Author Topic: What actually *IS* the stock market? (Seriously.)  (Read 8086 times)

fallstoclimb

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What actually *IS* the stock market? (Seriously.)
« on: June 25, 2014, 10:55:33 AM »
I know enough to not get in trouble.  I know that you shouldn't invest in taxable accounts until you max out your tax advantaged ones (and we are not there yet).  I know that you should use Vanguard whenever possible, and are best off investing in an index fund. I know not to attempt market timing and (but the best time to buy is when the stock market is low).  I know that the stock market has historically had a real return of 7% but it might be prudent to assume lower returns in the future. 

But I'm realizing I don't understand the basics of the stock market, and most of the books about investing that I pick up (so far just  "If You Can", "Your Money and Your Brain," and"The Signal and the Noise" had a nice discussion) gloss over the basics.  They talk about how to invest and the dangers of attempting to make predictions, but I want to know the actual nuts and bolts.

 For instance:

- What *actually* moves prices up and down?  Like if a company's annual profits statement is lower than normal, the stocks WOULD stay the same except for the investors reacting and selling off, right?  But I don't really understand that, because if everyone tries to sell the day the profits statement is released wouldn't the price plummet that day and then probably bounce back a little?  So the day the poor profits statement came out might actually be the worst day to sell? 

-And then how does selling even work?  Like what sets the actual prices that you read in the paper the next day?  Is that just the average price people paid for the stock?  How does the negotiation between buyer and seller work?  I imagine it must be automatic - is it like a marketplace where you secretly will accept and offer between x and xx amount and the buyer makes an offer and grabs up whatever stocks are available at their offered price? 

-When people bet on futures and other weird hedge fund things, how does that actually affect the stock market?  Is that money represented anywhere?

-What does it mean when the Dow is at 10,000 points (or whatever)?

-What IS the stock market?  Is it just the collective value of stocks that people hold?  Ignoring people who do crazy things like bet on futures or buy mortgages?

-I also don't understand the relationship between bonds and interest rates.


I know.  Don't blame me, blame the poor financial education in this country.  I even listen to Planet Money and I don't know this stuff.

On one hand its irrelevant because I do know the proper strategy to follow, but I am still curious.  Does anyone care to answer some questions (I assume most of you could recite this stuff in your sleep), or point me towards some good basic books?  I do like reading. 

matchewed

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #1 on: June 25, 2014, 11:22:28 AM »
  • What moves prices - buyers and sellers essentially. What people are willing to buy and sell at drive the prices.
  • Your second point is many many questions. How does selling work? I want stocks and someone is willing to sell them for that amount. It is quite automatic. If I need to buy a particular stock then I just ask to buy it at its price. There are many more complicated options out there within the realm of buying stock. Options like asking to buy at X but if it doesn't hit X to cancel the buy request. What sets the price? Generally the closing price plus whatever news and what people are planning on doing given that news. Many things can affect that much like they can during the market open. Just because the market is closed doesn't mean the prices remain static.
  • I believe futures are independent (kind of). The prices for futures markets are pulled from current markets.
  • It is an index. There is a calculation which determines the price given the companies in the Dow.
  • Pretty much.
  • Bonds are the entity borrowing money from you at a specific interest rate. That rate is determined by looking at the current federal interest rate.

I hope that helps a bit. And I may be wrong on some of my understanding as well. Glance through wikipedia. Most of your answers will be in there.


taekvideo

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #2 on: June 25, 2014, 11:27:40 AM »
I know enough to not get in trouble.  I know that you shouldn't invest in taxable accounts until you max out your tax advantaged ones (and we are not there yet).  I know that you should use Vanguard whenever possible, and are best off investing in an index fund. I know not to attempt market timing and (but the best time to buy is when the stock market is low).  I know that the stock market has historically had a real return of 7% but it might be prudent to assume lower returns in the future. 

But I'm realizing I don't understand the basics of the stock market, and most of the books about investing that I pick up (so far just  "If You Can", "Your Money and Your Brain," and"The Signal and the Noise" had a nice discussion) gloss over the basics.  They talk about how to invest and the dangers of attempting to make predictions, but I want to know the actual nuts and bolts.

 For instance:

- What *actually* moves prices up and down?  Like if a company's annual profits statement is lower than normal, the stocks WOULD stay the same except for the investors reacting and selling off, right?  But I don't really understand that, because if everyone tries to sell the day the profits statement is released wouldn't the price plummet that day and then probably bounce back a little?  So the day the poor profits statement came out might actually be the worst day to sell? 

Yes that's what moves the prices up/down, not sure about the best time to sell though... I'm not a day trader and wouldn't presume to be able to time the market ^^

-And then how does selling even work?  Like what sets the actual prices that you read in the paper the next day?  Is that just the average price people paid for the stock?  How does the negotiation between buyer and seller work?  I imagine it must be automatic - is it like a marketplace where you secretly will accept and offer between x and xx amount and the buyer makes an offer and grabs up whatever stocks are available at their offered price? 

You can place an order to buy or sell at a certain price, and other people can take you up on that offer.  You can also just buy/sell at market price which is somewhere between the highest "buy" offer and lowest "sell" offer that are still waiting to be taken.  It's really just supply and demand curves, and the equilibrium is constantly updated in realtime.

-When people bet on futures and other weird hedge fund things, how does that actually affect the stock market?  Is that money represented anywhere?

It shouldn't affect it directly, but anything can affect investor expectations and cause a change in price..

-What does it mean when the Dow is at 10,000 points (or whatever)?

The Dow Jones Industrial Average is one of the indices that tracks a bunch of big companies... I'm not sure if the number itself is really meaningful, but basically if it goes up by say, 20%, then that means the market on average has probably gone up about the same (some indices are more accurate than others).

-What IS the stock market?  Is it just the collective value of stocks that people hold?  Ignoring people who do crazy things like bet on futures or buy mortgages?

The stock market is just an exchange for publicly-traded stocks, where people can buy and sell them easily, like an electronic auction house.  The stocks themselves are an interest in the company... part ownership.

-I also don't understand the relationship between bonds and interest rates.

If you buy a 10 year bond paying 5% interest... then interest rates rise and new equivalent bonds are being issued at 6%... why would anyone want to buy your bond from you which only returns 5%?  The price of yours would fall to the point where it would be equivalent to buying one of the new 6% ones.  Of course if you hold yours for the full 10 years then you still get your full 5%/year returns, but you missed out on an opportunity of buying 6% bonds later.

It's similar if interest rates fall and new bonds are only issued at say, 4%... suddenly your 5% bond is worth more, and the price goes up until it's equivalent to current 4% bonds.
« Last Edit: June 25, 2014, 11:30:35 AM by taekvideo »

DoubleDown

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #3 on: June 25, 2014, 11:31:12 AM »
Great questions! I'm no expert (by a long stretch), but I'll do my best with my simplified knowledge. Maybe some better experts can weigh in!


