Finance Basics

Stocks 101


Before exploring stocks bonds and mutual funds we must first understand the concept of a “corporation.” A corporation is a legal entity that is somewhat like a person. A corporation can own things like buildings, desks, chairs and computers. It can hire and fire employees. They pay taxes. They can borrow money. Corporations are owned by individuals (and other corporations) who are called “stockholders.” The corporation is a separate entity from its stockholder so for example if a corporation borrows money only the corporation is at risk if it cannot pay the money back. By the same logic, if a corporation makes money, the money belings to the corporation not the stock holders – unless it decides to share some in the form of dividends.

At some initial point, a corporation sells stock to raise money. In return for buying stock, stockholders get to elect the board of directors who in turn hire the chief executive officer, set major policy, etc. If the company pays a portion of profits as a dividend, the stockholders enjoy that financial benefit. Stockowners wishing to sell their stock contact a “broker” who sells their stock at a  “stock market.” For performing this function, a broker charges a commission. The stock market is a place (physical or electronic) that brings together buyers and sellers. In a market, the laws of supply and demand determine the price. In theory, if a company does well, there should be greater demand for its stock and the price should go up while a company that is not doing well should see demand for its stock decrease. The reality is more complicated. At times, the price of a wide group of stocks can be adversely affected by factors other than the performance of the individual companies. Things that can affect stock prices include the concerns about the economy (e.g. employment data), changes in tax laws, inflation projections as well as intangibles such as “investor confidence.” Investor confidence is the belief that something good or bad will happen in the near future that causes investors to act.  

Why should we invest in stocks? Historically, over the long term, stocks offer the greatest reward to investors. Over the past 90 years, the stock market has averaged ~ 9.7% return; however, with great reward comes great risk. For example, if you invested money in the stock market January 1 2003 you would have experienced mind boggling returns of 23% over the course of the next 12 months; however, if instead you invested on January 1 2008, you would have experienced a staggering 37% loss over the next 12 months. Day to day and year-to-year variability can be nerve wracking; however, historically, the stock market has been the most productive long-term investment.

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