What is a Stock Anyway?

Fundamentals of Market Investing by Adam J. McKee

When companies want to grow faster than they can without new money coming in, they have to raise huge amounts of cash somehow.  Banks don’t tend to loan out billions of dollars to expand a business.  It’s just too risky for ultra-conservative bankers.  An important way of doing it is to “take the company public.”  Most companies start out as family businesses or partnerships.  “Taking the company public” means that that the original owners will take on “silent partners” in order to raise the money that they need to expand.  These new partners pay for their share of the company.

These silent partners usually own very small pieces of the company and do not get to make any decisions (that’s why they’re called “silent”).  They do, however, get a share of the company’s profit.  How companies are divided up into shares and sold developed over a long history, and is now heavily regulated by federal laws and agencies.  When you want to grow really big, you don’t just take on a few silent partners.  You chop the company up into millions of tiny little pieces and sell each of them.

Each of these little pieces of the company is called a share, or a stock.  Back in the good old days, they would print up a fancy stock certificate to represent each little piece of the company.  You can buy and sell these, and the company had no control over who owned how many shares or for what price you can buy or sell them.  When you go public, it means…public.

The stock market is a free market, and buyers and sellers haggle over the price of shares thousands of times each ad the market is open.  (Some trading can take place at night, but there are very few participants, and the volume is very low, which means that you cannot trust overnight price changes.  Some traders refuse to trade after hours and derisively refer to those that do as “the pajama people”).

The vast majority of stocks today reside in computers, and records are kept in an online investment account.  There are probably some old stock certificates floating around, but they are rare.  When a company goes public, they hire an investment firm like Goldman Sachs to do all of the paperwork, decide on the number of shares, and set the asking price.  These original shares are sold in an Initial Public Offering (IPO).

Once the shares are sold, they start trading on the open market.  The dollar amount that a stock is worth is decided on the open market where sellers and buyers haggle over the value.  For the individual investor, these are just “bid” prices and “ask” prices flashing on a computer screen.  Sellers want a high price, and buyers want a low price.  Because big companies have millions of shares out there, they are constantly changing hands (moving from one account to another account).

As an investor, you may be looking at a computer screen, but the value of stocks is determined by what people are willing to buy and sell them for.  Since people are involved, a psychological factor with which investors must contend.  This is why stock prices sometimes move up and down in seemingly irrational ways—people are irrational at times, especially when things get emotional.  Different investors can reach different conclusions based on different information.  Someone who believes a stock price will rise is known as a bull (or is said to be bullish), and someone that thinks it will go down is called a bear (or said to be bearish).

You can also be bullish or bearish on an entire index of stocks, or the whole stock market.  If you are bullish on a stock, you want to buy it because you think it will become more valuable and you will make a profit.  If you are bearish on a stock you own, you want to sell it because you think the price will go down and you will take a loss.  Most of the movement in stock prices that come from psychological factors are short-lived.  Stock prices tend to reflect the rational valuation of the companies they represent over time.  Therefore, as you can now see, investing in the stock market is not gambling, it is a business decision.

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