-What IS the stock market?  Is it just the collective value of stocks that people hold?  Ignoring people who do crazy things like bet on futures or buy mortgages?


It's like any market -- think of a flea market or another marketplace, with vendors selling things. In this case, the vendors are selling investments in companies (it sounds like you already know that stock shares are tiny little pieces of the company's ownership). Companies need to raise capital to do their business, so they sell partial ownership of their companies to investors. If the company does well and makes money, the profits are shared with those investors. Since this is a "virtual" market and not a physical marketplace, brokers (i.e., Wall Street) handle the actual buying and selling of shares. When you want, you can sell your ownership (shares) of the company to another buyer, which again is handled by a broker.


- What *actually* moves prices up and down?  Like if a company's annual profits statement is lower than normal, the stocks WOULD stay the same except for the investors reacting and selling off, right?  But I don't really understand that, because if everyone tries to sell the day the profits statement is released wouldn't the price plummet that day and then probably bounce back a little?  So the day the poor profits statement came out might actually be the worst day to sell? 

-And then how does selling even work?  Like what sets the actual prices that you read in the paper the next day?  Is that just the average price people paid for the stock?  How does the negotiation between buyer and seller work?  I imagine it must be automatic - is it like a marketplace where you secretly will accept and offer between x and xx amount and the buyer makes an offer and grabs up whatever stocks are available at their offered price? 

Prices are pretty much driven entirely by speculation. That is, people are speculating on whether or not a company is likely to do better or worse in the future. They buy when they think it will do better, and they sell when they think it will do worse. More people buying causes the price of the stock to go up (think price and demand: when something is in demand, the price goes up; and more people selling causes it to go down as this stock is no longer an in-demand commodity). Of course, what goes into that speculation is super complex, the stuff of entire industries and careers. There's no secretive or mysterious thing going on to set prices (unless there's illegal insider trading) -- it's just the overall marketplace and prices reacting to investors' buying and selling. People buy, the price goes up. They sell, the price goes down.

-What does it mean when the Dow is at 10,000 points (or whatever)?

The Dow Jones Industrial Average is an index, a collection of large (30?) companies that are supposed to represent a cross-section of important industries. So, large companies like IBM, McDonald's, Procter & Gamble, Disney, etc. typically make up the Dow. The value of the Dow is not a simple average, but a more complicated calculation that is something like the sum of all the share prices of the companies in the index with a weighted average.

As I started the answer on bonds/inflation, I see others have already weighed in, so I'll stop now!

MDM

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #4 on: June 25, 2014, 11:39:06 AM »
Glance through wikipedia. Most of your answers will be in there.
http://en.wikipedia.org/wiki/Stock_market


MDM

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #5 on: June 25, 2014, 11:57:20 AM »
One oh-by-the-way: one often hears that stock prices change due to an imbalance in the number of buyers and sellers.  E.g., "stock prices were up today because there were more buyers than sellers", or vice versa.

This is not correct.  There are always exactly the same amounts being bought as are being sold.  In every transaction, one side sells thinking the price is "too high", while the other side buys thinking the price is "too low".  This is the basis of Buffett's oft-quoted line, "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful".

fallstoclimb

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #6 on: June 25, 2014, 12:02:22 PM »
Right.  It literally never occurs to me to check wiki when it's something important, just for useless information like the history of bananas. 

Thanks for the responses for those of you who weighed in, I will probably be back with some more questions after reading the wiki!  Sometimes I just need things phrased a certain way before I get it. 

fallstoclimb

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #7 on: June 25, 2014, 01:28:10 PM »
OK, I read the wiki, it didn't really add much information.  Can we just walk through a scenario to take care of some lingering questions?


So, let's say Company X goes public and makes 100 shares available for purchase (I know it would realistically be much much higher). 

I assume there is a limit to how much someone can buy, right?  Like if I buy all 100 shares I will be the only 'shareholder' besides the company and they wouldn't want that much power in one person from the outside, right?  (This knowledge is from Arrested Development.)

Let's say I buy 10 shares at $2 each.  This raises over time, varies up and down a little, and when I am ready to sell the shares are worth $200 each (inflation adjusted) so I made a nice profit. 

Clearly I made a profit when I sold the shares.  But I also received quarterly dividends, correct?  In this case, would I earn 10% of all dividends since I own 10% of the shares?  I assume for the stocks I own through my TSP, the dividends are reinvested in more stocks, correct? -- And is this where compound interest comes into play?

Two more questions:

I know that companies go public in order to raise the money they get by selling off their shares.  But once they are public, how do they make money off of their stocks?  Do they just have to make more available for sale?  CAN they do that?

Finally, how do stock market crashes affect business profits?  Like, did Exxon suffer during the Great Recession?  I seem to remember they were still raking in huge profits.  So wouldn't their dividends still pay well even though their stock prices were lower?  Or did their stock prices probably not drop much?


If anyone knows of a book that covers basic issues like this, I am all ears.  I know there are TONS of books on economic theory etc but I like actual scenarios to read through. 

Franklin

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #8 on: June 25, 2014, 01:45:14 PM »
One oh-by-the-way: one often hears that stock prices change due to an imbalance in the number of buyers and sellers.  E.g., "stock prices were up today because there were more buyers than sellers", or vice versa.

This is not correct.  There are always exactly the same amounts being bought as are being sold.  In every transaction, one side sells thinking the price is "too high", while the other side buys thinking the price is "too low".  This is the basis of Buffett's oft-quoted line, "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful".

Not necessarily.  It's actually gauged by the orders drawn.  If one order comes in to buy 100 shares, and 100 people place orders to sell him 1 share each, then you would hear that sellers outnumbered buyers by 100 to 1.

mxt0133

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #9 on: June 25, 2014, 01:47:18 PM »
So, let's say Company X goes public and makes 100 shares available for purchase (I know it would realistically be much much higher). 

I assume there is a limit to how much someone can buy, right?  Like if I buy all 100 shares I will be the only 'shareholder' besides the company and they wouldn't want that much power in one person from the outside, right?  (This knowledge is from Arrested Development.)

There is no limit.  If someone wanted to buy a company like what Buffet does he will offer to take the company for a specific price and the shareholders and the board of director vote to approve or not.  It is normally reported at X per share or the total value paid for the company.

Assuming that the initial holders of the shares actually sell then you are essentially taking the company private because you are the only shareholder and you own 100% of the company.  This assumes that all shares a "floating" available in the public market.  Most companies have restricted and reserves stock that are not for sale to the public.  http://www.investopedia.com/articles/basics/03/030703.asp


dragoncar

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #10 on: June 25, 2014, 01:51:46 PM »
One oh-by-the-way: one often hears that stock prices change due to an imbalance in the number of buyers and sellers.  E.g., "stock prices were up today because there were more buyers than sellers", or vice versa.

This is not correct.  There are always exactly the same amounts being bought as are being sold.  In every transaction, one side sells thinking the price is "too high", while the other side buys thinking the price is "too low".  This is the basis of Buffett's oft-quoted line, "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful".

