What it is, how it works, and how to use it
What is the stock market? What are stocks? How do stocks fit into your big-picture financial plan? Here are some answers.
What is a Stock? What is a Public Company?
In broad terms, companies are defined by who owns them. Your local independent pizzeria is privately owned, probably by the folks who started it. Contrast this with Domino’s Pizza, which is publicly owned. What that means is that members of the public can buy stock in Domino’s. 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 of stock.
If you buy shares you become a part owner and receive these benefits:
- You can vote on certain company issues, such as the members of the Board of Directors and executive compensation
- If the company is profitable, you share in the profits as the stock value rises
- If the company returns some of its profit to shareholders, also known as dividends, you’ll receive a pay out
Sadly, you won’t get free pizza. But in the last five years the value of Domino’s stock has more than tripled. That will buy a lot of pizza.
Why Do Companies Go Public?
Companies generally go from private to public for two reasons: going public and selling shares is a way to raise a lot of money (or “capital”) quickly, and it gives the founders (and sometimes early employees) an opportunity to “cash out” on their hard work.
Companies must achieve a certain size and meet specific financial and other requirements to go public, which is why your neighborhood pizzeria is just, well, your neighborhood pizzeria and not Domino’s.
How Does the Stock Market Work?
The stock market, which began in Philadelphia in 1790, brings buyers and sellers together. Before computers, sales and purchases were made in person in one of several stock exchanges, where buyers and sellers “exchanged” money for shares. Today, that happens electronically. Buying and selling is also called trading; you’re trading your money for shares of stock, or vice versa. Similar marketplaces exist for bonds and other assets.
What Makes Stocks Rise or Fall?
Stock prices are based on future expectations. If investors expect a company to be profitable in the future, its stock price is likely to rise.
That doesn’t mean that the price of a stock will rise every day. In the short term, the market will react to many factors and the stock price will rise or fall. A hot new product, the loss of a key contract, or some other incident can cause a sudden rise or drop.
Those short-term fluctuations aren’t where investors should focus. Instead, take the longer view, building a risk-appropriate portfolio aligned with long-term goals and your overall plan.
Tracking the Market
The general direction of the market is usually judged by one of two indexes. Indexes use a combination of stocks to measure the market.
- The Standard & Poors 500 Index, referred to as the S&P 500, is the value of the 500 (actually 505) largest stocks in the stock market. The largest are Apple, Microsoft, and Amazon.
- 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, which change from time to time. Apple is also in the Dow, along with Microsoft, Visa, JP Morgan Chase, and 26 others.
Smart Investing is Boring
Buying and selling stocks may seem like a game or a gamble. To smart investors, it’s neither. Here are things to keep in mind:
The stock market is best used for long-term investments, such as saving for retirement. In the short run, stocks can rise or fall dramatically. In the long term, the overall market (as measured by the S&P 500) has averaged about a 10% annual gain. Invest for the long term and the law of averages will work in your favor.
Many investors get nervous when the market drops or excited when it rises. That’s natural. But when those emotions cause investors to try to time the market, results suffer. Studies show that market timers average about a 4% annual gain. Investing in the S&P 500 for 30 years may not give you an exciting story to tell, but an average gain of 10% a year will help you get to some exciting places. When it comes to individual stocks, buying and holding for the long-term is also often a good strategy. Had you purchased $1,000 worth of Apple stock on the day the first iPhone was announced in 2007, your investment would have gained $300 that day, and would be worth over $30,000 today.