Confused by the Stock Market? Don’t Be. A Primer on Stocks

by A Manly Guest Contributor on February 1, 2013 · 34 comments

in Money & Career

stock1

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. 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 100 years ago. This article provides an overview of what stock is, and how shares of stock are bought and sold on the market.

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 $500,000 per year, the earnings per share will be $50,000.

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. One of the owners may even decide to buy a share from another owner, so that he now holds two shares, or 20% of the company.

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 100% of the company. For a while this works well, with him earning $100,000 per year in profit and his employees doing pretty well also. 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 $50,000, and in exchange they each receive a 10% portion of the company. So John has raised $250,000 for his business, but now he only owns 50% of his company. The company can be considered to consist of ten shares worth $50,000 each, with John holding five of them and each of the five investors holding one of them. John can use this $250,000 to hire additional employees and buy more tools to grow the business at a quicker pace.

After five years, the profit of the business is up to $500,000 per year. Since John owns 50% of it, his portion of income is $250,000, and each of the investor’s portion of income is $50,000. 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 50% of the company and each of the five investors still owns 10%, but they decide that they’ll sell half of the company to the public in this 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 100,000 shares), and sells 500,000 of them to the public for $20 each. The rest of the shares are owned by John, who owns 250,000 shares (25% of the company), and the original five investors, who each own 50,000 shares (5% of the company each). John and the original investors diluted their ownership of the company (from 50% down to 25% for John, and from 10% down to 5% for each investor), but now, there is a lot more cash to work with.

By selling 500,000 shares to the public at $20 each, John raises $10 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 $100,000 in profit per year, a share worth 10% of the business only had a moderate amount of value. Later, when he grew the business to $500,000 in profit and eventually to $2 million in profit, a 10% portion of the company would be worth far more than it was back when the company was only making $100,000.

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, $10 million, or even more. The price of the shares at any given time compared to the IPO price of $20 will fluctuate, but over the long term, if the business grows, the value of each share will grow. 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 50% of that profit to pay $1.00 in cash dividends to each shareholder for each share they own. 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 50% of their profit as dividends to shareholders, then each shareholder will receive $2.50 in dividends per share that they own. There are some companies out there that have raised their dividends every year for over 25 or even 50 consecutive years.

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.

1) 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.

2) 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 (DRiPs). Under these plans, you own stock directly, and when the company pays cash dividends to shareholders, the company will automatically reinvest the cash dividends you would have received into buying more shares for you instead, including fractions of shares. Over long periods of time, you can grow a small number of inexpensive shares into a larger and larger number of more valuable shares, and exponentially increase your wealth and dividend income.

These plans are only for investors that intend to hold onto that company’s stock for quite a while. Unlike with a broker where you can easily buy and sell shares, these plans are meant for patient, long-term investors.

3) Invest in a Mutual Funds

If you don’t want to buy shares of individual companies, such as The Coca-Cola Company or General Electric, then mutual funds are another viable option.

A mutual fund is a collective investment vehicle where a pool of investors gather their money together and buy shares of many companies in one big fund. A fund manager is responsible for choosing which stocks to buy or sell within that investment vehicle. The assets that can be held within a mutual fund include stocks, bonds, cash, and other investments. Basically, rather than owning a specific stock, a mutual fund investor owns a piece of a bigger collection of a variety of stocks and/or other assets.

There are a vast number of different types of mutual funds, but they can be thought of as two general categories:

Actively Managed Mutual Funds. With an actively managed mutual fund, the fund manager is purposely selecting certain stocks to buy, hold, and eventually sell. Sometimes the fund manager’s goal is to try to provide a better rate of return for the investors than the average of other stocks, which means he’s attempting to “beat the market.” Other times, the fund manager may be trying to minimize volatility and preserve the wealth of the investors while still growing their money at a reasonable rate.

In order to pay for the buying and selling of shares within the fund, and in order to pay the fund manager, mutual funds typically have fairly high fees. The fees are a small portion of the fund value each year, but they can add up substantially over time.