Depends on your definition of "seller" and "buyer."  What you say is true, but when people say "more buyers than sellers," they mean "more people willing to buy at price X than people willing to sell at price X."  Every transaction has a buyer and a seller, but if I have the only apple on the island, and don't want to sell it to 10 hungry people who want to buy it, then from a layperson's perspective, there are more buyers than sellers.

netskyblue

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #11 on: June 25, 2014, 02:05:50 PM »
But it's entirely possible to have more people who want to sell than those who want to buy.  In such a case, the price drops.  If no one wants to buy at $50/share, maybe they'll want to buy at $45/share...or $40/share...or lower.

MDM

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #12 on: June 25, 2014, 02:09:41 PM »
One oh-by-the-way: one often hears that stock prices change due to an imbalance in the number of buyers and sellers.  E.g., "stock prices were up today because there were more buyers than sellers", or vice versa.

This is not correct.  There are always exactly the same amounts being bought as are being sold.  In every transaction, one side sells thinking the price is "too high", while the other side buys thinking the price is "too low".  This is the basis of Buffett's oft-quoted line, "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful".

Not necessarily.  It's actually gauged by the orders drawn.  If one order comes in to buy 100 shares, and 100 people place orders to sell him 1 share each, then you would hear that sellers outnumbered buyers by 100 to 1.
It's certainly true that the number of people placing buy and sell orders may not be identical.  But that isn't the point.  The point is that the popular press, and even some otherwise distinguished tomes, "explain" stock price movements (note the word "because" above) by saying "more buyers than sellers" or the reverse. 

To take the 100-to-1 example above, the price may have gone up, down, or stayed the same - 100 shares were traded, and it is irrelevant how many individuals bought or sold those shares. 

If the price did fall then the ratio would appear to "explain" the change: e.g., 100 people being fearful and Warren B. buying their shares at a lower price.  But it could just as well be the reverse: one over-optimistic buyer driving the price up while 100 people happily do buy low and sell high.

dragoncar and netskyblue have it right.  There is a supply vs. demand curve at play, and "everyone has a price".


MDM

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #13 on: June 25, 2014, 02:38:57 PM »
Let's say I buy 10 shares at $2 each.  This raises over time, varies up and down a little, and when I am ready to sell the shares are worth $200 each (inflation adjusted) so I made a nice profit. 

Clearly I made a profit when I sold the shares.  But I also received quarterly dividends, correct?  In this case, would I earn 10% of all dividends since I own 10% of the shares?
Yes, the dividends are paid to the stockholders.  There are cases where some stockholders are more equal than others, but for starters you can assume that if you own X% of the stock you indeed get X% of the dividends.

Quote
I assume for the stocks I own through my TSP, the dividends are reinvested in more stocks, correct? -- And is this where compound interest comes into play?
Don't know the specifics of your TSP.  In general one has the option to reinvest dividends by purchasing more shares of the same company, or take the dividends into checking/savings/money market account and then do whatever with money.  And yes, the dividends/interest you earn in one time period then earn dividends/interest in subsequent time periods so the "interest compounds".

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I know that companies go public in order to raise the money they get by selling off their shares.  But once they are public, how do they make money off of their stocks?
Good question.  The answer is "they don't."  They make money from the products and services they sell.  The initial stock offering gives them money to invest in manufacturing equipment, salaries, etc. so they can make more money.

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Do they just have to make more available for sale?  CAN they do that?
They don't have to, if cash flow from existing operations is sufficient, but they can.  Also, companies sometimes buy shares to make fewer available.  This tends to drive the price per share up, which can reward the company executives who have stock options...not that they'd let that influence their thinking. ;)

Quote
Finally, how do stock market crashes affect business profits?  Like, did Exxon suffer during the Great Recession?  I seem to remember they were still raking in huge profits.  So wouldn't their dividends still pay well even though their stock prices were lower?  Or did their stock prices probably not drop much?
Somewhat of a self-fulfilling question.  If the reason for a stock market crash is a global slump in business profits, then business profits will be down.  If the stock market crashes because people suddenly turn fearful but the overall business climate is good, business profits won't change.  You can check Exxon (XOM) specifics on Yahoo, MarketWatch, etc.

fallstoclimb

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #14 on: June 25, 2014, 02:53:08 PM »
Quote
Finally, how do stock market crashes affect business profits?  Like, did Exxon suffer during the Great Recession?  I seem to remember they were still raking in huge profits.  So wouldn't their dividends still pay well even though their stock prices were lower?  Or did their stock prices probably not drop much?
Somewhat of a self-fulfilling question.  If the reason for a stock market crash is a global slump in business profits, then business profits will be down.  If the stock market crashes because people suddenly turn fearful but the overall business climate is good, business profits won't change.  You can check Exxon (XOM) specifics on Yahoo, MarketWatch, etc.

I think I'm basically confused because so much of what I heard in the background of my life is counterintuitive.  If the market crashes because of a bubble burst, but a lot of companies are still doing well and paying dividends, and you're buying lots of stock at a low price -- that's great, right?  And the market always recovers.  So why are market crashes such a disaster?

Posthumane

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #15 on: June 25, 2014, 03:08:30 PM »
Not all companies pay dividends. Dividends are basically when the company takes (some of) the profit they made in that period and distributes it to their shareholders. What they can do instead is take those profits and invest them back into the company (by buying assets, investing in capital projects, and so on) and the value of the company goes up, which is reflected in its stock price going up. The former are sometimes referred to as dividend stocks while the latter are called growth stocks.

A temporary market crash is not necessarily a bad thing when you're only buying stocks, as in the case of someone accumulating for retirement. It can be a bad thing for people that are selling stock, such as the already retired, as it means they have to sell a larger percentage of their portfolio for the same amount. It is also a bad thing for entities which use the value of their portfolio as leverage for other investments (by borrowing against the value of their portfolios) since as their value drops the amount they can leverage drops, and they may find themselves deeper in debt than they should be.

dragoncar

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #16 on: June 25, 2014, 03:51:56 PM »

I think I'm basically confused because so much of what I heard in the background of my life is counterintuitive.  If the market crashes because of a bubble burst, but a lot of companies are still doing well and paying dividends, and you're buying lots of stock at a low price -- that's great, right?  And the market always recovers.  So why are market crashes such a disaster?

Um, unless it doesn't.  The US market always has, but other countries not so lucky.  I understand the appeal of an optimism gun, but I also don't consider the US invulnerable.

Also, the market usually crashes in anticipation of poor earnings reports and cut dividends.  Surely there will still be healthy profitable companies, but many also fall by the wayside.

warfreak2

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #17 on: June 25, 2014, 04:56:15 PM »
Some pictures are worth a thousand words. Other pictures are worthless without a thousand words. A Market Depth graph could belong in either category, depending on how much of a mathematician you are:



The bar chart shows how many shares there are available for you to buy (blue), or how many shares people are willing to buy from you (red), at each price. The price is currently about 830, because if you think it's worth 840 you can buy for less, and if you think it's worth 820 you can sell for more. The area chart underneath it is the same thing, but cumulative.

