Wouldn’t you love to be a business owner without ever having to show up at work? Imagine if you could sit back, watch your company grow, and collect the dividend checks as the money rolls in! As you’ve probably guessed, we’re talking about owning stocks. This fabulous category of financial instruments is, without a doubt, one of the greatest tools ever invented for building wealth.
Stocks are a part, if not the cornerstone, of nearly any investment portfolio. When you start on your road to financial freedom, you need to have a solid understanding of stocks and how they trade on the stock market.
Over the last few decades, the average person’s interest in the stock market has grown exponentially. What was once a toy of the rich has now turned into the vehicle of choice for growing wealth. This demand coupled with advances in trading technology has opened up the markets so that nowadays nearly anybody can own stocks. This paper is intended to explain all the basic questions about the investing. This will help new investors to lighten up their confusions and equip them the basic idea of Stock Market. Basic of Stock Market What Are Stocks?
Stock is a share in the ownership of a company. Stock represents a claim on the company’s assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Shares, equity, or stock, it all means the same thing. Being an Owner 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 (albeit usually very small) to everything the company owns. This means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company.
As an owner, 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 fancy piece of paper that is proof of your ownership. In today’s computer age, shareholders won’t actually get to see this document because the brokerage keeps these records electronically, which is also known as holding shares. 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 can be done with a click of the mouse or a phone call.
Debt vs. Equity Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the other hand, issuing stock is called equity financing.
Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO) (Mladjenovic, 2002). When buying a debt investment such as a bond, shareholders are guaranteed the return of their money (the principal) along with promised interest payments.
But in equity investment, being one of the owners of the company, shareholders assume the risk of the company not being successful – just as a small business owner isn’t guaranteed a return, neither is a shareholder. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn’t successful. Risk It must be emphasized that there are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not.
And there is no obligation to pay out dividends even for those firms that have traditionally given them. Without dividends, an investor can make money on a stock only through its appreciation in the open market. On the downside, any stock may go bankrupt, in which case shareholders investment is worth nothing. Although risk might sound all negatives, there is also a bright side. Taking on the greater risk also demands a greater return on 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%. Different Types of Stocks There are two main types of stocks: common stock and preferred stock. Common Stock A common stock is the basic stock a corporation issues. It just shows that shareholder own a fraction of the company. The common stocks are directly influenced by failures and successes of the company. Common stocks are more of a gamble. Since there is a higher chance of making profit, common stock owners are issued their dividends or profits after the preferred stock.
Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. 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 Preferred stock represents some degree of ownership in a company but usually doesn’t come with the same voting rights (Wikipedia, 2006). After all the common stock has been issued, companies begin to distribute preferred stock. The preferred stock owners are given their dividends before the common stock owners are.
Also, if the company goes out of business, and liquidates, the preferred stock owners are paid back the money they invested before the common stockholders are reimbursed. The main drawback of preferred stocks is that they cannot benefit as much from company profits because they are only paid a fixed dividend payment. How Stocks Trade Most stocks 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.
The other type of exchange is virtual, composed of a network of computers where trades are made electronically – Internet trading. The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. The New York Stock Exchange The most prestigious exchange in the world is the New York Stock Exchange (NYSE) (Encarta, 2006). The “Big Board” was founded over 200 years ago in 1792, with the signed of the Buttonwood Agreement by 24 New York City stockbrokers and merchants.
Orders come in through brokerage firms that are members of the exchange and flow down to floor brokers who go to a specific spot on the floor where the stock trades. At this location, known as the trading post, there is a specific person known as the specialist whose job is to match buyers and sellers. Prices are determined using an auction method: the current price is the highest amount any buyer is willing to pay and the lowest price at which someone is willing to sell. Once a trade has been made, the details are sent back to the brokerage firm, who then notifies the investor who placed the order.
