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Welcome to the Stock Market: A seemingly complicated topic explained in commonsense terms

If you’re one of these people who say or think that you don’t know anything about the stock market – prepare to be surprised.

You say you’re not interested in the markets because you’re afraid of losing money. You say that only professionals can make money in the markets and that you can only make money in the stock market if you have money to invest in the first place. I assure you – nothing is further from the truth.

The fact of the matter is, whether you like it or not, you are already a part of the stock market.

Believe it or not, every time you buy something, say an iPod, you are making money for a corporation, such as Apple. Whenever you buy a box of Kleenex, you are making the Kimberly-Clark Corporation just a tad richer. Whenever you steal the transmission out of a Corolla, you are making money for Toyota (since the owner has to get the engine replaced, courtesy of Toyota). I can go on, but is there a point?

Now, let me ask you: if you like a company’s product, why not buy some shares of that company? If you are making the corporation richer by buying their products, why not be a part of that company?

Is it possibly because you have never thought about it that way before or you simply didn’t know these options were available to you? Or maybe you just don’t understand the concept of shares and ownership of stock; maybe you don’t even know what a stock is?

Well, it’s okay and it’s nothing to be embarrassed about. It’s my job (and that of BigFatMoneybags.com) to open this world up to you and show you the opportunities that exist in the stock market.  Now let’s get started!

INTRODUCING THE STOCK MARKET!

The stock market is quite possibly the most magical place in the world to make money, second only to my rope selling business during suicide season. If there exists a place on this earth where you can take an initial investment large enough to buy a set of pots (or pans, whichever floats your boat) and turn it into enough to buy a duplex and a windmill to boot – it is the stock market.

Problem is, people either don’t understand what the stock market is or they don’t see the potential in it or they simply think it’s all a hoax. The technical term these types of people are classified under is: imbecile.

It seems that people don’t understand how you can take an initial investment of $5,000 and turn it into $10,000 (if you have somewhat decent stock-picking skills) or turn it into $1,000 (if you don’t) a year later. To understand how that is done you have to understand how the stock market works – which is what I will proceed to do right about…now.

The Stock Market Explained

You’ve probably heard some stupidly ecstatic talking head on TV screaming “Sell the children! The Dow has fallen 20 points!” or “Praise Jesus! The NASDAQ is up 112 points! Hallelujah!” Those words probably didn’t mean much to you in the past, but after reading and absorbing the knowledge in this article you will quickly understand what it all means and will be smarter than 99% of Wall Street, congratulations!

Before I go into explaining what the Dow or NASDAQ is, it will probably help to understand what a stock is in the first place:

A stock represents ownership of a company’s assets and profits and conversely in its liabilities and losses. A share represents how much ownership you hold of that company. Yes, it’s that simple.

You can purchase virtually any (major) company’s stock. Common examples are Apple (AAPL), Google (GOOG), Best Buy (BBY) and Nike (NKE) as well as any of the stocks found in The Gutman Fund. Those strange little abbreviations that look suspiciously like an alien language is actually how the stock is classified and is referred to as a “ticker” or a “stock symbol”.

If you’re so confused right now that you feel like hanging yourself with that rope you purchased from me, put it away; I will ease your spinning head with a little example:

The story of RICH

Let’s conjure up an interesting little company called Mr. Moneybag’s Rope Selling Emporium (Symbol: RICH). Currently, this company is a private corporation (meaning shares of this company cannot be bought and sold in the open markets) but to raise some extra dough Mr. Moneybag decides to “go public” meaning his company’s shares can be bought and sold in a stock exchange – this is what is referred to as an Initial Public Offering (IPO).

Mr. Moneybags drives on over to his investment banker and  after many hours of screaming and obscene hand gestures they determine that the company is worth $20 billion. It turns out that Mr. Moneybags is a greedy little chimp and decides he wants to sell off the entire $20 billion and take home the cash all to himself – problem is that not many people can afford to go out and spend $20 billion everyday (unless of course you are a Gutman). That’s why they have to take that number and cut it into smaller, more affordable pieces – known as shares.

Mr. Moneybags decides he wants everyone and their pet horse to be able to afford shares in his company, so he sets the price per share to be $100. Since the company itself is worth $20 billion, that means there are 200 million shares at $100 a pop ($100 x 200 million = $20 billion).

In real life, the investment banks and whoever else took part in the IPO would take a percentage of these funds, but for simplicity’s sake let’s pretend all these organizations were feeling Christmassy.