Suppose you want to buy 5000 shares. You are going to buy the cheapest 5000 shares available, so you stack up the blue bars left to right until they reach 5000, and then buy those. Now those shares aren't available to buy any more, the next buyer will have to pay more - the cheapest ones aren't there any more - so the price has gone up. (Of course, if nobody buys at that price, sellers might start asking for less.)

The area chart makes it easier to work out what happens. If you follow across horizontally from 5000 shares, the point where it hits the blue area is at a share price of about 900. So, based on the prices that people are currently willing to sell shares at, if you bought 5000 shares, then the price would go up from 830 to 900.

For me, seeing one of these graphs for the first time, a lot of things clicked at once. Hopefully others can have the same experience.
« Last Edit: June 25, 2014, 04:58:54 PM by warfreak2 »

YoungInvestor

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #18 on: June 25, 2014, 07:09:44 PM »
Some pictures are worth a thousand words. Other pictures are worthless without a thousand words. A Market Depth graph could belong in either category, depending on how much of a mathematician you are:

This is a great post. It also explains why you'll often see investors offering prices that are seemingly so high compared to a company's current price.

The "price" you see is the last trade that occured. There will usually also be a bid/ask, which represent the current highest price a buyer is offering and the lowest price a seller will settle for. These are the prices you could use for an instant buy/sell. You could also set your own price and wait for someone to pay it (Or to settle for it).

johnhenry

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #19 on: June 26, 2014, 09:01:20 AM »
Warfreak, that is a great post.  Thanks!

Sonorous Epithet

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #20 on: July 01, 2014, 11:25:00 AM »
Right.  It literally never occurs to me to check wiki when it's something important, just for useless information like the history of bananas. 

Useless! The history of bananas is enriching! ENRICHING! *shakes fist*

uranor

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #21 on: July 01, 2014, 10:44:28 PM »
There are a lot of good answers here, but if you are looking for a more structured learning, which I highly recommend, you could try looking at the Khan Academy https://www.khanacademy.org/economics-finance-domain/core-finance, there is quite a first rate education you can get from Sal (and free, as both "free speech"and "free beer").
When things are properly demistified and the big picture is clear, the details are more easily learned. I suggest not to bother with futures and options for some time (Sal does a good job at explaining those as well): your first task should be understanding some basic accounting, never a bad thing for a Mustachian: in fact you are a one-man (woman?) enterprise.
Then you should have a working understanding of probability theory and (rational) decision making (since you are here, that is a good start).
There are also great books that you can read to understand better: the bible on the subject is "The Intelligent Investor," by B. Graham, which you should be able to find in any library deserving its name, and then: "Value Investing from Graham to Buffet and Beyond" by B. Greenwald which is not expensive at all if you look for bargains.
Hope it helps you and others looking for financial enlightenment!

Dr. A

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #22 on: July 01, 2014, 10:50:14 PM »
OK, I read the wiki, it didn't really add much information.  Can we just walk through a scenario to take care of some lingering questions?...

I love this shit! I won't pretend to be an expert in any of this, just an enthusiast, but I think I've got a good handle on the basics.

For starters, I think you'd love Warren Buffett's Shareholder Letters <http://www.berkshirehathaway.com/letters/letters.html> They don't answer most of these questions directly, but there is so much knowledge to gain that helps put all the pieces together. And they are a surprisingly fun read.

So let's work on "Why does a company 'go public' and why are investors willing to buy those shares?"*

First, let's understand why any business has value in the first place. If my friend George owns a factory that produces fake mustaches, and he offers to sell it to me, I should be willing to buy it from him if the price is right. The reason is that George's business makes money. Each year he sells 100,000 mustaches, which makes him, say, $100,000 in profits. Now let's assume that his business will continue to make $100,000 a year for it's owner forever. The opportunity to earn that $100,000 should be worth something to me. So, if George offers to sell me the business for $1 million, I would expect to earn 10% on that investment, so I might agree to buy it.

Similarly, if George offers to sell me 10% of his business, while keeping the rest for himself, what he's really offering me is 10% of the profits, plus a say in how the business is run. I would buy 1 share of the mustache business, while George keeps 9 shares. He still has control over the company, but I have a claim on 10% of it. Theoretically, if the company were worth $1 million, I should be willing to pay $100,000 for 1 share out of 10.

By the same logic, if business improves and profits start going up, I should be willing to pay more for my 1 share, which means that all 10 shares are now more valuable.**

That very loosely, is what stocks are. When you buy one share of Exxon, you are buying a claim on one-four-billionth of their future profits, and one vote for the board of directors, who decide how the company should be run.

There are at least 8 different questions in this thread that could be addressed now, but let's go with, "why would George/Exxon sell me a piece of their company in the first place?" The banker's answer is "to raise capital", here's what I understand that to mean.

George has a good thing going. He's got an asset (his mustache business) that is worth $1 million if he sold it today, and it's paying him $100,000 a year to just keep cranking out mustaches. However, George is a big-time anti-mustachian and sees all of his business-owner buddies leasing new BMWs every spring, and wants to grow his business to make more money. However, it costs money to do that. Maybe he thinks the fake-mustache market is saturated, but that there is a ton of demand for glasses with plastic noses. However, in order to break into that market, he needs to build a nose-and-glasses factory, which costs big bucks.

Fortunately, he has several ways to get the money (capital) to build the factory. He could save up the company's profits and reinvest them into the new factory, but that will take a long time, and there is an opportunity cost to tying up that money. He could go to the bank and ask for a loan, but the idea for a new factory is risky and the bank wants to charge a lot of interest; plus, if the new factory fails, the bank may foreclose on the whole business. He could sell bonds, but let's forget about that for today. The last option is to sell of a piece of the business to raise cash to build the factory.

So George goes to Goldman Sachs and says "I'd like to do an IPO". Goldman (for a very, very generous fee) then goes out and rounds up some wealthy investors, mutual funds, hedge funds, etc. who might be interested in buying part of George's business. George may keep 75% of the company for himself, and the investors agree to buy the remaining 25% of shares at the IPO price. Lets say George sells 2500 shares at $10 each, and keeps 7500 for himself. He has now converted 1/4 of his business into cash that the company can use to build the new factory. The company as a whole is still worth $1 million, but $250,000 of it belongs to the investors, who are free to trade those shares with anyone else who wants to buy them.

What George is hoping to do is use the new factory to grow profits. If he spends the $250,000 to build a new factory, which creates an extra $100,000 a year in profits, the company now makes $200,000 a year ($100,000 on mustaches, $100,000 on glasses with noses). For someone looking for a 10% return, the whole company is worth $2 million. There are still 10,000 shares total, so each share is now worth $20. George still has his 75% (7500 shares) which are worth $1.5 million. Likewise, the investors shares are also worth $20 each, or double what they paid at the IPO. Everybody wins.

