Wednesday, August 20, 2014

The normal person's guide to the stock market

What makes these guys nervous? All sorts of things, from bad economic news to international conflict. Getty Images

Flip to CNBC and you'll more likely than not hear some mention of what the stock market is doing and how smart investors on Wall Street are reacting. And good for them. But even news sources that aren't specifically targeted at a business audience tend to have a lot of talk about the latest action in the markets. Yet somehow they manage to skip past the stuff a normal person actually needs to know. Here are the basics.

What is stock?

Stock is a share of a company. Shares of stock are also sometimes called equity. When you own stock, you own a little piece of a company and become what is called a shareholder. You also usually have a (very small) say in how the company is run and get to vote on important company matters like members of the board of directors.

Owning stock means you have claim to a share of a company's assets and earnings. A stock's value is measured in points, which are the same thing as dollars. When General Motors is at 33.9 points, that means it costs $33.90 to buy one share of GM stock.

Why do companies sell stock?

There are two reasons companies sell stock. One is that it's a way for a company to get cash so it can do things like expand or buy new equipment. The other way a company can do this is by borrowing money. Each of these options has costs and benefits. Borrowing money means paying interest, but selling new shares of stock means reducing the value of the shares owned by the existing shareholders. What's more, in order to be able to issue stock at all you first need to stage an initial public offering (IPO), which leaves you subject to extra regulation.

The other reason to sell stock — especially at the IPO phase — is that it lets people who own lots of shares sell them to someone else in order to get money. Mark Zuckerberg's Facebook shares were incredibly valuable even before Facebook became a publicly traded company, but there was no practical way for him to sell them without holding an IPO and putting Facebook shares on the stock market.

What is the stock market?

The stock market is the big arena in which people trade those shares of different companies. The actual places where stocks are bought and sold are called exchanges. The two main stock exchanges in the US are the New York Stock Exchange (NYSE) and the Nasdaq.

Both are based in New York, though only the NYSE has a physical location on Wall Street. The NYSE trading floor is the backdrop to those emblematic shots of brokers yelling and making hand signals at each other. The Nasdaq, meanwhile, is an electronic exchange. Both exchanges open at 9:30 AM Eastern every morning and close at 4 PM every afternoon. Over time the physical exchanges have become less important since computers have taken over more and more of the trading.

Which number should I watch to tell where the stock market is going?

There are a few numbers you can watch. Though there are several stock indexes, the big three are the Dow Jones Industrial Average (known as "the Dow"), Standard & Poor's 500 (or "the S&P"), and Nasdaq — which, confusingly, shares its name with the stock exchange.

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A look at 25 years of S&P 500 peaks and valleys.

These are all stock indexes: numbers that track a whole bunch of stocks at once. The Dow tracks the prices of 30 stocks that represent a broad range of major companies in all industries except transportation and utilities. The S&P 500, as the name suggests, tracks 500 major companies that are intended to be representative of the US economy. The Nasdaq includes thousands of companies that are traded in the Nasdaq exchange. The Nasdaq and S&P 500 are both weighted by firm size, while the Dow is not. Though they are calculated differently and can have differing day to day shifts, all of these big three tend to track together, broadly speaking.

All of these indexes are measured in "points," like individual stocks, but because of the ways they are calculated, it doesn't make sense to talk about them in terms of dollars the way it does for individual stocks. However, because they are based on stock prices, they all are subject to inflation.

You can find data on them in many places — often TV news networks will track at least one major index on a ticker in one corner of the screen. But you can also track them in real time via sites like Google, Yahoo Finance, and Bloomberg.

What makes the stock market go up and down?

Good economic news can boost stock indexes, and bad economic news can tank them. This is why after major economic releases, like jobs reports or GDP reports, stock indexes will sometimes post big jumps or declines. When the economy is growing, that is taken as a sign that the businesses in that economy are also growing. Likewise, a good job market is a sign of healthy businesses that have both the money and the need to hire, and that consumers will also have more money to spend.

News from the Federal Reserve, the nation's central bank, also tends to affect stocks. When the Fed pushes interest rates lower, it means it is trying to boost the economy by encouraging more borrowing. Seeing this stimulus can excite stock markets. Likewise, a Fed trying to cool the economy down by raising interest rates can send stocks tumbling. So when a Fed official even hints at what the Fed might do in the future, stocks can swing wildly.

The Fed can also affect the returns on investments like US treasuries — issuances of government debt — through its purchases. If the fed lowers the yield on treasuries, it can send investors looking for better returns in the stock market than they can find in a treasury.

Major international events can also send the stock market tumbling. Markets tend to get anxious when the potential for major international conflict can cause all sorts of disruptions, like hurting global trade. Markets were shaky, for example, when the unrest in Crimea recently began heating up.

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The 1987 stock market crash created chaos on the floor of the New York Stock Exchange.

Should I care when the news tells me the stock market had a bad day?