Index Funds. An index fund is a passively managed mutual fund. The fund manager is not purposely choosing specific stocks to buy or sell in order to meet any goals. Instead, an index fund follows a specific list of many companies.

The most widely followed index list is the Standard and Poor’s 500, which is usually referred to as the S&P 500. This is a list of 500 of some of the largest and most profitable companies in the United States, and serves as a primary benchmark for long-term stock market performance.

The only goal of the fund manager of an S&P 500 index fund, is to try to replicate the performance of the list. He’ll buy shares of stock of those 500 companies in roughly the same proportions that the index recognizes. Because this process is rather automated, the fees for index fund investors are very low.

Buying into an index fund allows an investor to quickly become diversified, because holding a simple S&P 500 index fund spreads your money over approximately 500 companies.

The Relationship Between a 401(k), an IRA, and Shares of Stock

One potentially confusing aspect about the stock market is the overlap between 401(k) plans, IRAs, and shares of stock. Some people tend to mistake 401(k) plans and IRAs for investments, but they are simply retirement vehicles for holding investments. Typically within a 401(k) plan, you can choose to invest in a variety of mutual funds, including index funds. Within an IRA, you can invest in mutual funds, individual stocks, and other assets.

Conclusion

By working to build up some assets, either in the form of individual stock ownership, or through index funds and other investments, you can increase the financial flexibility that you have with regards to what you work on and how you live your life.

The stock market can be a damaging thing to people that are unfamiliar with the mechanics behind it, and money that you need to have available in a few years should not be used to buy stock now due to the volatile nature of the market over shorter periods. Instead, investing in the stock market is a long-term approach that requires discipline and balance.

Talking with a financial professional to get good advice, or seeking out information from a variety of sources, can provide a very rewarding outcome. The long term average rate of return of the S&P 500 over the last century or so has been around 9% per year. This means that, despite being volatile, an investor would have increased their wealth by 9% per year on average over a very long time frame. A rate of return of 9% per year translates into a doubling of your money every eight years.

_________________________

Matt Alden S. is the publisher of Dividend Monk, an investing and personal finance site that helps readers move closer towards financial freedom. The site includes comprehensive articles on dividend stocks, long-term investing, indexes, stock valuation techniques, and building wealth.

{ 34 comments… read them below or add one }

1 Corporate lawyer February 1, 2013 at 2:34 pm

“Corporations are “publicly traded”"

Not necessarily.

2 Jordan Smith February 1, 2013 at 7:05 pm

Took a personal finance class at college this past semester and this was spot on for what I learned and the simplicity of how it was explained. Great article, but I think a guy who is a beginner would also benefit from some more talk on diversification: the difference between large cap, mid cap, and small cap (so we can figure out what on earth those penny stock ads are talking about!) and even international stock.

3 Aaron Monroe February 2, 2013 at 6:59 am

Hi,
One of my New years resolutions is to learn more about finances.

On a side note,your post abhout vintage photos wasgreat.Here is a site you might like:
http://www.retronaut.com

Thanks and have a great day.

4 R..... February 2, 2013 at 7:47 am

The problem with trading is that most people are making a ‘bet’ that the company will continue with good profits. They’re expectation is that the price will indeed rise and they’re investment will give them a wise return.

However this is not wise at all. This is gambling. With a lot of money.

You’re also trading your real labour for issued shares. Pieces of paper. Worthless. You don’t hold any materials like gold or silver, commodities, land and so forth.

If you do trade you can trade with “insurance” you can make another contract on the shares you own. These contracts are called “options”. To simplify you can sell an option like you’re renting a out your house. Buying shares without renting them out is like buying a house as an investment and not putting any renters in it. The person who purchases the option pays a small fee to have a contract that states when the shares rise to a certain agreed upon point he can buy them from you at a slightly lower price – meaning you sell the shares at a lower price to him (still making a profit plus the money from selling him the option) and he in turn sells the shares once they are in his – in turn selling them at the actual value and making himself a profit without much risk of holding ALL the shares in the first place.