So, fallstoclimb asked, "I know that companies go public in order to raise the money they get by selling off their shares.  But once they are public, how do they make money off of their stocks?" but that's not quite right. The company does not profit from selling shares, they sell shares in order to use the money to grow the business and make their own shares more valuable. The goal of selling shares is to do something with the money that will increase profits, which makes the shares of the company more valuable.

There is no limit to how many shares can be created, or how often they are sold. The day after the IPO, George could decide to create 1000 more share and sell them off if he wants to; however, he and all the investors that bought on day one would now own a smaller percentage of the company, because there are now 11,000 total shares.

Companies also frequently do the reverse and use extra cash to buy shares back from investors, in order to increase each investors ownership stake... but that's a topic for another night...

*Sorry in advance to everyone if I come off sounding like a teacher (or giant douchebag), it's just the only way I know how to answer complicated questions. I encourage you all to call me out for being full of crap on any of this.

**You probably know all this, but it's really important to the question of why a company would want to sell shares.
« Last Edit: July 01, 2014, 10:52:00 PM by Dr. A »

pom

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #23 on: July 04, 2014, 06:10:48 AM »
So, let's say Company X goes public and makes 100 shares available for purchase (I know it would realistically be much much higher). 

I assume there is a limit to how much someone can buy, right?  Like if I buy all 100 shares I will be the only 'shareholder' besides the company and they wouldn't want that much power in one person from the outside, right?  (This knowledge is from Arrested Development.)

There are countries that have limits, usually targetted at foreign investors.

There are also many countries that have rule that apply to large shareholders. For exemple in the UK, if you buy 30% of the shares you are force to make a bid for the 70% remaining. The idea is that with 30% you have pretty much full control (many people don't vote so you are probably close to 51% of the voting power). Once you have full control, you could misuse that power; the rule is there so that you can't have full power unless you buy everything (or at least offer to do so).

Anyway, maybe too much details.

clarkfan1979

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #24 on: July 04, 2014, 08:04:40 PM »
I would read the Intelligent Investor. The market is difficult to predict. However, people are relatively easy to predict. Their is field dedicated to this type of thing called Psychology. If you believe that the market is made of people it is a slam dunk.

DannyBadger

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #25 on: July 06, 2014, 12:58:30 PM »
Awesome explanation!  But...

Why would I invest in a company if it can magically create new shares which devalue my shares?  What happens to my percentage stake in the company when the company creates more shares?  Does it stay the same (I owned one share out of a hundred, and the company issues another 100 shares...do I own one share out of 200 or two shares out of 200?)

OK, I read the wiki, it didn't really add much information.  Can we just walk through a scenario to take care of some lingering questions?...

I love this shit! I won't pretend to be an expert in any of this, just an enthusiast, but I think I've got a good handle on the basics.

For starters, I think you'd love Warren Buffett's Shareholder Letters <http://www.berkshirehathaway.com/letters/letters.html> They don't answer most of these questions directly, but there is so much knowledge to gain that helps put all the pieces together. And they are a surprisingly fun read.

So let's work on "Why does a company 'go public' and why are investors willing to buy those shares?"*

First, let's understand why any business has value in the first place. If my friend George owns a factory that produces fake mustaches, and he offers to sell it to me, I should be willing to buy it from him if the price is right. The reason is that George's business makes money. Each year he sells 100,000 mustaches, which makes him, say, $100,000 in profits. Now let's assume that his business will continue to make $100,000 a year for it's owner forever. The opportunity to earn that $100,000 should be worth something to me. So, if George offers to sell me the business for $1 million, I would expect to earn 10% on that investment, so I might agree to buy it.

Similarly, if George offers to sell me 10% of his business, while keeping the rest for himself, what he's really offering me is 10% of the profits, plus a say in how the business is run. I would buy 1 share of the mustache business, while George keeps 9 shares. He still has control over the company, but I have a claim on 10% of it. Theoretically, if the company were worth $1 million, I should be willing to pay $100,000 for 1 share out of 10.

By the same logic, if business improves and profits start going up, I should be willing to pay more for my 1 share, which means that all 10 shares are now more valuable.**

That very loosely, is what stocks are. When you buy one share of Exxon, you are buying a claim on one-four-billionth of their future profits, and one vote for the board of directors, who decide how the company should be run.

There are at least 8 different questions in this thread that could be addressed now, but let's go with, "why would George/Exxon sell me a piece of their company in the first place?" The banker's answer is "to raise capital", here's what I understand that to mean.

George has a good thing going. He's got an asset (his mustache business) that is worth $1 million if he sold it today, and it's paying him $100,000 a year to just keep cranking out mustaches. However, George is a big-time anti-mustachian and sees all of his business-owner buddies leasing new BMWs every spring, and wants to grow his business to make more money. However, it costs money to do that. Maybe he thinks the fake-mustache market is saturated, but that there is a ton of demand for glasses with plastic noses. However, in order to break into that market, he needs to build a nose-and-glasses factory, which costs big bucks.

Fortunately, he has several ways to get the money (capital) to build the factory. He could save up the company's profits and reinvest them into the new factory, but that will take a long time, and there is an opportunity cost to tying up that money. He could go to the bank and ask for a loan, but the idea for a new factory is risky and the bank wants to charge a lot of interest; plus, if the new factory fails, the bank may foreclose on the whole business. He could sell bonds, but let's forget about that for today. The last option is to sell of a piece of the business to raise cash to build the factory.

So George goes to Goldman Sachs and says "I'd like to do an IPO". Goldman (for a very, very generous fee) then goes out and rounds up some wealthy investors, mutual funds, hedge funds, etc. who might be interested in buying part of George's business. George may keep 75% of the company for himself, and the investors agree to buy the remaining 25% of shares at the IPO price. Lets say George sells 2500 shares at $10 each, and keeps 7500 for himself. He has now converted 1/4 of his business into cash that the company can use to build the new factory. The company as a whole is still worth $1 million, but $250,000 of it belongs to the investors, who are free to trade those shares with anyone else who wants to buy them.

What George is hoping to do is use the new factory to grow profits. If he spends the $250,000 to build a new factory, which creates an extra $100,000 a year in profits, the company now makes $200,000 a year ($100,000 on mustaches, $100,000 on glasses with noses). For someone looking for a 10% return, the whole company is worth $2 million. There are still 10,000 shares total, so each share is now worth $20. George still has his 75% (7500 shares) which are worth $1.5 million. Likewise, the investors shares are also worth $20 each, or double what they paid at the IPO. Everybody wins.

So, fallstoclimb asked, "I know that companies go public in order to raise the money they get by selling off their shares.  But once they are public, how do they make money off of their stocks?" but that's not quite right. The company does not profit from selling shares, they sell shares in order to use the money to grow the business and make their own shares more valuable. The goal of selling shares is to do something with the money that will increase profits, which makes the shares of the company more valuable.

