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http://money.howstuffworks.com/personal-finance/financial-planning/stocks.htm
For a new investor, the stock market can feel a lot like legalized gambling. "Ladies and gentlemen, place your bets! Randomly choose a stock based on gut instinct and water cooler chatter! If the price of your stock goes up -- and who knows why? -- you win! If it drops, you lose!" Isn't that why so many people got rich during the dot-com boom -- and why so many people lost their shirts (not to mention their retirement savings) in the recent recession? Not exactly. But unfortunately, that's how many new investors think of the stock market -- as a short-term investment vehicle that either brings huge monetary gains or devastating losses. With that attitude, the stock market is as reliable a form of investment as a game of roulette. But the more you learn about stocks, and the more you understand the true nature of stock market investment, the better and smarter you'll manage your money. The stock market can be intimidating, but a little information can help ease your fears. Let's start with some basic definitions. A share of stock is literally a share in the ownership of a company. When you buy a share of stock, you're entitled to a small fraction of the assets and earnings of that company. Assetsinclude everything the company owns (buildings, equipment, trademarks), and earnings are all of the money the company brings in from selling its products and services. Why would a company want to share its assets and earnings with the general public? Because it needs the money, of course. Companies only have two ways to raise money to cover start-up costs or expand the business: It can either borrow money (a process known as debt financing) or sell stock (also known asequity financing). The disadvantage of borrowing money is that the company has to pay back the loan with interest. By selling stock, however, the company gets money with fewer strings attached. There is no interest to pay and no requirement to even pay the money back at all. Even better, equity financing distributes the risk of doing business among a large pool of investors (stockholders). If the company fails, the founders don't lose all of their money; they lose several thousand smaller chunks of other people's money. Perhaps the best way to explain how stocks and the stock market work is to use an example. For the remainder of this article, we'll use a hypothetical pizza business to help explain the basic principles behind issuing and buying stock. We'll start on the next page with the reasons why a restaurant owner would issue stock to the public.
PAYING DIVIDENDS The interesting thing about issuing stock is that even if the company is profitable, shareholders won't necessarily receive a check in the mail each year with their cut of the loot. Only a few companies, usually long-established firms, hand out annual profit shares called dividends. Most new companies are considered growth stocks, meaning that the company reinvests all profit to fuel growth and expansion.
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In the case of growth stocks, the investment only increases in value as the stock price rises. And stock prices only rise if more people are interested in buying shares in the company.
Selling Shares
Let's say that you've always dreamed of opening a pizzeria. You love pizza, and you've done your homework to figure out how much it would cost to launch a new pizza business and how much money you could expect to earn each year in profit. The building and equipment would cost $500,000 up front, and annual expenses (ingredients, employee salaries, utilities) would cost an additional $250,000. With annual earnings of $325,000, you expect to make a $75,000 profit each year. Not bad. The only problem is that you don't have $750,000 (building + equipment + expenses) in cash to cover all of those costs. You could take out a loan, but that accrues interest. What about finding investors who would give you money in exchange for a share of the ownership of the restaurant? This is the logic that companies use when they make the decision to issue stock to private or public investors. They believe that the company will be profitable enough that investors will see a good return. In this case, if investors paid a total of $750,000 for shares in the pizza restaurant, they could expect to earn $75,000 annually. That's a solid 10 percent return. As the owner of the pizza restaurant, you can set the initial price of the company, as well as the total number of shares of stock you want to sell. Interestingly, the price of the pizza business doesn't have to correlate with the actual value of the assets or the company's current profitability. You can set the price so that it reflects the future value of the investment. For example, if you set the price at $750,000, investors could expect a 10 percent return. If you set the price at twice that much, $1,500,000, investors would still get a respectable 5 percent return. If you issue a lot of shares, that would lower the price of each individual share, perhaps making the stock more attractive to lone investors. Another consideration is ownership. Each person who buys a share of stock essentially owns a piece of the company and has a say in how the company is run. We'll talk more about shareholders in a later section. But for now, it's important to understand that, as the owner, you may wish to buy a majority of the available shares yourself so that you remain in majority control of the company. We'll talk more about stock prices later. In the meantime, let's talk about stock exchanges -the clearinghouses where the world's biggest companies sell shares by the millions each day.
A Stock Exchange
Let's get back to our pizzeria example. If you want to launch one and are interested in recruiting a pool of investors, where would you find these people? You could place an ad in the paper or online, or you could simply contact friends and family. But what if some of your initial investors decide a year later that they want to sell their shares? They would each have to go out and find a new buyer, which might prove difficult, especially if the company isn't performing very well.