So in fact you can sell shares without having to have them in your possession if you buy an option contract with a shareholder. This is one way you can make money. This is also a person can make money off shares wether they go up or when they just platue.

Remember it’s an OPTION so the person who wants to buy the shares has the option of whether or not to buy the shares. That’s why they call them options.

There are put options and call options. Just different types of contracts. Your stockbroker won’t tell you about these because he either won’t know about them as he is too busy taking your money using the skills from what he learnt at university and trying to earn a wage instead of trading himself.

You can insure your shares. You can pay someone to make a contract with you that no matter how low the shares go they will have to buy them off you at the price you request. You lose less that way if it does drop. It will cost to do this and of course the seller of that option will be paid whether the shares drop or not (and people make money just doing this).

So if you are going to do shares and gamble, learn about contracts. They have been around for centuries, they might be called other things like ‘options’ so you’ll have to educate yourself.

Just as a last note. The 401k is one of the biggest market/government scams of the century. The government forces you to make an investment (yes you are forced). Then the companies that sell you the managed funds use your money to secretly make 20% profits in other markets, give you less than 5% take no risk themselves because it is all your money, have no responsibility if they lose your money, charge you a fee and get rich off your money. Talk about using other people’s money…

oh and don’t watch the market news. That’s where they tell you what they want you to hear and not what you should be doing. Remember you are getting biased advice from people that are being paid by the very trading businesses that are taking your money. Don’t be a fool. They are not your friends.

5 sugapablo February 2, 2013 at 8:24 am

I love how the author incorporated Movember into his example of a mustache comb business. Perfect for this website. :)

6 Matt February 2, 2013 at 9:01 am

@Corporate Lawyer,

True, there are privately held s-corps, c-corps, etc. This article is about the world of publicly traded stocks that most individuals have access to.

@Jordan,

Definitely. There’s certainly more that could be said, like about stock/bond diversification strategies, sector diversification, whether it’s worth picking individual stocks or whether it’s best to buy the market via an index fund, strategies on how to value a stock, etc.

Thanks for the comment and I’m glad to hear it was simply explained.

7 MustacheMan February 2, 2013 at 9:58 am

The S&P is up 123.7% since the 2009 lows and we’re just now getting around to “how to buy stocks” type posts… tells me it’s time to start getting short.

8 odinbearded February 2, 2013 at 10:45 am

R, I’m going to have to push back on your comments here. Saying that stocks are just like gambling has a ring of truth, but holding a share is a tangible asset. It’s no more worthless than cash or gold. You have a real, legal share of the ownership of a company. Yes, stocks can be risky. But buying and holding shares of a fundamentally sound company is no more of a risk than owning properties.

Options are not the risk-free investment that you describe. They require an initial investment and active management. Yes, there is less downside risk because you cannot lose more than your initial investment. But unlike a stock, you need to be more involved in the management of your options contracts to maximize your returns. Furthermore, calls and puts are explicity gambles. You do not receive dividends, you do not have ownership rights.

And I’m not sure how you could possibly call retirement accounts a scam. No one is forcing you to buy managed funds, no one is mandating that you pay exorbitant broker fees. An index fund with minimal management fees is the single best long-term investment vehicle for most people.

“the companies that sell you the managed funds use your money to secretly make 20% profits in other markets, give you less than 5% take no risk themselves because it is all your money, ”
This is simply false. For nearly all managed funds, you can read the prospectus and see exactly what stocks are being held, and the returns for each of them, as well as the historical return for the fund.

9 jerry February 2, 2013 at 11:46 am

Corporate lawyer…please be a little more explanatory. you post was not appreciated by me. I am trying to learn..

10 Brian February 2, 2013 at 1:51 pm

This is a good start for someone wanting to understand how stocks work. However, if you want to start investing, you need to learn how to read financial statements. Not all companies are created equal: not all are profitable, and not all pay dividends. Some companies are built for fast growth, some shoot for steady profits and slow growth, some are wildly volatile. Being able to read a balance sheet and cash flow statement will help you understand who the company is and how they do things. Remember, if a company goes under, you lose ALL of your investment, so choose wisely. Also, develop a strategy. Trading can be profitable, but you’ve got to keep on your toes 24/7 and know every trend before the public does. If you don’t want to do that, you might need to take a “buy and hold” strategy, so know you won’t get rich overnight. Pick one strategy, and don’t ever try to do both at once.