A stock market's day to day swings mostly act as a barometer for the broader economy. When the stock market jumps or falls by a lot, the culprit could be any of the things listed above, like a great or awful economic report.

The stock market also sometimes acts in completely mysterious ways. There was an enormous stock market crash in 1987 whose causes remain controversial today, and that was quickly reversed. It's important not to read too much into any one day's swings. Several days or even weeks of really great or ugly stock market readings taken together are a more meaningful indicator that some sort of a shift is happening. Of course, if you own lots of stock (or even a little) you should care at least a little about money you're making or losing.

It's important to know what you're looking at when you're reading any given stock index. All of these big indexes mentioned above are on different scales. For example, around the same time the Dow first closed above 16,000 points for the first time, in November 2013, the S&P was just inching above 1,800. That's why it's perhaps smarter to keep an eye on percentages when monitoring day to day shifts in the stock market — 100 points on the S&P 500 is way more than 100 points on the Dow.

Because these indexes are based on individual stock prices, they, too, are subject to inflation. That means when the news says an index breaks a record, it may not be a real record.

Should I own stock?

That depends on how much you're OK with taking a risk. Broadly speaking, stocks are more risky than a lot of other investments. Treasuries and savings accounts are among the safest bets of them all, but they also don't generally bring about the same kind of reward as stocks. With stocks, there is no interest rate continually pushing your investment higher, and it's much easier to lose money. But with risk comes reward. It's hard to lose money in a savings account, but you also only earn a little. Meanwhile, the average return on the S&P 500 from 2004 to 2013 was a little over 7 percent, according to calculations from the Stern School of Business at NYU.

If you have a 401(k) or some other sort of retirement plan, you already have a very easy path to owning stock, and there's a good chance you have some already. Lots of retirement plans allow you to invest via instruments like target date funds and index funds. These funds are big mixes of investments like stocks, bonds, and US treasuries. Because they're diverse, they're generally less risky than owning just one or two stocks alone.

How do I buy stock?

Though you can buy stock directly from some companies, almost all stock transactions are done through third-party brokers. But you have a lot of options for brokers, whether in-person or online though a service like Etrade or TD Ameritrade. That said, some companies offer direct stock purchase plans, which allow you to buy stocks directly from a firm. The advantage of these is that you don't have to pay big broker fees or give anyone a commission on your earnings. The disadvantage is lack of flexibility — under one of these plans, you can only buy or sell one stock. And owning one stock means you're subject to whatever problems befall that one company.

Can I buy stock in any company?

No. A company has to have made its shares publicly available in the stock market. When a company decides to jump into the market, it has an IPO. This is what is known as "going public." This directory from Bloomberg Businessweek is a good place to find out if a company is public.

What makes my company's stock go up and down?

There are a few factors, but the major one is a company's profits. Public companies report their earnings quarterly, and stocks take their cues from these reports.

But in between those reports, the business news drives stock prices. After September 11, airline stocks plummeted as investors guessed flying might not be a great business in the near future. Likewise, bad news about a company's products, like a massive recall, can pull a stock's price down.

Another factor is simply how promising a company looks. A company can be wildly successful without posting big profits, as Amazon has proven. That company has always taken a long view of success, investing its money in big projects like a grocery delivery service, and investors have thus far rewarded it, despite relatively low profits.

Take the value of all the outstanding shares of stock and add them all together and you have a measure of the company's size, in a figure that is known as the "market capitalization" or "market cap" for short. When one public company is said to be bigger or smaller than another, those are comparisons of market cap figures.

What's insider trading? Should I do it?

That depends. As the SEC explains, insiders like corporate executives, officers, employees, and board members can all trade their company's stock. That is technically insider trading and is legal, but they must also report all of those trades to the SEC. So if you fall into this category, then by all means: insider-trade away! (But there is a lot of paperwork you need to fill out; if you're in this position you're probably rich and should hire a lawyer).

But be careful, because this sort of trading can easily slip into illegal territory. This better-known kind of insider trading — the kind that's often mentioned in news clips of well-heeled types heading off to court hearings or prison — has to do with inside information.

When someone with non-public knowledge of developments within a company uses that information to drive their trades, that is illegal. This can involve a company's insiders themselves or anyone else who might be privy to that information: employees' family and friends, workers at brokerage firms who deal with the company, and even members of Congress. This is why hedge fund SAC Capital has recently been in all sorts of trouble.

What's high frequency trading? Should I do it?

Probably not, given that this a guide to the stock market for the average, everyday person. Average, everyday people do not engage in high-frequency trading (HFT). The topic is hot right now in part due to the new book "Flash Boys" from Michael Lewis. HFT involves the use of sophisticated computer algorithms to execute trades in fractions of a second. HFT can bring huge profits because these traders have the kind of speed that many investors don't, but some say these traders are gaming the market.

So if you have the equipment and are good at it, it could bring you some huge profits. If not, it might not be the easiest line of work to get into.

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