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October 23, 2016

How does the stock market work? Who decides the price of stocks?

  webmaster       October 23, 2016

Stocks are issued by companies, public and private, to denote ownership. For instance, by owning one share of General Electric (Ticker: GE) you own a small slice of General Electric. The more shares you own, the more of the actual company you own. If a company is doing well, more people will want to own part of the company, and therefore they'd be willing to pay more. That is what drives the price of stock. Would a business want to become a public company, they would sell stocks on the public market. The process of becoming a public is called an Initial Public Offering, (IPO). By issuing stock to the general public, the company is giving up some power over the company, as more people are able to vote. 

In the structure of a company, the shareholders elect the board of directors, who then elect the executive officers. So you can see how there could be a desire to hold on to power. 

There's a lot of buzz around IPOs, ie Facebook. IPOs are tricky to trade. There's generally a lot of excitement about large IPOs, and the price usually shoots WAY up in the beginning inflating the price to unsupported levels, before regulating itself back to a realistic price, ie Groupon, Shutterfly. When it comes to investing in IPOs, you can usually find a calendar or sorts of upcoming IPOs. For example:

Quarterly Reports
Once a company becomes public, they issue quarterly reports. These are essentially like their report cards. You can also find calendars of which companies are releasing their quarterly reports, and when. Companies commonly try to predict what their report cards will look like, and independent analysts do the same. These predictions generally come in the form of revenue, profits, and earnings per share. 
Companies can decide when their fiscal year starts. Some companies arrange it so it's based on what their sales trends are. For example, stores like Macy's will have strong holiday sales that are disproportionate to their normal operations. Same with UPS. 

Revenue is the amount total brought in, as dictated by sales. 

Profit is the amount the company has left over after reducing all their costs from the revenues. This is seen in a company's income statement. Here's a sample income statement:

Companies can increase profit in two ways: One, they can make sales; Two, they can control overhead and costs. The less a company spends, the less their costs chip away at revenue, the more profit they make. 

Earnings per share is a big one for investors. It basically divides these numbers by the total amount of stock shares held by investors. It's a measure of confidence. 

Mutual Funds
Mutual funds are essentially a collection of stocks that have similar characteristics. Some Mutual funds focus primarily on growth, so they'll feature stocks that show strong growth trends. Some focus on dividends, and will contain companies that issue high dividends.
Mutual funds are pretty common in retirement plans.

Dividends are basically a distribution of the company's profits to their shareholders. For example, Pfizer (PFE) issues dividends of 2.2%, meaning by the end of the year, they'll issue about 2.2% of the share price to investors. Dividend mutual funds, AKA income funds, are common in retirement because they offer a steady income for people who don't work. 

Steve Jobs sold Pixar to Disney for millions of shares of Disney stock. Disney pays dividends, not exactly sure what their rate is (honestly he probably got some special stock option not available to smaller investors, a la Warren Buffet and his recent investment in Bank of America (BAC)). Therefore, Steve Jobs got a dividend payout of about $43 million from Disney per year. His salary from Apple was only one dollar.

ETFs, or Exchange Traded Funds, are conceptually similar to Mutual funds, in that they are a collection of stocks based on various categories and managed by various investment firms. They differentiate in that ETFs, by definition, can be traded on the Exchange. 

For ETFs and Mutual funds, think of it as investing in the performance of a select portfolio. A portfolio is basically the stocks that you hold. I own shares of GE, Google (GOOG), PFE, therefore my portfolio consists of GE, PFE, GOOG.

ETFs to watch are SPY and QQQ. Both are designed to follow the S&P 500.

When reading about the economy you'll see things like Dow Jones, S&P 500 and NASDAQ.

These are weighted indices of stocks, and are designed to be an overall indicator of how stocks did on that day. If most stocks on the NASDAQ (typically a very technology heavy index), go up, the NASDAW will go up by their weighted average. This will make more sense as you keep following it.

Bonds are also issued by a companies and governments, but unlike stocks, are classified as a liability on the company's/government's balance sheet, because bond holders must be paid back. They incur no ownership in the company. The benefit of bonds is they are held by a contract to pay certain amounts of interest as stated in the contract. They also get priority during a company's unfortunate liquidation.

A brokerage house is a company licensed to buy and sell stocks or securities. Acting as an intermediary between buyers and sellers, Broker services are usually provided on a commission basis which vary with each brokerage house. 

Often, the price per trade is indicative of the level of service the firm offers. For example, a brokerage house that charges fees on the lower end of the scale may not execute trades as quickly as one that charges higher fees. Likewise, a firm that charges higher commissions usually offers more personalized service.
In addition to commissions, a brokerage firm may charge various other fees.

Stock Market Principles

Human beings have always invested for the future

And they have always made the same mistakes!

The Six Success Rules

The rules for successful stock market investing are not complicated. However, one must avoid the 'learning too much' syndrome. Learning too much is dangerous because in doing so our future judgement is clouded

Rule of Expected Returns
  • investors need to be realistic about the sort of returns they can expect. the first lesson to learn from market history is to be realistic
Rule of Staying Calm
  • all investing involves a degree of risk. Market volatility is inevitable, it goes with the territory. History shows that’s almost invariably prices eventually recover
Rule of Timing the Market
  • although it’s very tempting to try to time the market, in fact it’s virtually impossible to do it successfully
Rule of Avoiding Complex Products
  • investors should try to keep things simple, and the simplest way to invest in equities is via index funds
Rule of Diversification
  • the one lesson that screams from every page of market history is to diversify  'The Golden Rule'
Rule of Excessive Trading
  • despite the constant temptation to trade, the best thing that investors can do once they've built a portfolio that matches their attitude to risk is… nothing

Learn more about the Six Investing Principles by watching a few short videos which describe each principal in detail. In the videos, leading academics and financial experts explain Stock Market Principles.

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