11 Dave February 3, 2013 at 2:54 am

One of the main things to remember about being a private investor is that the ‘stock market’ has for decades been the haunt of massive companies whose only interest is to drive up their profits at your expense. Trading in ever-more complex forms of ‘contract’ and ‘option’, as mentioned above, is a fool’s game for anyone not on the inside track. Profit in these deals for Person A comes because Person B has made a bad call in accepting the deal in the first place, and takes a loss. Look instead at a guy like Warren Buffett, who actually invests in what the companies he buys really do, not what some fool can be conned into believing about their ‘on-paper’ prospects for short-term ‘growth’ in share prices.

12 JayMo February 3, 2013 at 8:22 am

Just thought I’d say thanks to AoM and Matt for this article, ’twas a good one. I’ll be checking out your site Matt. :)

13 Keith Brawner February 3, 2013 at 11:33 am

Readers;

You will see quite a few controversial ideas in this comment thread. The above explanation of what a stock is, and who would want to purchase one, is valid, but simplified. An investment strategy should be crafted based on individual needs, which are dependent on _your_ life.

Please read additional material, or consult an investment adviser (or trusted, money-knowledgeable, friend) before pursuing an investment plan. If you don’t know anyone, ask your tax consultant or attorney to help you find one. If you don’t have contact with these people, then ask any high-status person (except your doctor!) for a recommendation.

Some books you may consider are:
The Four Pillars of Investing (for investing advice)
Your Money or Your Life (for life and investment advice)
Fail-Safe Investing (for the 80% cheaters solution)

– Keith

14 R...... February 3, 2013 at 11:57 am

odinbearded

If you hold tangible gold in your safe at home it’s real. If you hold paper it’s just paper. Try to understand the difference. Legal share yes, but still just a piece of paper that can be devalued easily to what it is actually worth. Paper. Gold, silver is an element. You can’t fake it, manufacture it (it’s an element), destroy it (unless you go all Goldfinger and make it radioactive so no one will touch it) and so on. That’s why it’s been in use for so long. It’s difficult to counterfeit.

Yes as I described you have to pay for options. No you don’t have to watch them because they are a contract – you have outlined all the ins and outs in the contract.

IRS. Tax. Wages. 401k….. stop paying it into it. Ask the money be given to you and spent the way you with. Go on – try, see what happens.

Yup they show you the returns you would receive and what are held they don’t tell you what they do with the cashflow they receive from everyone combined because they don’t have to. Look into it before saying that it is simply false. You are basing everything off that everybody is honest. They’re not going to show you what they do privately as a company.

15 Chuck February 3, 2013 at 4:51 pm

‘R…’ your comments are absolutely ridiculous– the world financial system is not some conspiracy or con. Your premise is based on the idea that people love money– I can tell you that this is true and the very reason why investments aren’t a swindle. Bad investments and managers and advisers don’t last long because the entire system is evolutionary and if you don’t provide return, or if you cheat, then no one, collectively managing trillions of dollars, will give you money. I won’t even dignify those comments by explaining the inverse relationship between prices and yields.

You are also incorrect about a stock being meaningless paper. If you had ever read a newspaper, you’d see that the owners of a company have an actual claim on the company’s assets; they are junior to bond claims, but that is why the potential upside is higher.