Problem is, finding a buyer for every tiny little share can take longer than it takes a hundred-and-seven year-old lady to back out of her driveway. That’s why stock exchanges exist – so, instead of going out and asking Aunt Erma to buy some stock in your rope-selling business, you can refer to a stock exchange which will electronically connect buyers and sellers without any hassle on your part. [Some of the stock exchanges you commonly hear on the news everyday:  New York Stock Exchange (NYSE), NASDAQ and the Toronto Stock Exchange (TSX)]

Buying and selling shares on a stock exchange used to be done by stock brokers but nowadays with the advent of that contraption commonly referred to as the internet, online brokerages are all the rage now. The process of buying and selling shares of a stock is done within seconds. (More on this and choosing online brokerages later)

And thus, Mr. Moneybag’s company was sold off bit by bit in a pretty short amount of time (honestly, how can someone not want a piece of a company like that?).

It’s important to remember that when a company sells its soul in an Initial Public Offering, a Board of Directors is elected by the owners in order to manage the day-to-day operations of the company. It’s also good to know that ANYONE, literally ANYONE can trade stock – all you need is some money, a bank account and to be a human being.

And that is the story of how Mr. Moneybags made $20 billion in one day.

How the price of a stock is determined

So now you know what a stock is and how shares of stock are bought and sold. What I still didn’t explain is how you can take an initial investment of a few thousand dollars and turn it into many thousands of dollars or lose almost all of it.

The only way you can make money in the markets and take your initial investment and turn it many times more is by buying low and selling high. If you know anything – literally anything – about stocks, you know that their share price always fluctuates.

An example of buying low and selling high? You buy one hundred shares of a company at $10 a share, meaning your initial investment is a grand total of $1000 ($10 x 100 shares). A year later each share is worth $15, meaning you can sell your one hundred shares for $1500 ($15 x 100 shares) – a tidy profit of 50%. Question is, why does the price of each stock change and how can you use that to your advantage?

The reason that stock prices jump around as much as a rabid kangaroo infected with rabies is due to the wonderful market forces known as supply and demand. As simply as it gets:

When the demand for a certain stock is higher than the supply available, the price per share of the stock will rise. Since everyone wants a piece of the pie and there’s not enough of that delicious pie to go around, people are willing to pay a little bit more for every piece, thus the price per share rises.

When the supply of shares for a certain stock is higher than the demand (meaning there is low demand), the price per share of the stock falls. Say, Aunt Erma accidentally used insecticide instead of sugar and the only way people can sell their slices is by cutting the price, hence the price per share falls.

That having been said, there is also the case of what actually determines the demand of a stock. We know that the supply is determined by the amount of shares available to be purchased, but what factors lie behind demand?

The main reason investors are willing to pay more or less for a stock is because of what they think the stock is worth. If they believe the stock is worth more than its current price, they will pay a higher value for it. On the other hand, if the investor believes the stock is worth less, they will sell the stock if they own it or they will wait for the price of the stock to drop so they can buy at a price they deem suitable.

NEVER associate a company’s stock price with its value (how much it is actually worth – also known as a stock’s intrinsic value).

As I said earlier, you want to buy low and sell high – the only way you are going to do this effectively is by buying a stock that is worth one dollar for fifty, thirty or even ten cents and then sell it when it reaches its intrinsic value. Remember, just because a stock is trading at gargantuan levels, doesn’t mean it’s actually worth that much.

The problem is, determining how much a stock is actually worth is where everything gets a little tricky. I’m not going to go into too much detail about that in this article as valuating stocks is slightly more advanced than the scope of this article – if you would more about the hardcore stock valuating skills (you know, the ones that make you all the money) then head over to my website, which you can find a link to in the bottom of this article.

Factors Affecting the Perceived Value of a Stock

The most common factor affecting how investors’ perceive the value of a company is by its earnings. If you don’t know what earnings are (really?): they are the profits a company makes (commonly referred to as “the bottom line”).

So, if a company doesn’t make any money, it’s doubtful it will stay in business – thus the perceived value of the company falls.

Investors, and the inbred mules on Wall Street, watch earnings reports like hawks. If a company reports better than expected earnings, they will pile into the company, thus demand rises. If the results are worse than expected, expect the price to plummet. And since companies are required to report their earnings four times a year (every three months – referred to as a “quarter”), you can bet that there will be many occasions for stocks to swing back and forth like a wild monkey on a swing.

Other reasons the price of a stock will rise revolve around good news such as analyst upgrades, management restructuring or due to speculation, such as rumours of a larger company buying your company out.

Over a longer period of time, the price per share of a company will rise as the company grows and becomes more and more profitable (remember, if you own shares of a company you own a share of the profits).

Common reasons a stock will fall in price? The exact opposite of the last paragraphs: bad news regarding the company as well as analyst downgrades are some examples of why stocks fluctuate in price.

If learning about all this seems daunting to you or you are thinking that this information is only available to insiders (employees of companies), there is a good chance you are poor. The beauty of the stock market is that it is built to be fair for everyone (or at least is supposed to be), meaning that you have access to the same information as any insider. So now you don’t have any excuses for not being rich, sorry.

