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How The Stock Market Works
It Might Surprise You

An ongoing questions...

On August 8th, 2011 President Obama gave a state of the union address and the same day the stock market (DOW Industrial Average) dropped 635 points, of which 200 points are considered to be in direct correlation to the speech. I generally, do not watch the news, but at this time I was monitoring my stock portfolio and wondered why there was such a large drop in the market. I did some research and realized that my original understanding of the stock market was faulty.

Since I am a CPA and provide advice to my clients about investing for the future, I figured it was my duty to have a complete understanding of this device (the stock market) that so many peoples futures are tied to. We have all heard the horror stories about people who lost their retirements in the tech bust, and the mortgage bust, but the ongoing question I had was, 'How did all of these companies that people have money invested in lose so much value in one day?'

The answer, which I dreaded would be the answer, was that the stock market and stock prices are not tied directly to the companies that the stock is invested in. This article will discuss, what a stock is, how retirement accounts work, and how the stock market works.

Standard advice, generally from financial advisors (people who get paid to give advice about and trade stocks), is that the stock market is your best bet for accumulating money and earnings for the future. I have spent many hours analyzing and building models that look for alternative ways to invest for your retirement, that do not include using the stock market.

What is a Stock?

A stock is a single share of ownership in a company. This is the most basic idea of owning stock. A company needs money, so they are willing to sell a portion of the company in exchange for the cash that this sale provides. The number of shares that a company has can range from hundreds to millions. So while you might buy 100 shares of stock, this might not represent a large share of ownership in the company.

As a shareholder, you are now invested in the profits of the company. If the company declares a dividend, you will receive a share of the dividend in relation to the percentage of ownership that you have.

Example: A company has 1,000,000 shares outstanding, and you own 100 shares, for an ownership percentage of .01%. They declare a dividend of $15,000,000 and you get a dividend of $1,500. This is a very simple example. It is not much more complicated than this, but often companies will not declare any dividends.

Owning stock allows you to have votes within the companies decision making process, though this is very limited.

Many stocks purchased together in a portfolio are called a mutual fund. So instead of owning 100 shares of Pepsi, you might buy a Soda related mutual fund, and now you will own several shares of all sorts of related companies. This is called diversification. Most long term portfolios have many funds in them, rather than single stocks.

The long term value of stocks is based on the stock price. If you buy 100 shares of a $10 stock for $1,000, and in 5 years the price has doubled to $20 a share, your portfolio has double in value from $1,000 to $2,000. On top of that, you may or may not have received cash dividends. The value of your portfolio is changing from minute to minute. The gain is not truly realized until you have sold the stock and have the cash to prove you have made gains.

What is the Stock Market?

The stock market is the place where stocks are traded. If you own shares in Microsoft, and wanted to sell them, you would make them available on the stock market, and someone else who is willing to buy them would do so. The main stock market for America is the NASDAQ. It stands for National Association of Securities Dealers Automated Quotation.

The important thing to understand about the stock market is that it is a secondary market. Generally, when you buy a stock, you are not buying it from the company that it originated from. You are buying it from a brokerage house that represents a seller, which is a previous investor that wishes to sell the stock.

There are many stock markets. The New York Stock Exchange is the main market in the United States, and most countries have their own market. You can trade stocks in many markets if you wish.

What is a Retirement Account

Retirement accounts are where people put their money in to save for the future. While there are many different types of retirement accounts, and many different names for them, they all basically work the same way. It is basically just a bank account that belongs to you. The general rules are that you cannot have access to the money in the account until you reach the age of 59 1/2 without major tax consequences, and the earnings in the account accumulate tax free.

Traditional IRA, Roth IRA, 401k, 403b, Pension, and Annuity are some of the many names that these accounts go by. They are just bank accounts that are generally invested in stocks and mutual funds.

Is your entire retirement plan dependent on the stock market?