—-

As for 401ks and Roth 401ks, they are absolutely superior investment vehicles compared to investing in a non tax-advantaged account. They are exactly the same as a regular account, except you get tax deferral or exemption, which is objectively superior to not having this feature. They don’t have any hidden fees– companies, like say Vanguard, allow you to investment in broad markets for fractions of a percent a year in fees. Some fund loads are .05%, that’s $1/$2,000 per year, and the services they provide cost them lots of money, and the fee rules and schedules are incredibly transparent. The only downside to these accounts are limitations of about $17,500 and $5,000 contributions per year, from the government, BECAUSE of how great the tax-treatment is. Do more research on these funds if your company offers them and you are not partaking. And remember, never put tax-advantaged investment, like a triple tax-exempt municipal bond, into a tax-advantaged account. The choice between Roth and 401k only depends on whether you expect your tax rate now to be more or less than your tax rate in retirement. If you think rates will rise, then you want to use Roth accounts, and if you expect to be in a lower tax bracket in the future, then use 401ks more often. And always try to use up all of your company’s ‘match’ if they offer it– it’s free salary!

There is a lot of advice online about different investments to make based on your personal wealth and age and income and needs, but I’d like to add a comment or two that are often overlooked (I trust you can get pretty good general advice here, but the following is often not said.) If your income is equity-like, then you should invest slightly more bond-like, and if your income is bond-like (like say someone with a pension or tenure) then you should invest comparatively more equity-like. And remember to consider your future income in addition to your personal savings, and remember that your home is an investment as well, with somewhat low risk and return.

I pretty much only invest in index funds ETFs, and so my average load, “fees”, is maybe .2% a year, which is incredibly competitive– easily dwarfed by the stock market swings of +/- 12% a year. I think REITs are a good investment for 10-20% of your portfolio (the government is creating a massive Commercial Real Estate bubble, but for now times are good), and the rest in equities, but I’m young and don’t want to hold bonds with their low yields– I’d rather have dividend paying stocks. I also am about 60% us-invested, and put the other 40% into international companies, especially in emerging markets.

I recommend “A Random Walk Down Wall Street” by Burton Malkiel, who was not only a great prof at Princeton, but wrote a very great book on investing for the general public. It isn’t perfect, but it’s better than anything else I’ve come across.

16 ZH February 3, 2013 at 10:00 pm

There are two books by Benjamin Graham, the father of Value Investing, that all investors (not speculators or day traders or gamblers) need to read.

These books are “The Intelligent Investor”, and “Security Analysis”.

Warren Buffet used Graham’s methods to amass his fortune and the wealth in Berkshire Hathaway.

Worth a read if you are looking to invest for the long term.

Another great, discussion-provoking, post. Keep up the great articles, AOM!

17 MustacheMan February 3, 2013 at 11:07 pm

Chuck… the only problem with your book recommendation is that the premiss of the book has been proven to be totally incorrect for quite some time.

Coming from someone who trades synthetic credit instruments for a living, the book “Ivy Portfolio” by Faber is the only text that that gives retail investors a fighting chance. I think it’s chapter 7 that covers risk mgmt which is the most important chapter in the book.

If you google “doug short” he tracks the returns from the methodology every month.

Furthermore stocks have been a terrible investment since the year 2000 because the returns are *still* negative when adjusting for inflation.

A question I always ask people when they talk about markets is, “Do you think you can be successful in the NFL right now?”
No.
“Then why do you think you can perform better than institutions?”

“investing” or trading the stock market as a retail client is akin to thinking you can play pro football.

A word of wisdom: The “fundamentals” of all companies are irrelevant when investing/trading. Every asset that trades on an exchange goes up or down due to supply and demand at any X point in time for that asset. It’s literally econ 101

Do not make the mistake of trying to figure out the cause of supply or demand entering the market. Not only does it not matter, there’s a million different reasons an institution buys or sells something. Don’t get sucked in to the media saying “That markets are rallying bc of xyz”. It’s all BS. They still can’t figure out what caused the recession.

Another book recommendation is “Manias Panics and Crashes” by kindleberger. Good history on credit cycles.

18 Nick February 4, 2013 at 3:42 am

Great article. I think more young people could use such a primer into how the stock market works. During the “Occupy” protest I spoke with some of the protesters in a local branch of the protest and found that many of them took the view that business was some sort of private empire out to rob them. They would argue that “business X” was making huge profits and therefore taking all the money. I didn’t bother trying to explain that unlike a sliced pizza, there isn’t a finite amount of money in the world but knowing that the business they were talking about was publicly traded, I suggested that the buy some of its stock and therefore get a share of that supposed huge profit. The reply I got made me think they could use a primer on the stock market like yours.

