Stocks and Bonds
Stock Market
The term of the stock market refers to a set of exchanges and other venues where shares of publicly held companies are bought and sold. Stocks are conducted through formal exchanges and over-the-counter (OTC) marketplaces. OTC marketplaces deal with the process of trading securities via a broker-dealer network. A broker-dealer is a person or firm that’s in the business of buying and selling securities for its own account or on behalf of its customers. It primarily acts like an agent, as it executes orders on behalf of its clients, but can also act as a dealer when it trades for its own account.
*the terms “stock market” and “stock exchanges” are often used together, as traders in the stock market will buy or sell shares on one or more of the stock exchanges that are part of the overall stock market.
The stock market is a free market economy, meaning that it deals with an economic system that’s based on supply and demand and little to no government control.
It’s not too complicated to understand: the stock market allows buyers and sellers of securities to meet, interact, and transact money. The good thing about the market is that it allows price discovery for shares of corporations and will serve as a barometer for the overall economy. This ensures that buyers are assured of a fair price, high degree of liquidity, and transparency.
History of the stock market
Now, before we get into how specific stocks and bonds work, let’s go into the history of the market first. The first stock market was the London Stock Exchange which began in a coffeehouse in 1773, where traders met to exchange shares. It wasn’t till 1801 though, that it was made clear that a formal system was necessary to deter fraud and unreliable traders. They slowly established rules and agreed to a paid membership fee to belong to the exchange , which paved the way for the first ever stock exchange in London. Through the years, this market has grown tremendously, as the London Stock Exchange (LSE) provides cost-efficient access to the world’s deepest and most liquid pools of capital and is home to a wide range of companies. This has made London one of the world’s leading financial cities in the world and made it a well-known hub for international trade, banking, and insurance.
How the stock market works:
The stock market provides a controlled and regulated environment for individuals to transact in shares with zero to low operational risk (the chances and uncertainties a company faces in conducting its daily business activities and procedures)
*The stock market acts as primary and secondary markets
Primary stock markets: allows companies to issue and sell shares to the public through the process of initial public offering (IPO), which helps companies raise necessary capital from investors. The company then divides itself into several shares and sells those shares to the public at a certain price per share. This is where the stock market comes into play, as it’s used as the marketplace where these shares are sold.
*Investors own company shares with the expectation that the value will rise, so they can receive a dividend payment.
That word hopefully sounds familiar! Let’s talk more about a dividend.
A dividends simple definition is just the distribution of a company’s earnings to its shareholders that is determined by that company’s board of directors.
distributed quarterly and can be paid out in cash or in the form of reinvestment (an additional stock)
this number is determined by the dividend yield
Dividend yield: expressed as a percentage and is the financial ratio that shows how much a company pays out in dividends each year relative to its stock price.
*the formula is easy: total dividends paid/net income is the dividend payout ratio
The dividend yield correlates directly with the dividend, as these yield change relative to the stock price
More mature companies hand out dividends, as sort of a “thank you” for investing their money into them
Secondary stock markets: the place where investors buy and sell the securities they already own. It;s what is known as the “stock market,” as it’s the place where investors trade securities after they are put up to sell on the primary market.
-providing liquidity to investors: trading with a large number of investors ensures that the value of the securities won’t get lost as investors buy and sell securities
(gives small traders a chance to participate in market)
Understanding the difference between the two markets: when companies issue stocks or bonds for the first time and sell them to investors, that transaction occurs directly on the primary market. Now later, it’s up to the investors if they want to take their share of the company, and they carry out this share on the secondary market.
Primary markets often have a set market price, as it’s coming straight from the company
Secondary markets, on the other hand, have market prices determined by supply and demand
I’m sure this term must sound familiar, but if not, let’s give a refresher!
The Law of supply and demand is the theory that explains the interaction between the sellers for a resource and the buyers for that resource. In simpler times, the less supply there is of a particular resource, the more demand.
Relating supply and demand to the stock market:
If the majority of investors believe that a stock will increase in value (the money you are getting after investing in a stock) and they rush to buy it, then the stock price will rise, because of the demand. (If you really want the stock, you’ll have to pay the price now, otherwise there’s plenty of other candidates!)
The same thing goes if people believe that a stock will lessen in value, and therefore, there will be no demand for the stock. The stock price will decrease, because there’s nobody competing to buy the stock.
Well, think about it like this. When a company is first starting off, what do they need?
Yup, you guessed it, money!
The way they get this money is by issuing stocks to raise the funds to operate their business and the shareholder (owner/holder of the stock) may have a claim to part of the company’s assets and earnings.
The shareholder is considered an owner of the issuing company and is determined by the shares an investor owns relative to the amount of outstanding shares there are.
Example: if a company has 10,000 shares of stock outstanding and one person owns 100 shares, that person would own and have a claim to 1% of the company's assets and earnings.
Shareholders and corporations:
Though stockholders don’t own a corporation, the corporation is a special type of organization that treats these stockholders as legal persons by law. Corporate property, however, is legally separated from the property of shareholders. This limits the liability of the corporation and the shareholder. If a corporation goes bankrupt, a judge may order that a corporation sell all of their assets, but the shareholders' assets won’t be at risk. Now, the court can’t force a shareholder to sell their shares, but the value of your shares would have probably fallen.
*Keep in mind: If you own 33% of the shares of a company, then you don't own ⅓ of that company, you own ⅓ of the company shares. This is known as the “separation of ownership and control”
Owning stock gives you the right to vote in shareholder meetings, receive dividends if and when they are distributed, and the right to sell your shares to somebody else.
Now, let’s get into the two different kinds of stocks: Common and preferred
Common stocks: entitles owners to vote at shareholders meeting and to receive any dividends paid out by the corporation
Preferred stocks: don’t have voting rights, but have a higher claim on assets and earnings as opposed to common shareholders (ie. if a company goes bankrupt and is liquidated, owners of a preferred stock will have priority)
As discussed, stocks are issued by companies in order to raise capital to grow/fund the business. The corporation issues these shares in return for money. Bonds vary from stocks, as bonds are creditors to the corporation that issues these stocks. They are responsible for paying both the interest, and the repayment of the principal invested.
These bondholders are then given legal priority if a company went bankrupt. Stockholders, on the other hand, don’t receive anything in the event of a bankruptcy, so holding bonds is typically less risky than holding stocks.
Now, let’s talk about what we all want to know how to do, MAKE MONEY!
First, let’s trace back to our dividends. We’ve established dividends are simply cash distributions of a company’s profits. For example, if a company has 1000 shares, declaring a $5000 dividend, then stockholders will get $5 for each share they own. Another way to make money is a concept called capital appreciation, which is just the increase in the share price. If you sell a share for $10, and the stock is later worth $11, then the shareholder has made $1.
All investments come with a certain degree of risk, but historically, owning a stock has proved to outperform other investments in the long run.