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A stock market solves this problem. Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange). The New York Stock Exchange (NYSE) is an example of such a market. In your neighborhood, you have a "supermarket" that sells food. The reason you go the supermarket is because you can go to one place and buy all of the different types of food that you need in one stop -- it's a lot more convenient than driving around to the butcher, the dairy farmer and the baker. The NYSE is a supermarket for stocks. The NYSE can be thought of as a big room where everyone who wants to buy and sell shares of stocks can go to buy and sell. Modern stock exchanges make buying and selling easy. You don't have to actually travel to New York to visit the New York Stock Exchange. You can call a stock broker who does business with the NYSE, or you can buy and sell stocks online for a small fee. There are three big stock exchanges in the United States: NYSE - New York Stock Exchange AMEX - American Stock Exchange NASDAQ - National Association of Securities Dealers If these exchanges didn't exist, buying or selling stock would be a lot harder. You'd have to place a classified ad in the newspaper, wait for a call and haggle on a price whenever you wanted to sell stock. With an exchange in place, you can buy and sell shares instantly. Stock exchanges have an interesting side effect. Because all the buying and selling is concentrated in one place, and since it's all done electronically, we can track the constantly fluctuating price of a stock in real time. Investors can watch, for example, how a stock's price reacts to news from the company, media reports, national economic news and lots of other factors. For example, all publicly traded companies need to issue quarterly earnings reports through the Securities and Exchange Commission (SEC). If those earnings are lackluster, shareholders might decide to sell some of their stock, which would lower the stock price. But if the newspaper reports an overall increase in the popularity of pizza, more people might buy shares and the price would go back up. But before we delve too deeply into the intricacies of stock prices, let's talk about corporations. Even if you own your own pizza business, you can't sell stock in the company unless you become a corporation. We'll discuss that on the next page.
Corporations
Any business that wants to sell shares of stock to private or public investors needs to become acorporation first. The legal process of turning a business into a corporation is called incorporation. If you start your pizzeria with your own money (even if it's borrowed from the bank), then you've formed asole proprietorship. You own the entire restaurant yourself, you get to make all of the decisions, and you keep all of the profits. If three people pool their money together
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and start a restaurant as a team, then they've formed a partnership. The three people own the restaurant themselves, sharing the profit and decision-making. A corporation is different, and it's a pretty interesting concept. A corporation is a "virtual person." That is, a corporation is registered with the government, has its own Social Security number (called a federal tax ID number), can own property, sue and make contracts. (It can also be sued.) By definition, a corporation has stock that can be bought and sold; all of the owners of the corporation hold shares of stock in the corporation to represent their ownership. One characteristic of this "virtual person" is that it has an indefinite and potentially infinite life span. There is a whole body of law that controls corporations. These laws are in place to dictate how a corporation operates, how it's organized, and how shareholders and the public get protection. For example, every corporation must have a board of directors. The shareholders in the company meet every year to vote on the people who will "sit" on the board. The board of directors makes the decisions for the company. It hires the officers (the president and other major officers of the company), makes the company's decisions and sets the company's policies. Consider the board of directors as the virtual person's brain: Even if a corporation has a single employee who also owns all of the stock in the corporation, it still has to have a board of directors. Another reason that corporations exist is to limit the liability of the owners to some extent. If the corporation gets sued, it's the corporation that pays the settlement. The corporation may go out of business, but that's the worst that can happen. If you're a sole proprietor who owns a restaurant, and the restaurant gets sued, you're the one being sued. "You" and "the restaurant" are the same thing. If you lose the suit, then you can lose everything you own in the process. Let's talk more about the relationship between shareholders and corporations in the next section.
Shareholders
Shareholders are the people who own shares of stock in a company. Collectively, the shareholders are the owners of the company, since each share of stock entitles the owner to a say in how the corporation is run. Shareholders elect a board of directors to make the company's major decisions, such as the number of shares to be issued to the public. Interestingly, not all corporations decide to have public shareholders. Corporations can choose to be privately or publicly held. In a privately held company, the shares of stock are all owned by a small group of people who know one another. They buy and sell their shares amongst themselves. A publicly held company is owned by thousands of people who trade their shares on a public stock exchange. Trying to please thousands of anonymous shareholders is a difficult task for any corporation. So why do they do it? The main reason that companies choose to issue stock to the public is to raise a large quantity of investment capital quickly through an initial public
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offering (IPO). The corporation might sell one million shares of stock at $20 a share to raise $20 million in a short amount of time (that's a simplification, however -- the brokerage house in charge of the IPO will extract its fee from the $20 million). The company then invests the $20 million in equipment and employees. But what do the shareholders get out the relationship? If the corporation chooses to pay an annual dividend, then shareholders will receive a cut of the profits every year. Very few young companies issue dividends, however. They're more likely to issue growth stocks, in which all of the profits are reinvested. In this case, shareholders are banking on the fact that the right corporate management will help the company grow and generate even more profit. It's this potential for future success that will help determine the stock price on the open market. And if the shareholder holds onto a growth stock for long enough, he could eventually sell it for a significant gain. We'll take a closer look at the market forces behind stock prices in the next section.