Although there is human contact in this process, computers play a huge role in the process too. The Nasdaq The second type of exchange is the virtual sort called an over-the-counter (OTC) market, of which the Nasdaq is the most popular. These markets have no central location or floor brokers. Trading is done through a computer and telecommunications network of dealers. 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. Other Exchanges The third largest exchange in the U. S. is the American Stock Exchange (AMEX). The AMEX used to be an alternative to the NYSE, but Nasdaq had filled that role since. In fact, the National Association of Securities Dealers (NASD), which is the parent of Nasdaq, bought the AMEX in 1998. Almost all trading now on the AMEX is in small-cap stocks and derivatives. Buying Stocks
You’ve now learned what a stock is and a little bit about the principles behind the stock market, but how do investors actually go about buying stocks? Investors don’t have to go down into the trading pit yelling and screaming your order. There are two main ways to purchase stock: Using a Brokerage The most common method to buy stocks is to use a brokerage. Brokerages come in two different kinds. Full-service brokerages offer to investors (supposedly) expert advice and can manage the investor’s account; they also charge a lot.
While discount brokerages offer little in the way of personal attention but are much cheaper. At one time, only the wealthy could afford a broker since only the expensive, full-service brokers were available. But when Internet came, the online discount brokers have been available, more affordable. DRIPs & DIPs Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are plans by which individual companies, for a minimal cost, allow shareholders to purchase stock directly from the company. Drips are a great way to invest small amounts of money at regular intervals. Bull and Bear Markets
In addition to the three market theories mentioned above, there are other ways of thinking about the market as a whole, that are less theoretical and more grounded in what is actually happening to them. One way is to describe the overall trends in the market, such as by defining them as bearish or bullish. The Bulls A bull market, loosely defined, is a market in which the major stock indexes have risen by over 20% over a substantial period of time, usually measured in months or years. Bull markets can happen as a result of an economic recovery, an economic boom, or simple investor psychology (Khan, 1998).
The longest and most famous of all bull markets is the one that began in the early 1990s in which the U. S. equity markets grew at their fastest pace ever. The Bears Bear markets are the exact opposite of bull markets: they are markets in which the major indexes have declined by 20% or more over a period of at least two months (a decline that large for any shorter time period is simply called a “correction”, especially if it followed a substantial rise). Bear markets usually occur when the economy is in a recession and unemployment is high, or when inflation is rising quickly.
The most famous bear market in U. S. history was, the Great Depression of the 1930s. Price Chart/ Stock Table A price chart graphically illustrates a stock’s price action over a selected period — one year, for instance. Some investors, called technical analysts or chartists, feel it’s a waste of time examining financial statements, dissecting analysts’ forecasts or pondering a firm’s prospects vis-a-vis the competition. Instead, they believe that a price chart tells them everything they need to know about a stock. Chartists say stock prices move in trends.
That is, a stock that has already been moving up in price (up trend) will continue its winning ways, while one going the other way (downtrend) will continue to disappoint its shareholders. The analysis is easy. If the stock is in an up trend, the price will be higher on the right side than in middle or left side of the chart. Conversely, the right side will be lower than the middle or the left side if it’s in a downtrend. Conclusion In conclusion, people around us might say that Stock Market is a gamble and investors might lose their money anytime.
It will only happen if the investor will not do his responsibility as investors. Investing is not easy, investor need to do his assignment in order to gain. There have been untold ways about how to make the stock market easier and safer for the new investors. Few, if any, are likely to prove useful or effective. But in order to minimize the risks of financial market imbalances, it is important that there be a well thought-out laws for investing, rules and regulations that implement properly, smoothly, and honestly. This task requires the participation of all concerned investors.
Bibliography Khan, A. (1998). Stock Investing for Everyone: Tools for Investing Like the Pros (p. 136). San Jose, CA: Bookworld Services Microsoft® Encarta® Online Encyclopedia (2006). Stock Exchange. Retrieved last December 03, 2006, from http://encarta. msn. com/encyclopedia_761560145/Stock_Exchange. html#s1 Mladjenovic, P. (2002). Stock Investing for Dummies (p. 9). Indianapolis, Indiana: Wiley Publishing, Inc. Wikipedia, the free encyclopedia (2006). Preferred stock. Retrieved last December 03, 2006, from http://en
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