19 R..... February 4, 2013 at 5:58 am

‘home is an investment as well’

And thus the illusion is complete.

20 Nate February 4, 2013 at 8:41 am

I think more young people should get a basic knowledge of how the stock market works (and credit cards, and checking accounts, and IRAs, and 401k plans, etc) starting in high school. I had parents who were sticklers about our household finances to teach me and my siblings but a lot of other people weren’t so lucky.

Just my two cents.

21 James Gamble February 4, 2013 at 11:29 am

If you’re just getting started with investing, I recommend checking out Betterment.com. I’ve been using them since October of 2012, and my returns have been trending up since I opened my account (Currently at 3.5%). They tend to average between 7-8% overtime. Not super high, but much better than a savings or checking account.

22 The TomCat February 4, 2013 at 5:19 pm

TAOM.com is my homepage and I am so glad it is, thank you for this primer, It is everything I learned in 7th grade and promptly forgot and now feel like an idiot at 23 years old, now to just learn grade school math and I’m set!

23 davey tree February 4, 2013 at 7:39 pm

Ya know, I think the fact that everyone has been pushed into stocks via Tax sheltered annuities and IRAs is a really big part of the reason why, over the last 15 years, our economy has been subject to a series of bubbles—and part of the reason why 2007 happened. Think about it: you have most Americans shelling money into wallstreet and nearly nobody has the knowledge required to be responsible investors. And the way most 401k funds are set up, most people don’t even own single shares in single companies. We have a fractured prepackage product managed by a third party. So it’s nearly impossible to be responsible.

On top of that, businesses who get our money have no accountability. In the old days people would buy bonds at the local bank (or something similar), and the bank manager might coach your kid’s baseball team or go to your church or something. But now, the people who get to gamble with our money are nameless/faceless and likely, a thousand miles away.

My advice? True manliness involves knowing yourself and knowing your stuff. If you think you can know your way around the Stock Market, go get it! But most people have no business getting involved with stocks. For most people it’s just respectable gambling. A manly man will invest in what he knows. Buy land, invest locally, or buy some other appreciable asset that YOU know and that YOU can manage.

24 Steve February 5, 2013 at 10:08 pm

ZH has the best advice of anyone. If you’re interest in investing on your own you MUST read “The Intelligent Investor” by Ben Graham. If you find it interesting and the concepts come naturally to you, then read “Security Analysis”.

Otherwise, the retail investor is better to invest in index funds as it is often as difficult to choose a legitimate fund manager as it is a mutual fund. If you want to invest in a mutual fund you should look for a manager with a respectable track record of at least 10 years and should understand the manager’s investment strategy.
A good investment vehicle for after tax earnings is a Roth IRA, all profits and returns earned within this account can compound tax free.

In the end, it’s hard to beat index funds these days that have the lowest expense ratios seeing that probably less that 50% of managers outperform the market. Unless you can take an unbiased and rational approach to purchasing undervalued businesses with a margin of safety that preferably have a competitive advantage.

25 Steve February 5, 2013 at 10:15 pm

MustacheMan, I agree the market is looking a little frothy right now. Especially HY with a desperate search for yield, equities I think have room to run for the intelligent investor.

I also agree that short term price movements are determined by supply/demand. Although, everyone knows this…that’s the function of a market..to determine a price efficiently based on participants inputs. Claiming the fundamentals of a company are “irrelevant” is falling into the same trap as claiming EMH. The Superinvestors disprove both..

26 NG February 6, 2013 at 10:29 am

Things not to invest in:

Gold – somebody above mentioned this as a better alternative to stocks, saying that “(pieces of paper) are worthless.” That couldn’t be further from the truth. That piece of paper is a credit on tangible capital. Gold has very little intrinsic value. And even if you’re still dead-set on commodity investing, gold is still a shoddy investment. Copper, aluminum, and oil have trounced gold with respect to returns.

