Stock markets are forums in which buyers and sellers of company shares are linked together-mainly by brokers and dealers acting as shareowner representatives. As a stock investor, you should know a little about stock markets and how they work.
The traditional avenues for stock trading are stock exchanges where stocks and bonds are sold using the auction method. The three major stock markets are the New York Stock Exchange (NYSE), which lists over 3,500 stocks; the American Stock Exchange (AMEX), which lists 1,000 stocks; and the National Association of Securities Dealers Automated Quotation (NASDAQ), which lists 4,000 stocks. NYSE and AMEX have a trading floor, and all buy and sell order are routed electronically or brought in person to the exchange floor.
The NASDAQ is a different type of market. There is no trading floor, and it operates entirely through a massive computer network. It is an immense electronic dealer quote board. It is an open market with multiple dealers making a market for a given stock. Each dealer posts a bid price and an offer price. If you are selling stock, you look for the dealer making the highest bid; if you are buying stock, you look for the dealer posting the lowest offer. The current price for stock is the best bid and the lowest offer. Unless you are involved in “day trading,” your broker will route your orders to the dealer with the best price. Stocks will be quoted at the last traded price and at the best quoted current bid and offer. You can find these prices in most newspapers and on the internet.
Stock prices move according to supply and demand. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. Individual stock prices are quoted every day. To observe the market's performance, you can follow the major market indexes-Dow Jones Industrial, NASDAQ, and S&P 500. The Dow, created back in the 19th Century, tracks 30 United States companies in different sectors of the economy. NASDAQ tracks technology companies. The Standard & Poor 500 tracks 500 of the largest companies. It is the broadest and the most reliable indicator of market performance.
Stock markets are divided into sectors that represent major industries or groups of companies. New emerging companies and most technology companies are growth companies. Growth stocks appreciate in value but pay little or no dividends. They have a potential tax advantage for investors, particularly long-term investors. The increase in the value of the stock is not taxable until the investor sells it and receives a capital gain. If the investor holds the stock for more than a year, the capital gain is taxed at a favorable long-term rate.
High growth, however, is usually associated with high risk. One of the fundamental rules of investing is that risk and return are directly related. The higher the potential returns from an investment, the greater the risk of losing money. Investments with low risks have lower returns than higher risk securities. Although common stocks had outperformed other types of investments over the long term, they also tend to be more volatile than other investments. This means that the prices of common stocks will fluctuate more than bonds or other types of securities. Some types of common stocks such as small-caps will also tend to be more volatile than other types like large-cap stocks.
Steady companies, such as electric utilities, are cash-generating. Most profits are paid to investors as dividends instead of being retained in the business. Dividends are a benefit of owning stocks for investors who need income. However, for the investors in high tax brackets, dividend income, which is taxed at ordinary income rates, could be a disadvantage. These investors might prefer grow stocks that do not pay dividends in order to avoid increasing their taxable income.
Blue chip companies are large, solid companies with established reputations. There are usually few risks with blue chips. You are most likely to grow at the pace of the economy with fewer risks than with most other stocks.
Preferred stocks offer a fixed return. Investors with this type of stock get a piece of the profits first. Whether the company suffers a loss or gain, these investors usually are not affected. Most companies, however, do not offer preferred stock.
By purchasing stocks from a particular company, you invest in the company as an owner. In return, you expect a share of the profits. If a company does well-if the market for its goods or services is expanding and its earnings are increasing-then its shareholders can expect to see the value of their shares increase. If the company does not prosper, however, if it goes bankrupt-then its shareholders can easily lose their entire investment.
The prices of individual stocks are influenced by the overall performance of the stock market. If the market suffers a general decline, then the prices of most common stocks are likely to decline as well.
All investments involve risk. Though most types of risks are common to all securities, other risks may only relate to one type of security. You may not be able to sell a security quickly at a reasonable price. This type of risk tends to increase as the amount of trading in a security decreases. Small over-the-counter stocks are illiquid. Another risk is that, due to inflation, the value of the dollar will decline over time and cause a decline in purchasing power. Historically, equity securities and variable annuities provide the best protection against this type of risk since their returns tend to increase with inflation.
Before you buy stock, do your homework. Is the management frank with its shareholders? Is it simply trying to create buzz for the stock? How do you feel about taking risks? What if you lose all your investment? Could you survive such a loss? Are you prepared to stay for the long haul? The most common mistake investors make is pulling out of a fund too soon. When you decide which stock you wish to purchase, check out its performance. A stock's past will not guarantee its future, but you can get an idea of its performance for the last few years. And always remember-your investment is at risk. Nothing is guaranteed!
