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The Definition of a Stock Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim to everything the company owns. As an owner among many other shareholders, you are entitled to your share of the company's earnings as well as any voting rights attached to the stock. A stock is represented by a stock certificate. This is a piece of paper that is proof of your ownership. In today's computer age, you won't actually get to see this document because your brokerage keeps these records electronically, which is also known as holding shares "in street name". This is done to make the shares easier to trade. In the past, when a person wanted to sell his or her shares, that person physically took the certificates down to the brokerage. Now, trading with a click of the mouse or a phone call makes life easier for everybody. Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run. In the same line of thinking, being a shareholder of Anheuser Busch doesn't mean you can walk into the factory and grab a free case of Bud Light! The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed, at least in theory. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors and billionaire entrepreneurs who make the decisions. For ordinary shareholders, not being able to manage the company isn't such a big deal. After all, the idea is that you have delegated to the management the duty to make a return on your investments. The importance of being a shareholder is that you are entitled to a portion of the company's profits and have a claim on assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid. This last point is worth repeating: the importance of stock ownership is your claim on assets and earnings. Without this, the stock wouldn't be worth the paper it's printed on. Another extremely important feature of stock is its limited liability, which means that, as an owner of a stock, you are not personally liable if the company is not able to pay its debts. Other companies such as partnerships are set up so that if the partnership goes bankrupt the creditors can come after the partners (shareholders) personally and sell off their house, car, furniture, etc. Owning stock means that, no matter what, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets. Debt vs. Equity It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until the banks and bondholders have been paid out; we call this absolute priority. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful. Although risk might sound all negative, there is also a bright side. Taking on greater risk demands a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts. Over the long term, an investment in stocks has historically had an average return of around 10-12%.
There are two main types of stocks: common stock and preferred stock. Common Stock Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid. Preferred Stock Some people consider preferred stock to be more like debt than equity. A good way to think of these kinds of shares is to see them as being in between bonds and common shares. When there is more than one class of stock, the classes are traditionally designated as Class A and Class B. Berkshire Hathaway (ticker: BRK), has two classes of stock. The different forms are represented by placing the letter behind the ticker symbol in a form like this: "BRKa, BRKb" or "BRK.A, BRK.B". Definition Although common, the term 'the stock market' is a somewhat abstract concept for the mechanism that enables the trading of company stocks. It is also used to describe the totality of all stocks and sometimes other securities, with the exception of bonds, commodities, and derivatives. The term is used especially to apply within one country as, for example, in the phrase "the stock market was up today", or in the term "stock market bubble". Bonds are still traditionally traded in an informal, over-the-counter market known as the bond market. Commodities are traded in commodities markets, and derivatives are traded in a variety of markets (but, like bonds, mostly 'over-the-counter'). The size of the worldwide 'bond market' is estimated at $45 Trillion; the size of the 'stock market' is estimated as about half that. The world derivatives market has been estimated at about $300 Trillion. The major U.S. Banks alone are said to account for about $100 Trillion. The stock market is distinct from a stock exchange, which is an entity (a corporation or mutual organization) in the business of bringing buyers and sellers of stocks and securities together. For example, 'the stock market' in the United States includes the trading of all securities listed on the NYSE, the NASDAQ, the Amex, as well as on the many regional exchanges, the OTCBB, and Pink Sheets. Asian examples of stock exchanges include the Tokyo Stock Exchange, Osaka Stock Exchange, the Hong Kong Stock Exchange, etc. European examples of stock exchanges include the Paris Bourse (now part of Euronext), the London Stock Exchange and the Deutsche Börse.