The Tale of Risk

Of course, when you invest in the stock market there is always some element of risk involved. Then again, whenever you engage in any activity there is some element of risk involved, for instance when you are riding your bike to class there is a chance of you hitting a bump and, long story short, end up with bits of your head all over the road. There is even risk when you are reading a book: those sharp corners plus your eyes can equal an unpleasant trip to the hospital.

That’s why you should wear a helmet when you go biking or wrap your books in foam when you are reading in order to mitigate your risk as much as possible.

Of course there are many people who choose not to be prepared with a helmet handy for when they have their lives flashing before their eyes as they are falling off their bike head-first into the concrete in slow motion.

Granted, a very small portion of people end up with pieces of their heads missing when they go biking so it would make sense for them not to want to wear those clunky helmets. Then there are the bikers who bike down the middle of the road while keying cars and running over koala bears. For these types of reckless people, a helmet would be a good idea, yet many still don’t wear one.

This analogy of bikers and risk applies directly to investing. As there are different types of bikers there are different types of investors. Some choose to be safe and take necessary precautions in order to avoid having to sell their organs in order to pay off the bills (equivalent to wearing a helmet while biking) while others are too busy recklessly investing without doing a smidge of research and thus end up not noticing the wall they are about to collide into…head-first…with no helmet…while riding their bicycles and losing all their money.  Karma is sweet.

I can go on talking about bicycles, pieces of head all over the ground and throw in a random reference to investing every now and then but I think you get the idea.

There are many investment strategies that will reduce the risk that comes with any investment such as dollar cost averaging, diversification, asset allocation or even investing in mutual funds. Again, I do not want to get too technical in this article so if you are interested in all of the investment strategies available to you then head over to my website which will be linked to at the end of this article.

All you really have to remember about stocks and risk is that the fastest growing stocks tend to be the ones that are the safest. Many people will launch boulders and packs of man-eating Rottweilers at me for saying what I just said, but then again doesn’t it make sense that the more people are buying of something, the better the quality?

There’s a reason Apple sells iPods by the pound while its stock price went from $2 to $200 and why Amazon is considered to be the next of kin to Jesus – and I dare anyone to tell me these stocks were “risky”. There are thousands of other such examples, but I’m too lazy to list them all.

And as for the people who say that investing in the stock market is the same thing as gambling? I’m not even going to dignify that with a response.

Some More Things to Consider

Stock Indexes

If you watch the news you will constantly hear newscasters screaming hysterically about some strange contraption known as the “Dow”.

When they refer to the “Dow” they are referring to the Dow Jones Industrial Average, a stock market index. The point of this index is to represent the state of the stock market as a whole; whether it does so effectively or not is a topic for a completely different article.

The Dow Jones Industrial Average is simply the average of thirty “blue-chip” stocks such as IBM, General Motors, McDonald’s and Microsoft. These companies are big, bulky, well-established and are considered to be rather dandy representatives of their sectors.

If the Dow rises in value, it is considered that the economy is doing well; if its value falls, it’s considered that the economy is not doing so well.

Other stock market indexes are the S&P500 and the Russell 2000, although the Dow is the index that is most closely followed.

Dividends

Dividends are one of the ways a company distributes its earnings to shareholders. They take the form of cash, stock or even property.  The amount of the dividend is determined by the board of directors; the more shares you own, the more dividends you get.

Also, high-growth companies (the kind of companies I like) tend to reinvest their earnings in order to sustain their super growth instead of giving their money away to shareholders, this results in the price per share rising.

Another reason I don’t like dividends is due to tax reasons. Just remember: you have to pay tax on dividends and paying tax means you make less money.

Different Types of Stock

There are also different types of stocks. The ones that I constantly refer to are “common stock” and is the type that most people refer to when they are discussing stocks.

There is also “Preferred Stock” as well as different classes of stock, such as “Class A” and “Class B”. I’d tell you more about these types of stocks…but there’s no point. Stick to common stock, that’s where the money is.

Different Types of Markets

When everything is fine and dandy and stock prices are rising in price while everyone is making money – it is referred to as a “Bull Market”.

When people are stockpiling food reserves, selling their kidneys to black market organ dealers, haggling their kids away for pocket change and when stock prices are falling – it is considered a “Bear Market”.

So now when you hear people using these terms, you won’t feel all that helpless anymore…maybe even on their level…or better yet, more powerful…powerful enough to crush their skulls into dust…and to conquer the world…with a flick of your finger.

Yes, the stock market can do that for you.

In Closing

Congratulations, now you know how the stock market works! With this knowledge alone you can go out and make greater returns off of the stock market than most “professionals” ever dreamed of making.

About the Author

Mr. Moneybags is the richest being in the universe to ever have existed and ever to exist. He writes about building wealth in the stock market, business and personal finance on his blog and is determined to prove that the subject of money shouldn’t make you want to douse yourself in gasoline and run into a forest fire.

You can find more of his amazing articles on his blog at http://www.BigFatMoneybags.com

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