The standard retirement plan advice is to put your money into a retirement account, managed by a financial broker, which will be invested in the stock market. Do you have money saved for your retirement? Do you have a company pension plan, 401k, or annuity? Do you have a Roth or Traditional IRA (Individual Retirement Account)? If you do, they are all most likely invested in the stock market. You probably get mail annually or quarterly about the performance of your portfolio, and you probably get regular mailings with prospectuses, that are full of a lot of undecipherable information.

It is a very good idea to understand the thing that your money (future) is invested in. You don't have to become a stock broker to own stocks and mutual funds, but as the person, whose future and retirement hinge on the success of this investment plan, don't you think you should know a little bit about it?

What is an IPO

Now that you know what a stock is, what a stock market is, and what retirement accounts have to do with this, it is time to understand how the stock market works. The IPO, or initial public offering is the first step in the process.

Companies sell stock to the public to raise capital. The first time they do this, it is called going public, and it is accomplished through an initial public offering (IPO). At the time a company goes public, the initial stock price is based on the value of the company. If a company has a net value of $1,000,000, and it sells 70% of the company using 70,000 shares, then the initial stock price will be $10 per share.

A company rarely sells all of it's shares, because the control of the company is determined by who owns the highest percentage of shares. In fact, a hostile takeover, is when another company buys up so much of the outstanding stock, that it has a higher percentage of ownership than the company itself, and is allowed to take the company over by force.

Generally, IPO's are sold to brokerage houses (Stock Brokers), not to the general public. The stock brokers turn around and sell the stock on the open (secondary) market to their clients. It is like real estate, in that you might own real estate, but you are not a real estate broker. If you want to buy real estate, you get a real estate agent to handle the deal, real estate agents must work for a broker. So technically, real estate moves from person to person through a broker. There are exceptions to these rules in both real estate and stocks, but we will not discuss them.

What is the open market?

After the IPO the stocks are traded on the open market. There are several markets, but the one that most American companies are listed with is the NASDAQ. The NASDAQ is an automated system that is charged with matching buyers and sellers offers and executing trades based on changes in the market. The important thing to understand is that this market is based on supply and demand. You want to sell a stock, the price of that stock is based on the current market price and who else is willing to buy it, and at what price.

This concept is the major problem with the stock market. If a bunch of people sell their stock at one time, the stock available for sale goes up and the price of the stock will drop. The daily fluctuating price of the stock is affected by supply and demand, not by the performance of the company. The performance of the company matters, in that it affects the perspective of the people who own the stock and their opinion of its value.

How are the prices set?

The price of a stock is set automatically by a massive computer system based on the trades that are made. When someone wants to buy stock, they place a buy order stating the number of shares they want and what they are willing to pay for it. There will be many of these in the system for different amounts of stock and at different prices. When someone else extends a buy order, the computer system matches them up and the deal is done. The difference in these prices from the going rate for these stocks effects the current sales price of the stock.

If there are more people selling than buying, and the asking prices are not being met, the price goes down. If there are more people buying than selling, and the stock is moving very quickly the computer system adjusts the prices up.

None of these transactions have anything to do with the value of the companies being traded. They only have to do with the perception of the people buying and selling. If you think Microsoft stock is a good buy and lot of other people think the same thing (commonly based on news reports or financial information about the company), then a lot of people will want to buy and fewer people will want to sell. The law of supply and demand requires that the price has to go up so that some people will not want to buy anymore, and the market can find equilibrium. All of this is controlled by a computer system that only keeps track of supply and demand.

How do I make money?

The best way to make money in the stock market, is the same as making money in any other retail trade... 'Buy low and sell high'. The difference between the purchase and sales price is your profit. However, how do you get the information that you need to be sure that you are buying low and selling high? How do you know what is a good buy? There are several online tools that you can use to get historical information about stocks, but the fact remains that if stocks are tied to popular opinion, and a simple state of the union speech can drastically change the stock market so drastically, how can you ever predict what the stock market is going to do?

You can't. How do you pick a dog or a horse at a gambling track? How do you know if your house will go up in value after you purchase it? We have imperfect historical information that give us something, but this information is not predictive. None of the histrorical data told us that the stock market would crash in 1929 and no historical data can tell you if the state of the union address will cause the market to fall. There is a lot of historical data that you and your financial advisor can use to make decisions about the stock market, but historical data only gives you an indication about the future. Historical data will not predict wide spread panic that causes markets to fail. It cannot predict the tech bust or the mortgage bust crisis's. Historical data is just that, in the past, and an indicator of the future, but not predictive.