There is no limit to how many shares can be created, or how often they are sold. The day after the IPO, George could decide to create 1000 more share and sell them off if he wants to; however, he and all the investors that bought on day one would now own a smaller percentage of the company, because there are now 11,000 total shares.

Companies also frequently do the reverse and use extra cash to buy shares back from investors, in order to increase each investors ownership stake... but that's a topic for another night...

*Sorry in advance to everyone if I come off sounding like a teacher (or giant douchebag), it's just the only way I know how to answer complicated questions. I encourage you all to call me out for being full of crap on any of this.

**You probably know all this, but it's really important to the question of why a company would want to sell shares.

warfreak2

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #26 on: July 06, 2014, 01:35:13 PM »
Awesome explanation!  But...

Why would I invest in a company if it can magically create new shares which devalue my shares?  What happens to my percentage stake in the company when the company creates more shares?  Does it stay the same (I owned one share out of a hundred, and the company issues another 100 shares...do I own one share out of 200 or two shares out of 200?)

Welcome to the forum.

If a company decides to offer more shares, then yes, it devalues your existing shares - but they raise money which they can use to grow the business, so earnings go up, and hopefully your shares become worth even more than they were to start with. The company's incentives are supposed to be aligned with the sharedholders', because the executives get a large portion of their compensation in company stock, so they don't want to devalue it. There are also laws about what companies are allowed to do with company funds - the CEO can't just pocket it and dissolve the company, for example, that would be embezzlement.

The second situation you describe is called a split. In that case your holdings effectively stay the same.

dragoncar

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #27 on: July 06, 2014, 06:13:23 PM »
Awesome explanation!  But...

Why would I invest in a company if it can magically create new shares which devalue my shares?  What happens to my percentage stake in the company when the company creates more shares?  Does it stay the same (I owned one share out of a hundred, and the company issues another 100 shares...do I own one share out of 200 or two shares out of 200?)

Welcome to the forum.

If a company decides to offer more shares, then yes, it devalues your existing shares - but they raise money which they can use to grow the business, so earnings go up, and hopefully your shares become worth even more than they were to start with. The company's incentives are supposed to be aligned with the sharedholders', because the executives get a large portion of their compensation in company stock, so they don't want to devalue it. There are also laws about what companies are allowed to do with company funds - the CEO can't just pocket it and dissolve the company, for example, that would be embezzlement.

The second situation you describe is called a split. In that case your holdings effectively stay the same.

I'm not so sure issuing more shares necessarily devalues your shares.  If you own 1 of 100 shares in a $100 company ($1/share) and the company issues 10 shares and sells them each for $1, then you now have 1 of 110 shares in a $110 company ($1/share). 

Of course, your voting rights have been diluted.

Also, the company might not sell them for $1/share.  They might sell them for much less (common with venture capital seed money?), or much more (common with partial acquisitions?).

Or, you could own 1/100 shares but 10 shares were reserved by the company during the ipo.  The company could split shares 2x, so you now own 2/100 shares, and the company can sell the 10 Rolf the reserved shares to raise capital.

As mentioned above, there are rules about how you can be diluted, particularly for publicly traded companies.

Grateful Stache

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #28 on: July 06, 2014, 07:46:08 PM »

I love this shit! I won't pretend to be an expert in any of this, just an enthusiast, but I think I've got a good handle on the basics.

For starters, I think you'd love Warren Buffett's Shareholder Letters <http://www.berkshirehathaway.com/letters/letters.html> They don't answer most of these questions directly, but there is so much knowledge to gain that helps put all the pieces together. And they are a surprisingly fun read.

So let's work on "Why does a company 'go public' and why are investors willing to buy those shares?"*

First, let's understand why any business has value in the first place. If my friend George owns a factory that produces fake mustaches, and he offers to sell it to me, I should be willing to buy it from him if the price is right. The reason is that George's business makes money. Each year he sells 100,000 mustaches, which makes him, say, $100,000 in profits. Now let's assume that his business will continue to make $100,000 a year for it's owner forever. The opportunity to earn that $100,000 should be worth something to me. So, if George offers to sell me the business for $1 million, I would expect to earn 10% on that investment, so I might agree to buy it.

Similarly, if George offers to sell me 10% of his business, while keeping the rest for himself, what he's really offering me is 10% of the profits, plus a say in how the business is run. I would buy 1 share of the mustache business, while George keeps 9 shares. He still has control over the company, but I have a claim on 10% of it. Theoretically, if the company were worth $1 million, I should be willing to pay $100,000 for 1 share out of 10.

By the same logic, if business improves and profits start going up, I should be willing to pay more for my 1 share, which means that all 10 shares are now more valuable.**

That very loosely, is what stocks are. When you buy one share of Exxon, you are buying a claim on one-four-billionth of their future profits, and one vote for the board of directors, who decide how the company should be run.

There are at least 8 different questions in this thread that could be addressed now, but let's go with, "why would George/Exxon sell me a piece of their company in the first place?" The banker's answer is "to raise capital", here's what I understand that to mean.

George has a good thing going. He's got an asset (his mustache business) that is worth $1 million if he sold it today, and it's paying him $100,000 a year to just keep cranking out mustaches. However, George is a big-time anti-mustachian and sees all of his business-owner buddies leasing new BMWs every spring, and wants to grow his business to make more money. However, it costs money to do that. Maybe he thinks the fake-mustache market is saturated, but that there is a ton of demand for glasses with plastic noses. However, in order to break into that market, he needs to build a nose-and-glasses factory, which costs big bucks.

Fortunately, he has several ways to get the money (capital) to build the factory. He could save up the company's profits and reinvest them into the new factory, but that will take a long time, and there is an opportunity cost to tying up that money. He could go to the bank and ask for a loan, but the idea for a new factory is risky and the bank wants to charge a lot of interest; plus, if the new factory fails, the bank may foreclose on the whole business. He could sell bonds, but let's forget about that for today. The last option is to sell of a piece of the business to raise cash to build the factory.

So George goes to Goldman Sachs and says "I'd like to do an IPO". Goldman (for a very, very generous fee) then goes out and rounds up some wealthy investors, mutual funds, hedge funds, etc. who might be interested in buying part of George's business. George may keep 75% of the company for himself, and the investors agree to buy the remaining 25% of shares at the IPO price. Lets say George sells 2500 shares at $10 each, and keeps 7500 for himself. He has now converted 1/4 of his business into cash that the company can use to build the new factory. The company as a whole is still worth $1 million, but $250,000 of it belongs to the investors, who are free to trade those shares with anyone else who wants to buy them.

What George is hoping to do is use the new factory to grow profits. If he spends the $250,000 to build a new factory, which creates an extra $100,000 a year in profits, the company now makes $200,000 a year ($100,000 on mustaches, $100,000 on glasses with noses). For someone looking for a 10% return, the whole company is worth $2 million. There are still 10,000 shares total, so each share is now worth $20. George still has his 75% (7500 shares) which are worth $1.5 million. Likewise, the investors shares are also worth $20 each, or double what they paid at the IPO. Everybody wins.