Actively managed funds – time and time again, it has been proven that index funds (passively managed) have continually outperformed the “wheelers and dealers”, yet people still keep putting their money into actively managed sinkholes.

27 Jake February 8, 2013 at 3:41 am

Anyone who wants to learn more about finances, look no further than investopedia.com. They have info on everything finance/investing/saving related. I started going there in high school with the original intent of learning about bonds. I spent plenty of time learning about them and then moved on to stocks, etf’s, mutual funds, reit’s, mlp’s, drp’s, etn’s, hedge funds, indices, forex, retirement, precious metals, annuities, life insurance, IRA’s, credit scoring, options/futures/derivatives, and more. Make a goal of reading at least an article or two a day on whatever interests you, and eventually you’ll be able to talk most people under the table about a lot of things.

28 Rob February 26, 2013 at 7:04 pm

@Brian, nail on the head. From my perspective, knowledge is power. The key component that gives me confidence in a company is the quarterly financial statements, year end financial statements, & projected forecast. They are relatively easy to breakdown and will give you a good idea of what is going on under the hood. Study them diligently.

Research everything you can about a company you are interested in before buying. Know the competition. Know the direction of the industry. Compare yearly cost data like R&D, manufacturing, and operating expenses, and pay attention the bottom line (cash flow ie profit margin). If you see a good pattern, ie increased productivity in addition to increased profit margins over a couple years, chances are things are gaining traction and it may make sense to invest. Publicly traded companies will usually have financial statements available online for download on their homepages, in quarterly reports and year end reports. Study them! It is a lot of work and there is no quick and easy way. If you don’t want to put in the effort to put together a comprehensive picture of a company you are interested in, you might as well hit the roulette table, because putting money down on numbers you think are going to hit is about as smart as betting on hearsay market.

My father was not a wise investor. He played off hype, television, and gambling tactics, and he lost. I learned from his losses growing up, and although I’m a cautious investor, I strive to make the right educated moves when the iron is hot. Impulsive investing is an oxymoron.

29 healthtrekker March 9, 2013 at 9:20 pm

@Steve @ZH: Bingo! -Best advice here.

The books by Graham, and also “One up on Wall Street”, by Peter Lynch.

-Just remember after reading Lynch, that just because you like the company and/or their products, it doesn’t necessarily make it a good stock.

I generally stick with best companies in the world, in the best industries in the world, that pay great dividends but not so high it’s unsustainable, and have a pretty good ‘moat’ around their business. -The “Gold-Plated-Supertanker” approach.

Generally: No Automakers, Aerospace, Drugmakers or Biotech. Those are all kinda crappy businesses.

Also, check the box in your brokerage account that says, “Re-Invest All Dividends in Dividend-paying stocks.”.

This is like Compound-Interest, but for stocks. -And Benjamin Graham himself called it the most powerful force in investing, iirc.

Examples of the golden-supertanker stocks I’m talking about are DEO, JNJ, PG, MO, PM, INTC, MDLZ, UN, BRK.B, PEP, etc.

I own a few of these, but by all means, do your own research.

Get a membership to AAII and Morningstar. Buy The Stock Trader’s Almanac. Read Investor’s Business Daily. William J O’Neill’s book on investing is pretty good, too. CANSLIM!!!

Always remember, that it takes self-discipline, not just money. There is an old joke in the investment community about doctors having all the money but none of the humility, so they all suck as investors.

If you want to Trade, one book is “A Beginner’s Guide To Short-Term Trading”, by Toni Turner. -But you have to know other things to fill in the blanks she leaves.

The single most important thing in that book is: Know Your Sell-Stop Point before you ever enter a trade, and put that order in immediately after you take your initial position. You will absolutely get your face ripped off if you don’t practice good money-management.

You have to limit the # of shares you buy to be no more than 25% of your capital in any one position, and allow no more than 2% of your total cash to be risked as a stop-loss.

Ex: if you have $20k, so your loss on any one position can only be $400.00. So if you have 400 shares in, then you can only let it go down 1 point.