The Problem With Financial Advisors

Financial advisors are people that manage stock portfolios for people who do not have the time or expertise to do it on their own. This is just about everyone.

If you have a very long term view of the stock market, and intend to hold stocks or mutual fund purchases for a long time, then you can ride out a lot of bumps and dips in the stock market. This is the principle that has kept a lot of financial advisors in business for a very long time. They can convince you to buy with the idea of thinking about your future, they tell you what you should buy, and when the market looks bad they normally will convince you that you have to ride out the storm. They make money on your portfolio and their income is tied to keeping your money in the market and making trades.

If you ask a real estate agent if you should buy a home, they will give you a list of reasons why you should, and a list of ways you can overcome your lack of money or desire to buy a home. They get paid to get you to buy and sell real estate. Financial advisors get paid to get you to invest. Even flat fee investors get paid to keep your portfolio with their company, and while their incentive structure is better than that of the pay per trade advisor, the general incentive remains the same.

Can you trust them? That depends on the person that you are dealing with. But it does not change their incentive to get you to keep your money with their company. Many financial advisors work for large companies that essentially offer them incentives to push that companys products (mutual funds). If your money is in a Merrill Lynch account you can be pretty sure that your advisor will regularlly suggest Merrill Lynch funds that will meet your needs. While there is nothing inherently wrong with this and many of the products are sound, can you trust someone who is not entirely objective?

Most financial advisors do not make much more money than everyone else. Generally, when I want advice about getting rich, I want to take it from a rich person.

The final and most poignant issue I have with the financial advisor industry is that they make no promises about your portfolio's performance. They will tell you all kinds of good stuff about a stock, a fund, or your overall portfolio, but in the end if you ask them what your return will be, they will not make a promise. This is a problem with the stock market, not the advisor. They are actually unable to promise anything because they don't know what the market holds.

How is this different from gambling?

Gambling is defined as, 'to bet on an uncertain outcome, to take a risk in the hope of gaining an advantage'. The bottom line is that buying stocks is gambling. In both stock and gambling markets, there are people whose entire lives are devoted to understanding and making predictions about games and markets, and the results are near the same. A good brokerage house makes good predictions, but not anywhere near 100% correct. A good sports gambling predictor will consider himself a success if he predicts over 70% of the games that he has picked. We are not talking about super complicated predictions either. We are predicting whether 1 of 2 teams will win a game, or whether a stock will gain or lose value. These are all 50% predictions. Both financial advisors and professional gamblers can state a host of historical and predictive information about a a specific stock or gambling activity.

We are placing our money in it (the wager), and we are uncertain of the outcome (either gains or losses). In addition, both stock investing and gambling are subject to random events (luck), that can make your rich or clean you out. The book, 'Fooled by Randomness' by Nassim Taleb, discusses how random the stock market is, and the inability of humans to recognize the inherent risk involved, due to our heuristics, biases, and risk aversion. Humans prefer small daily gains, with the potential of terrible random losses, because it is easy to ignore the potential future loss as long as your are happy each time you see your stock portfolio has gained in value.

What do I do Now?

I wish the answer was simple. The beginning of knowledge is the desire to understand something. Simply by reading this article you have likely been given information you were not aware of before. The goal of the article is to help you understand that your financial future is likely tied to something that is easily swayed by popular opinion, and managed by people who have a very high incentive to keep you in the market and making trades.

My first suggestion to anyone that wants to make a change is to attempt to understand what they will be investing in. Attempt to understand the risk associated with any investment that you make. Investing in your future should be an active process that you must regularly revisit. It should not be a passive process that you allow some faceless person to do for you.

If you have read any of my other articles or have seen papers on real estate analysis that I have done, then you know that I recommend real estate as a stable, predictable long term investment.

If you have any questions please email me Richard Bowen, CPA