So, fallstoclimb asked, "I know that companies go public in order to raise the money they get by selling off their shares.  But once they are public, how do they make money off of their stocks?" but that's not quite right. The company does not profit from selling shares, they sell shares in order to use the money to grow the business and make their own shares more valuable. The goal of selling shares is to do something with the money that will increase profits, which makes the shares of the company more valuable.

There is no limit to how many shares can be created, or how often they are sold. The day after the IPO, George could decide to create 1000 more share and sell them off if he wants to; however, he and all the investors that bought on day one would now own a smaller percentage of the company, because there are now 11,000 total shares.

Companies also frequently do the reverse and use extra cash to buy shares back from investors, in order to increase each investors ownership stake... but that's a topic for another night...

*Sorry in advance to everyone if I come off sounding like a teacher (or giant douchebag), it's just the only way I know how to answer complicated questions. I encourage you all to call me out for being full of crap on any of this.

**You probably know all this, but it's really important to the question of why a company would want to sell shares.

This is a well thought-out and beautiful explanation!


ampersand

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #29 on: July 06, 2014, 08:39:30 PM »
This is a great post! Its key to understand the stock market at its most basic level. I'll try to answer a few of the questions; please forgive me if what I say is redundant with a number of great posts made by other contributors

We've established that a share, is literally a part of ownership of a company. If you buy a share of a company directly (not through a mutual fund/ETF) you will start receiving mail from them. For example, I own a few B shares of Berkshire Hathaway (Warren Buffet's Company). I have the opportunity to vote on major decisions of the company as well as see a copy of their annual report showing their performance/balance sheet. I will note here that businesses can have several different kinds of shares. Berkshire has A shares and B shares. A's are approximately worth 1500 x B shares.

To actually purchase more shares of BRK.B I have a brokerage account (Optionhouse, TD Ameritrade, Chase, eTrade, etc etc). There are several different type of trades available to use. I'll use the 2 most common here: the "market Trade" and the "limit trade". If you were are watching the market for a stock you'll see two important numbers. The "Bid", and the "Ask". A seller may have an asking price of $100.01, and the bid might be $99.99. If you were to put in a buy "market" order, you would pay $100.01 to the seller asking $100.01 (the difference is called the "spread"). If your order was for more shares than were on offer at $100.01, you would purchase whatever the next lowest price a bidder was willing to sell at.

In instead of a market buy, you used a limit buy, you would specify that you would only purchase stock at a certain price, say $99.99. Then, you wait. If a seller decides, he really has to sell, he can put in a market sell, and sell to the highest price purchaser (the first in line at $99.99). If however, there is more demand, then the price might keep going up as the sellers might put limit orders higher ($101). In that case, no one ever sells you stock.

In addition to the bid/ask prices, the third (and arguably more important) number is the price of the last transaction. This is whats reported in the graphs you see. The numbers you see in the newspaper are the price of the last transaction of the previous day. Some orders are specifically timed to occur at the end of day. It should be noted that there are sales after hours as well.

OK, I'm going to try and define a few more terms so as you see them, you have an idea. (I'm by no means and an expert, so please someone jump in if I botch this)

Index: An index is a metric thats create/used to give an understanding/part  of the market as a whole. One of the most commonly used one is the S&P 500. Standard and Poors (S&P) creates a list of 500 large cap (large capital) companies that it believes adequately express the opinion of the entire market. In this case the sum (?) of 500 companies share prices. http://www.investopedia.com/ask/answers/05/sp500calculation.asp. Then during trading this numbers as Shares of AT&T go up, and shares of Johnson and Johnson & Johnson go down. Theres nothing particularly special about indexes, and you could actually could create one if you so desired; for example: the ampersand index,  the summation of all companies that include an ampersand in their name (AT&T, Johnson&Johnson, Etc). You cannot buy indexes directly, only mutual funds that closely follow the stated index.

Mutual Fund: A group of money controlled by a company to follow a certain goal. There are several common "types".
There are "index" mutual funds. Their goal is to follow a stated index. They generally just buy and sell the same stocks that are in the index that they follow at the correct percentages. Because the stocks change very rarily, they can do this at a relatively low cost and without significant effort. Many of the vanguard funds fall under this designation.
"Active Mutual Funds are run by managers who think that they can beat the market through analysis/skill/luck. Because they are trading more frequently they also incur higher costs/taxation, and expect more money for their efforts that result in higher fees. There are precious few mutual funds that can consistently perform over the costs of the big indexes.
Mutual funds generally only give share prices at the end of the day.
"Target Date Funds"
Mutual funds are not restricted to just stocks. Target fund dates present themselves as the easy way for novices to not worry about asset allocations. The funds directors determine what they believe to be the ideal allocations of stocks/bonds for a given date. Essentially this means that as the funds go closer to their end date, they become more conservative, and become more reliant on bonds. aka a 2060 fund is mostly stocks right now. A 2020 fund will have a significant portion of bonds to preserve itself against a market downturn.

Exchange Traded Fund (ETF). These are very similar to mutual funds in that they contain a number of different stock/bond/other sources. The main difference, is they trade in real time during the day. So instead of all the math happening at the end of the day, it happens in realtime throughout the day. SPY is a ETF that has shares that mimics the S&P 500. You can find an ETF for about anything now: Gold, indexes, REIT's.

Real Estate Investment Trusts (REITS): These deal in real estate. They are treated specially in the tax code in that they can pass along their profits directly to their share holders without tax, but cannot keep anymore than a very small percentage of it for internal use.

Intrinsic value: To go back to the mention of George's Mustache Company, if his business is going to make $100k every year for forever it has an intrinsic value attached to it.

OK; I think that covers a few of the terms you're going to see as you start to explore the subject. I want to bring up two different competing theories of the market. The "Efficient Market Hypothesis" states that the market is always correcting itself so that the price is always exactly what the underlying securities (Properties/stocks/bonds) are worth. Basically, the market always has it figured out and is pricing things according to what they are actually worth.

A lot of people thing this is bogus (including me). It is extremely difficult to determine the "intrinsic value" of a company at any given time. If you knew their exact sales values, and had a crystal ball about future sales numbers, sure, but in reality.... its tough. Therefor, a lot of people are making educated guesses, or even worse buying without really understanding. (AKA. if I bought shares of Verizon wireless now, I don't know anything about their balance sheet/ market positions/patents etc). Because of the lack of knowledge, many people think that at any given time, certain stocks are over/under priced.

Value investors specifically look for undervalued stocks, purchase them, and then hope that enough people come around to seeing the value in those companies to return the value to a reasonable level. A common example is Warren Buffet buying up American Express when they were having a PR fiasco. Eventually the share prices returned to a reasonable level, and he made out like a bandit.

You also mentioned dividends. When a company is making a lot of money and its stacking up in its bank acount as cash they have 3 real options. They can A. Reinvest the money into equipment, processes, infastructure (AKA, buy a new mustache making factory to produce more mustaches). B. They can return that cash to shareholders through dividends.  or C. They can issue share buy backs.