Stock Prices
Stock prices aren't fixed. From the second a stock is sold to the public, its price will rise and fall based onfree market forces. It is these ever-shifting market forces that make short-term movements of the stock market so difficult to predict. And that is precisely the reason why short-term stock market investing is so risky. Market forces aren't a total mystery, though. We know, for example, that prices rise and fall primarily because of changes in supply and demand. In a free market system, the price of any commodity will rise as demand for it increases, as long as there's a fixed amount of the commodity in circulation. The same is true for stocks. If there are a fixed number of shares in circulation, then the price of the stock will rise as more people want to buy it, and fall as more people want to sell it. Beyond supply and demand, the logic behind stock prices gets a little fuzzy. Since supply of stock is generally fixed, the riddle is to figure out what influences demand. Why do people want to buy or sell a certain stock? Earnings and profit certainly play a large role. If your pizzeria posts record sales in the most recent quarter, then it will probably attract more investors, pushing up the stock price. But earnings only tell half the story. There is local and global competition to consider, the rising costs of pizza ingredients, the possible unionization of pizza delivery boys and more. Professional stock analysts and brokers (as well as amateur investors) try to take all of these factors into account when trying to predict the future movements of a stock's price. After all, it's the change in a stock's price over time that determines its ultimate value to shareholders. The key to investing is "buy low, sell high." You want to buy a stock at $2 a share and then sell it when it's $20 a share. The safest way to buy low and sell high is to invest in a slow growth stock -- usually an established company with a long track record of success like Coca-Cola or IBM -- and hold onto it for many years. This allows the stock price to weather short-term fluctuations, but average steady growth over time. A muchriskier
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investment strategy is to try to pick the "next big thing" and cash out quickly after the stock price skyrockets. The inherent risk of the stock market is that any number of forces -- logical or otherwise -- can push prices up or down. In recent years, we've witnessed the boom and consequent bust of two large stock market bubbles that formed around the Internet sector in the early 2000s and the housing market six years later. In both cases, commodities became overvalued, and investors poured money into unprofitable or unsustainable markets. When the truth came out, investors rushed to sell, sending stock prices through the floor. One way to safely invest in the stock market is to find a stockbroker who understands your investment strategy and trades accordingly. Learn more about stockbrokers and ways to measure market performance on the next page.
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For lots more information on stock, the stock market and related topics, see the links on the next page.
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Related Articles How Banks Work How the Fed Works How Recessions Work How 401(k) Plans Work How 529 Plans Work How Gas Prices Work How do stock options work? How Stock Market Trends Work Why does the stock market use fractions? If all the money in the U.S. only totals $6 trillion, how can the NY Stock Exchange have stocks valued at $15 trillion? How much money is "all the money in the world"? How does the Social Security system (in the U.S.) work? How Investment Scams Work How Money Market Accounts Work How Certified Financial Planners Work More Great Links U.S. Securities and Exchange Commission (SEC) NASDAQ New York Stock Exchange Understanding and Controlling Your Finances - introduction to personal finance Sources CNN Money. "What is a stock?" Money 101. http://money.cnn.com/magazines/moneymag/money101/lesson5/index2.htm Investopedia. "Stock Basics" http://www.investopedia.com/university/stocks/default.asp#axzz1QEz88Wh0
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being able to write checks and use debit cards rather than carrying cash? Any and all of these may be the answer, particularly with the conveniences of electronic banking today. Now, we don't even have to manually write that check -- we can just swipe a debit card or click the "pay" button on the bank's Web site. In this article, we'll look into the world of banking and see how these institutions work, what you would have to do to start your own bank, and why we should (or shouldn't) trust them with our hard earned cash.
What is a bank?
According to Britannica.com, a bank is: an institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid and charged, respectively. Banks are critical to our economy. The primary function of banks is to put their account holders' money to use by lending it out to others who can then use it to buy homes, businesses, send kids to college... When you deposit your money in the bank, your money goes into a big pool of money along with everyone else's, and your account is credited with the amount of your deposit. When you write checks or make withdrawals, that amount is deducted from your account balance. Interest you earn on your balance is also added to your account. Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it. In this way, money grows and flows throughout the community in a much greater amount than physically exists. That $100 makes a much larger ripple in the economy than you may realize!
