Introduction
to the Stock Market
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What are Stocks?
A stock is an investment vehicle
that represents an equity or ownership interest in a company.
For example, assume that a small privately held company has
a total market value of $1 million. The owners of that company
may choose to sell stock (representing a partial ownership
in the company) to the general public. Assume that they offer
to sell 1 million shares of stock at a price of one dollar
per share (for a total of $1 million). If you, as an individual
investor, invested $10,000 in this company you would be given
stock certificates representing 10,000 shares of stock. Your
10,000 shares of stock represent 1% of the total stock of
the company. If the value of the company goes up over time,
the value of your 1% ownership interest also goes up at the
same rate. A large company like Coca-Cola will have millions
of shares of stock held by thousands of investors and representing
billions of dollars in market value.
Why should I invest in stocks?
Stocks have historically outpaced
other investment vehicles in terms of total return on investment.
This has certainly been true over the past several decades.
Historically, investors who have bought and held a diversified
portfolio of stocks have enjoyed a steady increase in the
value of their equity investments over time. As a general
rule, returns on stock investments have outpaced inflation
and generated a real increase in wealth for stockholders.
Over the past 50 years, the S&P
500 has averaged a 10% annual return - far more than an investor
would have received by investing in CD's or other money market
investments. The Dow Jones Industrial Average has returned
an average of about 9% over the same period. What is more,
in recent years, average returns have been increasing slightly
- moving the average return ever higher.
Notwithstanding the recent correction
in the market - precipitated primarily by the bursting of
the internet bubble, the stock market appears poised to generate
significant wealth for stockholders well into the future.
Isn't the stock market just for rich people?
To the contrary. The stock market
is an important investment vehicle for individuals of all
incomes and circumstances. In fact, a solid investment strategy
is probably more important to individuals with modest means
than it is for people with great wealth. The compounded returns
that have typically characterized the stock market will be
vitally important to individuals who are counting on their
investments to ensure a comfortable lifestyle into retirement.
How do I make money in stocks?
Stock Price Appreciation
If you had been fortunate enough
to invest $2,000 in the stock of Dell Computer at the beginning
of 1990 and held it for ten years, the value of that initial
$2,000 investment would have grown to well over a million
dollars. Of course, most stock investments have not performed
as well as Dell. But it provides a valuable insight into the
potential for wealth accumulation through stock price appreciation.
Dividends
In addition to stock price appreciation,
as a stockholder you will be entitled to a percentage of any
profits that are distributed as dividends to company owners.
Not all companies distribute dividends to shareholders, but
many do. Dividends are generally paid quarterly. These dividend
streams can be an important factor in the overall return on
your initial stock investment. As a general rule, companies
that are growing rapidly do not pay dividends. They use all
of their profits to finance their growth. If a high growth
company manages its growth wisely, the stock price appreciation
that is achieved over time will generally more than make up
for the lack of dividends.
Who do I buy the stock from?
When a company decides to sell it's
stock to the general public it undertakes an initial public
offering (IPO). To ensure a successful IPO, the company will
typically retain the services of a good investment banking
company like Merril Lynch or Goldman Sachs. The investment
banker will identify potential investors and create an initial
market for the stock. Once this initial stock offering is
sold out, then in order to purchase shares of that company
you must find an investor who already owns the stock and submit
an offer to purchase some or all of his shares on the secondary
market.
How does the stock market work?
Thanks to the creation of stock
exchanges, it is generally not difficult to find buyers and
sellers of public stocks. A stock exchange is simply a collection
of buyers and sellers of stock securities. Market prices are
efficiently established through a continuous auction process
that is governed by the laws of supply and demand. Order is
maintained through a rigid set of rules, an impressive array
of technology, and an organized hierarchy of intermediaries.
A dedicated network of traders, brokers, and specialists ensures
that buy and sell orders are executed in a timely and professional
manner.
Stock Exchanges
The New York Stock Exchange is one
of the most famous and successful exchanges in the world.
It is home to some of the largest and most respected companies
in the world. If you wish to trade the stocks of these companies,
you must ultimately do so on the floor of this venerable exchange.
However, there are many other large and important exchanges
- both in this country and in most other countries thoughout
the world.
NASDAQ
Historically, if a company's stock
was not listed on one of the major exchanges, then it was
typically traded in what is referred to as the "over-the-counter"
(OTC) market. In recent years, the term "over-the-counter"
has been largely replaced by the NASDAQ monikor. NASDAQ is
the acronym for the National Association of Securities Dealers
Automated Quotation system. The NASDAQ market is not housed
in a central location like the New York Stock Exchange, rather
it is a computerized network of traders and brokers spread
throughout the country. Through the NASDAQ's sophisticated
quote system, stocks are traded electronically in much the
same manner as they are traded on the floors of the major
exchanges.
Do I need a stock broker to buy and sell
stocks?
As a small individual investor,
you will not have access to the trading floors of the major
exchanges. You must rely on a broker to execute your orders
for you. Until very recently, most stock brokers had rigid
requirements regarding the number of shares that could be
purchased at one time and imposed minimum standards on the
size of the accounts that they managed. They also charged
high fees for their services. This created a significant barrier
to investment for the small investor. With the advent of discount
brokers, however, it has become much easier and cheaper for
small investors to participate in the stock market. The internet
has further shifted the balance of power in favor of the small
investor. On-line brokers now account for an important and
growing segment of the total market. Companies like E*trade,
Ameritrade, Charles Schwab, TD Waterhouse, and a host of others,
have done a remarkable job of leveling the playing field for
the small investor. It is relatively easy to set up an on-line
account with one of these companies.
How much money do I need to get started?
Most of the on-line services will
allow you to open an account with a $500 balance - and sometimes
less. Many will even offer you a number of free trades to
help you get started.
What will it cost me to buy and sell shares
of stock?
Fees vary considerably. Most disount
brokers charge between $10 and $25 to execute a trade. However,
some are currently advertising rates as low as $8 per trade.
You will pay this fee when you buy the stock and again when
you sell the stock. You need to factor these brokerage commissions
into your thinking as you evaluate the potential for generating
a profit through the buying and selling of stocks.
Will I get advice on picking stocks?
If you trade through discount brokers
you will generally not receive advice on investments. Full
service brokers such as Merril Lynch will assign you to a
broker who will dispense advice. The fees for these full service
brokers are dramatically higher than those charged by their
discount counterparts. Many investors believe that they are
better off doing their own research on potential stock investments
and saving themselves a lot of money in commissions.
What if I have a problem understanding
how the system works?
Most of the discount brokerage companies
have very reliable trading systems and provide excellent customer
service free of charge. With a little homework you will be
able to select an on-line service that fits your needs.
Understanding
Investment Risk
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