The Stock Market Deconstructed
Many people have no idea how the stock market works. It is actually quite simple. The owner(s) of a private company decide they want to sell shares to the public. They file documents with the SEC and hire an investment banking firm to go on a road show to drum up interest in the stock. Once the company goes public, anyone with a brokerage account can purchase the shares.
Analysts from various financial institutions begin covering the company and issue ‘guidance’ as to how much they think the company will make each quarter when they release their financial performance numbers. If the analysts think the company will make $1 a share and it earns less than that, generally the stock will fall in price. Conversely, if the company makes more than $1 a share, the stock will typically rise in price.
This goes on-and-on each quarter as the stock price ebbs and flows. Bad news — like a sudden product recall — will cause the stock price to drop, while good news — like an announcement of a new product — will cause the stock price to increase. Hedge funds might ‘short’ the company and hope the stock price goes down. They borrow shares to sell now and buy them back later — hopefully at a lower price.
Investors like to invest in stocks because, in theory, there is no limit to how high the stock price can go. Most billionaires made their fortunes via stock appreciation from the companies they either started or acquired. Massive fortunes are almost always tied to ownership in a company.
A stock can build wealth in two ways: dividend payouts and appreciation. A dividend is a payment to the shareholders, usually on a quarterly basis. Appreciation occurs when a stock goes up in price. Typically investors seek appreciation when they are young and dividend payouts when they grow older as their tolerance for risk decreases.
Stocks can be purchased in a brokerage account with little or no transaction costs. They can also be purchased by buying shares of a mutual fund or exchange-traded fund which pool investor money to buy stocks according to their investment strategy. A fee is charged but you typically don’t see it because it is built into the share price.
That’s the stock market in a nutshell. Pretty simple, huh?