Participants in the stock market range from small individual stock investors to large hedge fund traders, who can be based anywhere. Their orders usually end up with a professional at a stock exchange, who executes the order. How Stocks Trade Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor. You've probably seen pictures of a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signaling to each other. The other type of exchange is virtual, composed of a network of computers where trades are made electronically. The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. Just imagine how difficult it would be to sell shares if you had to call around the neighborhood trying to find a buyer. Really, a stock market is nothing more than a super-sophisticated farmers' market linking buyers and sellers. Before we go on, we should distinguish between the primary market and the secondary market. The primary market is where securities are created (by means of an IPO) while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing-companies. The secondary market is what people are referring to when they talk about the stock market. It is important to understand that the trading of a company's stock does not directly involve that company. Actual trades are based on an auction market paradigm where a potential buyer bids a specific price for a stock and a potential seller asks a specific price for the stock. (Buying or selling at market means you will accept any bid or ask price for the stock.) When the bid and ask prices match, a sale takes place on a first come first serve basis if there are multiple bidders or askers at a given price. The purpose of a stock exchange is to facilitate the exchange of securities between buyers and sellers, thus providing a marketplace (virtual or real). Just imagine how difficult it would be to sell shares (and what a disadvantage you would be at with respect to the buyer) if you had to call around trying to locate a buyer, as when selling a house. Really, a stock exchange is nothing more than a super-sophisticated farmers' market providing a meeting place for buyers and sellers.
On the Nasdaq brokerages act as market makers for various stocks. A market maker provides continuous bid and ask prices within a prescribed percentage spread for shares for which they are designated to make a market. They may match up buyers and sellers directly but usually they will maintain an inventory of shares to meet demands of investors. There are many stock exchanges located in just about every country around the world. American markets are undoubtedly the largest, but they still represent only a fraction of total investment around the globe. The other main financial hubs for stock trading are Tokyo, home of the second largest stock exchange in the world - the Tokyo Stock Exchange; London, home of the London Stock Exchange; Paris, home of the Paris Bourse, now part of Euronext is an order-driven, electronic stock exchange; and Hong Kong, home of the Hong Kong Stock Exchange. The last place worth mentioning is the over-the-counter bulletin board (OTCBB). The Nasdaq is an over-the-counter market, but the term commonly refers to small public companies that don't meet the listing requirements of any of the regulated markets, including the Nasdaq. The OTCBB is home to penny stocks because there is little to no regulation. This makes investing in an OTCBB stock very risky. In the eraly days, buyers and sellers were individual investors, such as wealthy businessmen, with long family histories (and emotional ties) to particular corporations. Over time, markets have become more "institutionalized"; buyers and sellers are largely institutions (e.g., pension funds, insurance companies, mutual funds, hedge funds, investor groups, and banks). The rise of the institutional investor has brought with it some improvements in market operations (but not necessarily in the interest of the small investor or even of the naïve institutions, of which there are many). Thus, the government was responsible for "fixed" (and exorbitant) fees being markedly reduced for the 'small' investor, but only after the large institutions had managed to break the brokers' solid front on fees (they then went to 'negotiated' fees, but only for large institutions). However, corporate governance (at least in the West) has been greatly affected by the rise of institutional 'owners.'
Just as it is important that networks for transport, electricity and telecommunications function properly, so is it essential that, for example, payments can be transacted, capital can be saved and channelled to the most profitable investment projects and that both households and firms get help in handling financial uncertainty and risk as well as possibilities of spreading consumption over time. Financial markets constitute an important part of the total infrastructure for every society that has passed the stage of largely domestic economies. The financial system performs three main tasks: first, it handles transfer of payments; second, it channels savings to investments with a good return for future consumption; and third, it spreads and reduces (local enterprise) economic risks in relation to the players' targeted returns (but note that systemic risk is not thereby reduced— it merely becomes less concentrated and uneven). Moreover, unforeseen risks, or catastrophic risks (such as the complete collapse of the financial system or government institutions), may not be capable of being spread, or insured against. The smooth functioning of all these activities facilitates economic growth in that lower costs and enterprise risks promote the production of goods and services as well as employment. In this way the financial system contributes to increased prosperity. The stock market is one of the most important sources for companies to raise money. Experience has shown that the price of shares and other assets is an important part of the dynamics of economic growth. Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an Argus eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions. Financial stability is the raison d'être of central banks.