If that’s not a good enough compromise between protection and keeping yourself from getting ‘stopped-out’ in a volatile stock/market, then you need to reduce the # of shares you buy to allow for a greater number of points in your hard&fast sell-stop-limit/market order.

Anyway, a small bit of info.

+Also. Be Humble. Do Not Do Anything So Fancy You Don’t Understand It.

Fortunes have been irrevocably-lost that way. Many of them.

-Just ask the Black-Scholes guys…

30 healthtrekker March 9, 2013 at 11:41 pm

Before I forget it.

The other bit I was going to say is that now is a really sketchy time to buy stocks. Lots of people are nervous at these new Dow highs.

There is supposed to be this “Great Rotation” out of Bonds and into mostly dividend-paying stocks. -Which will bid the hell out of their prices.

Also, The Fed is mostly behind this rally, instead of jobs.
-But, they have stated that they’re not taking their foot off the gas-pedal anytime soon,
And their printing-press is a lot bigger than yours.

Also, only 4 sectors have led most of the recent run-up: Consumer Staples, Consumer Discretionary, Healthcare, and Technology. -It hasn’t been an insanely-broad-based rally.

***Also, one of the BIGGEST contrarian-indicators has come up recently: The Return of The Individual Investor.
-Any time you hear that, it’s generally good to Run!
The Individual (as opposed to pros/institutions) has a reputation for Buying Tops and Selling Bottoms.

So please be careful out there!
Look how high the P/E is on a stock like PG, and you can see that there are some blue-chip names way overpriced.

CNBC Fast Money has even called the race to broaden-out people’s holdings into stocks Other than the ones bid up, but still as-close in quality as possible as , “The Trash Dash”

A lot of the smarter guys on that network feel this is going to be an individual-stock-picking, buy-on-the-dips market for awhile.
+And that there will be a Big Correction coming soon, because we’ve had such a long run since 11/08 or 3/09, depending on how you call the last bottom.

So (in my Completely Amateur opinion) if you’re not an active trader, you probably want to stick with only the blue-chip, best-of-breed stuff that could easily survive a big correction; and also keep a fair portion of your cash on the sidelines, so you can buy on the dips when the correction(s) do hit.

-But as Toni Turner reminds us: “Nobody, but Nobody knows the future of the stock market.”
So: just one idiot’s opinions and I am sure to be wrong one way or another about its direction.

31 LittleJohn March 24, 2013 at 5:26 pm

Great article! I stumbled onto this sit a few days ago and now i’m addicted to it. If the stock market is considered gambling so it driving, eating a hamburger, and playing a pick up game of basketball. The 30 year rolling return of the SPX shows that its not gambling.

There are so many stratagies for investing and no single one is perfect or necessarly being the best. Believe know one that says this is the best way. Read some good books, paper trade, and develope your own thesis.

32 Mike March 29, 2013 at 9:57 pm

Great article! I’m a complete rookie to stocks and I’ve taken a look at many articles and youtube videos online trying to explain stocks but I never understood the concept. The examples of the Mustashe Comb company was on point and really got me understanding better! Thanks for the contribution!!

As far as stock trading sites, what do you guys recommend? There are so many of them, eTrade, scottTrade, etc….

33 They go up, they go down April 8, 2013 at 11:47 pm

Investopedia is a great site. Also look at yahoo finance. Watch P/E (want it low), PEG (want it low), Div Yield (want it high), ROE (want it high) and ROA (want it high). Also don’t forget about market -to-book. There is a ton out there. Get familiar with some technical indicators to help time trades. Check it out the Ichimoku cloud. Get a descent broker that has experience. Remember dart throwing monkeys have better performance records than a majority of mutual fund managers. There are no guarantees in finance. But where there is no risk, there is no reward. When everyone is rejoicing in high returns may be time to get out or hedge, when the world is upside down, time find some undervalued companies and buy!

34 stock trading facebook December 9, 2013 at 8:15 am

I simply could not go away your website before suggesting that I really loved the usual information a person supply on your guests?
Is gonna be back steadily to inspect new posts

Leave a Comment

Previous post:

Next post:

Site Meter