership of a public company is collectively called “stock.” The shares of stock that are bought and sold between investors represent tiny fractions of that business. For an example of a private company, if ten people hold equal portions of a small carpentry business, then the company can be thought of as consisting of ten shares, with each owner/investor holding one share. Since it’s divided ten ways between these shareholders, if the company earns a profit of $5. The owners of the carpentry business could collectively decide to reinvest those profits into growing the company, or they could use some of the money to pay themselves part of the profits. If they want to leave the business, they could sell their share to someone else.
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One of the owners may even decide to buy a share from another owner, so that he now holds two shares, or 2. A modern corporation works the same way, except that instead of ten shares, it consists of millions or even billions of shares.
Corporations are “publicly traded,” meaning that there are “x” number of shares available and anyone can buy or sell them on an exchange. To organize that many owners into a leadership team, the shareholders vote for directors to lead the company. On an annual basis, the shareholders can vote to elect people to the Board of Directors, which is the highest operating authority in the organization. The Board then appoints the leadership team, including the Chief Executive Officer and other top management to run the day- to- day business operations. The Board of Directors makes high level decisions on the direction of the business, and they also make the decision on whether to reinvest all profits back into the company for growth, or to pay out a portion of the total profit as cash payments, called dividends, to the shareholders.
Why Do Businesses Go Public? Companies that go public generally do so because they want to collect more money for growth opportunities. If the owners of a privately held company want to have an easier time selling their private shares, or if they want to sell part of their company to the public to raise money for the business to grow faster, they hold an Initial Public Offering, referred to as an “IPO.” During an IPO, they will sell some of the shares of the company to the public, and from that point on, people can buy and sell those shares amongst themselves. A smaller example can illustrate the basic process: A man named John owns a business that sells premium mustache combs — the best in the world.
He has ten employees, and he owns 1. For a while this works well, with him earning $1. But it seems like every time Movember rolls around, it gets harder and harder to keep up with all the sales.
After careful consideration, he decides to invite five fairly wealthy acquaintances to help grow his business. They each chip in $5. So John has raised $2. The company can be considered to consist of ten shares worth $5. John holding five of them and each of the five investors holding one of them. John can use this $2. After five years, the profit of the business is up to $5.
Since John owns 5. They collectively decide, however, to keep reinvesting part of these profits back into the company to hire more employees and to buy more equipment.
After ten years, the company has grown even larger. It now has total annual profit of $2 million, and dozens of employees. But John is a particularly ambitious fellow, and he wants to spread his premium mustache combs throughout the world, and maybe even expand into other manly hygiene products. So John and the five investors decide to “go public,” which means they will have an IPO and sell a portion of their company to public investors. John still owns 5. IPO. This will bring in a lot of new money to fund their expansion.
John breaks the company into one million shares (meaning each one of the original ten shares was broken into 1. The rest of the shares are owned by John, who owns 2. John and the original investors diluted their ownership of the company (from 5. John, and from 1. By selling 5. 00,0. John raises $1. 0 million for his men’s hygiene business to hire employees and purchase more tools in order to make all the mustaches of the world that much better.
The initial five wealthy investors are happy too, because now they can easily sell their shares to anyone. They could sell their shares and retire, or they could buy more if they want to. Now that John’s company is public, they have a lot more specific requirements to fulfill. They have to produce audited financial statements four times per year, they have to follow standards of sharing internal company information, and shareholders get to elect a Board of Directors to run the company. Shares of Stock are Bought and Sold on a Stock Exchange. Since publicly traded companies consist of so many shares and are owned by so many people, it would be difficult to just buy and sell shares informally.
To solve this complexity, the buying and selling of stock takes place on a dedicated stock exchange. The largest exchange is the New York Stock Exchange on Wall Street, and there are other major ones such as the NASDAQ, the London Stock Exchange, and the Tokyo Stock Exchange. These exchanges are marketplaces (either physical or electronic) where the products that are bought and sold are shares of stock. People can buy or sell shares of stock for a price they can agree on, and this price goes up and down over time based on the supply and demand of buyers and sellers. Over the short term, stock prices can be volatile because buyers and sellers have a whole multitude of reasons for trading stock at any given time. Over the long term, the business performance of the underlying company determines the value of the stock. When John’s business was only making $1.
Later, when he grew the business to $5. When the company was later split into a million shares, each share was less expensive because it only accounted for a tiny fraction of the company, but John and the original five investors each then owned thousands of shares due to the splitting of their original, larger shares. If John continues to skillfully manage what is now a publicly traded men’s hygiene products company, he could grow total profit to $5 million, $1.
The price of the shares at any given time compared to the IPO price of $2. Each share in this case represents one millionth of a growing company. For example, when the company has $2 million in profit and one million shares, John and the Board of Directors may decide to use 5. The shareholders may keep holding shares, and receive these dividends every time the company pays them. Years later, if the company is bringing in $5 million in profit per year, and they’re still paying out 5. There are some companies out there that have raised their dividends every year for over 2.
On the other hand, if John’s business performs poorly over time, and the annual profit declines, then the shares of stock will eventually decline in value. If his company were to ever go bankrupt, then the price and value of shares would drop to $0. How to Buy Shares of Stock. To buy a stake in publicly traded businesses, you have a few primary options. There is no best option; it depends on whether you want to pick individual stocks or not, how much money you have to invest, and what your goals are.
Use a Broker to Buy Shares of Stock. Rather than going to a stock exchange yourself, you can use a middleman to do the buying and selling for you. A broker is a person who is registered with the exchange and able to buy and sell shares of stock on it. In older times, you’d have to call up your broker or see him in person, but nowadays most interaction is done online.
You can create an account online with a brokerage firm, and buy or sell stock within your account. It’s similar to online banking, and the shares that you hold will be held in this brokerage account.
For those that prefer seeing a broker face to face, there are full service brokerage firms that provide this option. They can provide personal investment advice and assist you with achieving your financial goals. Either way, you’ll typically have to pay brokerage fees in order for them to buy and sell stock for you. Investors that often buy and sell stock can accumulate a lot of fees, but by investing for longer periods and buying less frequently, you can keep the cost low. Participate in a Direct Stock Purchase Plan. Another low- fee or no- fee option is that you can buy stock directly from the company in a system called a Direct Stock Purchase Plan (DSPP). You can become a registered shareholder of the business directly through their transfer agent (the organization that manages and keeps track of their shares), and occasionally pay cash to buy more shares.
Certain types of Direct Stock Purchase Plans are called Dividend Reinvestment Plans (DRi.
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