The stock market, individual investors, and financial risk "With each passing year, the noise level in the stock market rises. Television commentators, financial writers, analysts, and market strategists are all overtalking each other to get investors' attention. At the same time, individual investors, immersed in chat rooms and message boards, are exchanging questionable and often misleading tips. Yet, despite all this available information, investors find it increasingly difficult to profit. Stock prices skyrocket with little reason, then plummet just as quickly, and people who have turned to investing for their children's education and their own retirement become frightened. Sometimes there appears to be no rhyme or reason to the market, only folly." This is a quote from the preface to a published biography about the well-known and long term value oriented stock investor Warren Buffett. Buffett began his career with only 100 U.S. dollars and has over the years built himself a multibillion-dollar fortune. The quote illustrates something of what has been going on in the stock market during the end of the 20th century and the beginning of the 21st. Behaviour of the stock market From experience we know that investors may temporarily pull financial prices away from their long term trend level. Over-reactions may occur -- so that excessive optimism (euphoria) may drive prices unduly high or excessive pessimism may drive prices unduly low. New theoretical and empirical arguments have been put forward against the notion that financial markets are efficient. What Causes Stock Prices To Change? Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall. Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies. That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don't equate a company's value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at $100 per share and has 1 million shares outstanding has a lesser value than a company that trades at $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250 million). To further complicate things, the price of a stock doesn't only reflect a company's current value, it also reflects the growth that investors expect in the future. The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business. Public companies are required to report their earnings four times a year (once each quarter). Wall Street watches with rabid attention at these times, which are referred to as earnings seasons. The reason behind this is that analysts base their future value of a company on their earnings projection. If a company's results surprise (are better than expected), the price jumps up. If a company's results disappoint (are worse than expected), then the price will fall. Of course, it's not just earnings that can change the sentiment towards a stock (which, in turn, changes its price). It would be a rather simple world if this were the case! During the dotcom bubble, for example, dozens of internet companies rose to have market capitalizations in the billions of dollars without ever making even the smallest profit. As we all know, these valuations did not hold, and most internet companies saw their values shrink to a fraction of their highs. Still, the fact that prices did move that much demonstrates that there are factors other than current earnings that influence stocks. Investors have developed literally hundreds of these variables, ratios and indicators. Some you may have already heard of, such as the price/earnings ratio, while others are extremely complicated and obscure with names like Chaikin oscillator or moving average convergence divergence. Other research has shown that psychological factors may result in exaggerated stock price movements. Psychological research has demonstrated that people are predisposed to 'seeing' patterns, and often will perceive a pattern in what is, in fact, just noise. (Something like seeing familiar shapes in clouds or ink blots.) In the present context this means that a succession of good news items about a company may lead investors to overreact positively (unjustifiably driving the price up). A period of good returns also boosts the investor's self-confidence, reducing his (psychological) risk threshold. Another phenomenon -- also from psychology -- that works against an objective assessment is group thinking. As social animals, it is not easy to stick to an opinion that differs markedly from that of a majority of the group. An example with which you may be familiar is the reluctance to enter a restaurant that is empty; people generally prefer to have their opinion validated by those of others in the group. In one paper the authors draw an analogy with gambling. In normal times the market behaves like a game of roulette; the probabilities are known and largely independent of the investment decisions of the different players. In times of market stress, however, the game becomes more like poker (herding behavior takes over). The players now must give heavy weight to the psychology of other investors and how they are likely to react psychologically. We are also liable to succumb to biased thinking. An example is when supporters of a national football team (or a favorite stock), for instance, are overconfident about the chances of winning (or the stock moving up). So, why do stock prices change? The best answer is that nobody really knows for sure. Some believe that it isn't possible to predict how stock prices will change, while others think that by drawing charts and looking at past price movements, you can determine when to buy and sell. The only thing we do know is that stocks are volatile and can change in price extremely rapidly. The important things to grasp about this subject are the following: 1. At the most fundamental level, supply and demand in the market determines stock price. Irrational behavior Furthermore, the stock market is comprised up of a large amount of speculative analysts, or pencil pushers, whom have no substantial money or financial interest in the market, but make market predictions and suggestions regardless. Over the short-term, stocks and other securities can be battered or buoyed by any number of fast market-changing events, turning the stock market in a generally dangerous and difficult to predict environment for those people whose lack of financial investment skills and time does not permit reading the technical signs of the market. Conclusion Today, average individuals face sometimes very difficult risk management decisions that were not required of previous generations. Both opportunities and risks for the individual investor have been amplified many times over. Yet the average investor still lacks the relevant knowledge. Everyone cannot be a specialist in risk management and financial theory.
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