Tuesday, August 11, 2009

Dollars and Sense- What is the Stock Market

This is the second in our series called Dollars and Sense. See part 1 here.

Last time we talked about what money actually is. Now let’s talk about what exactly is the stock market.

The stock market is an exchange where individuals go to buy and sell shares of a company. Shares of a company represent a percentage ownership in that Company. So for example if a Company has 1,000 shares outstanding then you essentially own 1/1000 of that Company for each share you own. The total value of a Company’s outstanding shares at any given time is called their market capitalization. This is the total “value” of the Company as determined by Wall Street.

One thing to note is that a Company does not directly benefit from the value of their shares going up. The stock market is a secondary market where individuals trade shares. Only when Company’s issue new shares or when a new Company undergoes an initial public offering (IPO) is the Company receiving the money. Occasionally, if a Company feels their stock is undervalued the Company may purchase their own shares and resale them later or purchase them for stock awards for their employees.

A stocks price is determined by a lot of factors. First and foremost the earnings and performance of the Company affect the stock price. Anytime a Company has unplanned or unforeseen success the stock price will go up. The opposite is also true. Everyday though we see the market shifting. These shifts are related to the publics’ view of the economy as a whole as well as industry indicators, etc. Now I would be one rich man if I could tell on a daily basis how the market is going to perform, but that is really not possible. There are so many factors that affect stock prices that it becomes hard to predict market swings.

There are really two types of investing that I know of speculative and value investing.

Value investing is similar to what Warren Buffett does. Essentially, you study the financial statements of a Company and select Company’s that currently are undervalued. When Buffet started he worked with Benjamin Graham author of the Intelligent Investor and was able to find Company’s that had a book value (the value of all their assets less liabilities) higher than the stock price. This was guaranteed profit. You won’t see this today as information is too readily available. In today’s world what Buffett does is select Company’s he feels will grow (see more recently coca cola) over the long term due to their business model and management. Value investors are less concerned with the short term swings in the market.

The second type of investing is speculative. People who speculate attempt to time the swings in the market and therefore trade many stocks quickly with hope of getting small gains over the long term. They attempt to take advantage of the volatility of the market. It is important to note that no one has consistently been able to beat the market using this strategy. In fact, 80% of brokers don’t beat the market in any given year. Rarely does anyone do it twice in a row.

Our next Dollars and Sense Article will look at how I recommend the common person investing in the stock market. As always feel free to email any questions you have or any ideas for new posts.

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