It is then up to the management on how they think they can make the most money. If they think they can make a better return on the money than the market they will use the money for investment. If they think their business wont benefit more than the general market they choose between dividends and buybacks. Everyone likes a dividend, but they have to pay taxes on that money. If the share price is at a lower value though, the company can opt to buy back shares and destroy them. AKA if their are a 120 shares available and the company purchases 20 shares and "destroys" them, the other holders shares effectively become more important. If the had 20 shares before (1/6 ownership), they now have 1/5 ownership and don't have to pay taxes on the increase in value until they sell their shares.

If on other hand the other hand the company needed cash, they can sell shares and dilute everyone's ownership. This is why its important to read up on company management to determine their trustworthiness before buy shares of an individual company.

Ok... enough of me babbling. I'll attempt to answer direct questions as they come up. In the mean time. I'd suggest reading "The Warren Buffett Way"  by robert hagstrom. The motley fool (www.fool.com) has good articles on companies and their share value. Their mutual funds also have the clearest/best prospectus available in the industry. (If only other mutual funds would take the time to write such a clear/precise definition).

Best of luck in the learning curve. You're asking the right questions. I regret deeply that the american school systems don't teach this.


WiseGuy

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #30 on: July 06, 2014, 08:50:00 PM »
I know enough to not get in trouble.  I know that you shouldn't invest in taxable accounts until you max out your tax advantaged ones (and we are not there yet).  I know that you should use Vanguard whenever possible, and are best off investing in an index fund. I know not to attempt market timing and (but the best time to buy is when the stock market is low).  I know that the stock market has historically had a real return of 7% but it might be prudent to assume lower returns in the future. 

But I'm realizing I don't understand the basics of the stock market, and most of the books about investing that I pick up (so far just  "If You Can", "Your Money and Your Brain," and"The Signal and the Noise" had a nice discussion) gloss over the basics.  They talk about how to invest and the dangers of attempting to make predictions, but I want to know the actual nuts and bolts.

The markets are quite advanced and there are many of them - equities, bonds, forex, options, futures, etc.  and each field has a ton of complexity as well.

I'd suggest investing the time and reading books to learn faster (since there's so much info).  You can find lists of good books on this site or elsewhere online.

Dr. A

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #31 on: July 06, 2014, 10:05:34 PM »
Awesome explanation!  But...

Why would I invest in a company if it can magically create new shares which devalue my shares?  What happens to my percentage stake in the company when the company creates more shares?  Does it stay the same (I owned one share out of a hundred, and the company issues another 100 shares...do I own one share out of 200 or two shares out of 200?)

Welcome to the forum.

If a company decides to offer more shares, then yes, it devalues your existing shares - but they raise money which they can use to grow the business, so earnings go up, and hopefully your shares become worth even more than they were to start with. The company's incentives are supposed to be aligned with the sharedholders', because the executives get a large portion of their compensation in company stock, so they don't want to devalue it. There are also laws about what companies are allowed to do with company funds - the CEO can't just pocket it and dissolve the company, for example, that would be embezzlement.

The second situation you describe is called a split. In that case your holdings effectively stay the same.

I'm not so sure issuing more shares necessarily devalues your shares.  If you own 1 of 100 shares in a $100 company ($1/share) and the company issues 10 shares and sells them each for $1, then you now have 1 of 110 shares in a $110 company ($1/share). 

Of course, your voting rights have been diluted.

Also, the company might not sell them for $1/share.  They might sell them for much less (common with venture capital seed money?), or much more (common with partial acquisitions?).

Or, you could own 1/100 shares but 10 shares were reserved by the company during the ipo.  The company could split shares 2x, so you now own 2/100 shares, and the company can sell the 10 Rolf the reserved shares to raise capital.

As mentioned above, there are rules about how you can be diluted, particularly for publicly traded companies.

Glad my long-winded essay on IPOs was appreciated.

One thing that I think helps to clarify this idea is to remember that most companies actually hold shares of themselves in the company treasury.* So, if there are 100,000 shares total, the company itself may hold 10,000.** If you own 1 share of the company, you also indirectly own a percentage of the 10,000 shares in the treasury. Since you own 1/90,000 shares that are "outstanding" you effectively own 1.11 shares out of 100,000 total (your 1 actual share + 10,000 treasury shares/90,000).

Now lets say a company with 100,000 shares outstanding and zero in the treasury creates and sells 10,000 new shares.^ Prior to doing this, shares are worth $10, which means the company is worth $1 million. At the instant they create the shares, you own 1.1 shares (1 share directly, 0.1 shares indirectly). Your voting power hasn't changed (because the shares in the treasury can't vote) and your STAKE in the company is still worth $10, because your claim on the profits is still 1 out of 100,000.

Once the company sells the newly-created shares, it essentially converts the 10,000 new shares into cash. Your voting power has decreased, because you have 1 vote out of 110,000 now, and so has your economic interest in the company. However, the company treasury now has an extra $100,000 in it (10,000 shares * $10 each). Since everything else about the company is the same as it was before the stock sale, it should be worth $1.1 million divided among 110,000 shares. So, your share should still be worth $10. Your hope, and the management's goal, is to use that extra cash to invest in the business and grow profits so all those share become more valuable.

Of course, the real world is a lot more complicated than that. Remember that the current share price does not measure the actual value of the company (something that can't be determined precisely), but merely what investors think the value of the company is at this moment. So, if the company sold shares for more than they are actually worth, this is good for current shareholders, but if they sell for less than the company is actually worth than it is bad for shareholders. Also, the company is not obligated to sell the new shares at the price they are currently trading for.

Finally, shares are often created in order to grant them to upper management as compensation... but that's a whole different can of worms that I do not understand remotely well enough to opine on.

*These are shares of the company that are actually owned by the company, which is not the same as shares owned by the individuals who operate the company, like the CEO, Board of Directors, etc.
**I believe (not 100% sure) that the company can just create or destroy shares within its own treasury whenever it wants.
^This is called a "secondary offering", as opposed to an IPO or "initial public offering"

warfreak2

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Re: What actually *IS* the stock market? (Seriously.)
« Reply #32 on: July 07, 2014, 08:54:37 AM »
I'm not so sure issuing more shares necessarily devalues your shares.  If you own 1 of 100 shares in a $100 company ($1/share) and the company issues 10 shares and sells them each for $1, then you now have 1 of 110 shares in a $110 company ($1/share). 
This is a valid point but not quite correct.

The company's net worth (a.k.a. shareholder equity) increased by $10, but a healthy company with a net worth of $100 should normally have a market capitalization (i.e. total value of all shares) significantly above $100. If a company's market cap is only equal to its net worth, that means that they might as well just disband the company, sell off all the assets, pay off all the liabilities, and distribute what's left to the shareholders.

So there is still a gap which has to bridged by the company increasing its profitability.