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your money, you'll get it. However, if everyone goes to the bank at the same time and demands their money (a run on the bank), there might be problem. Even though the Federal Reserve Act requires that banks keep a certain percentage of their money inreserve, if everyone came to withdraw their money at the same time, there wouldn't be enough. In the event of a bank failure, your money is protected as long as the bank is insured by the Federal Deposit Insurance Corporation (FDIC). The key to the success of banking, however, still lies in the confidence that consumers have in the bank's ability to grow and protect their money. Because banks rely so heavily on consumer trust, and trust depends on the perception of integrity, the banking industry is highly regulated by thegovernment.
Types of Banks
There are several types of banking institutions, and initially they were quite distinct. Commercial bankswere originally set up to provide services for businesses. Now, most commercial banks offer accounts to everyone. Savings banks, savings and loans, cooperative banks and credit unions are actually classified as thrift institutions. Each originally concentrated on meeting specific needs of people who were not covered by commercial banks. Savings banks were originally founded in order to provide a place for lower-income workers to save their money. Savings and loan associations and cooperative banks were established during the 1800s to make it possible for factory workers and other lower-income workers to buy homes.Credit unions were usually started by people who shared a common bond, like working at the same company (usually a factory) or living in the same community. The credit union's main function was to provide emergency loans for people who couldn't get loans from traditional lenders. These loans might be for things like medical costs or home repairs. Now, even though there is still a differentiation between banks and thrifts, they offer many of the same services. Commercial banks can offer car loans, thrift institutions can make commercial loans, and credit unions offer mortgages!
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Loaning money is also inherently risky. A bank never really knows if it'll get that money back. Therefore, the riskier the loan the higher the interest rate the bank charges. While paying interest may not seem to be a great financial move in some respects, it really is a small price to pay for using someone else's money. Imagine having to save all of the money you needed in order to buy a house. We wouldn't be able to buy houses until we retired! Banks also charge fees for services like checking, ATM access and overdraft protection. Loans have their own set of fees that go along with them. Another source of income for banks is investments and securities.
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initial offering that shows their level of commitment and helps get the bank going. The required amount in Florida is 25 percent. In other states it may be as low as 10 percent to 15 percent of the total capital needed to start the bank. This group then becomes shareholders in the bank. In most cases, there is a limit of 24.9 percent to how much stock an individual or company may have, unless the company is a holding company.
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Before you actually file your application, it is recommended that you set up a pre-filing meeting with the state's department of finance and banking. This will help make sure that you have all of the information you need to file. Usually, the biggest delays come from incomplete background and/or financial information. Once you have all of the details ironed out, you fill out the charter application and submit it (along with a lot of other information) to the state's board of finance and banking -- or, if you're applying for a federal charter, you'll send it to the Office of the Comptroller of the Currency. Here is the list of items you have to include in Florida: The names and addresses of all of the organizers and the holding company (if there is one) The names of the proposed directors, the CEO, the senior loan officer and the cashier The name and address of the bank The number of shares, par value, and share prices for each share that will be sold The total amount of common stock, as well as surplus and reserves for operating expenses The number of shares of bank stock that each organizer plans to purchase Where the money for purchasing those shares is coming from Names and addresses of proposed investors who will own more than 10 percent of the bank's total stock A completed charter application (form DBF-C-10 in Florida) for each organizer, proposed director and principal stockholder, CEO, senior loan officer, cashier, and all other executive officers Pro forma financial statements An addendum to those financial statements that explains assumptions and strategies to achieve the projected market share for each type of product or service Assumptions used to calculate earnings Everyone involved in the purchase or lease of the proposed bank building Any business or personal affiliations between the bank property seller or lessor and any of the organizers, other bank officers, and shareholders who will own 10 percent or more of the bank stock Copies of location feasibility studies and local zoning laws Copies of results of any environmental tests conducted at the bank's location Projected organization costs (this includes filing and regulatory fees, professional and consulting fees, payroll and payroll taxes, rent, capital-raising costs, printing, postage, telephone and office supplies) Proposed salaries and benefits for bank officers Copies of any employment contracts that may be given to officers Copies of proposed bank policies And finally, your detailed business plan! As you can see, there is a lot of information that has to be gathered and submitted with your charter application. Leaving out any of this information, or having some of it incomplete, will
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slow down the review process considerably. There will also be a filing fee, which in Florida is $15,000. Most other states require a similar amount. If your application is deemed complete, then a decision will be given within 180 days. If your charter is granted, you will usually have up to one year to open your bank. In all states, you are required to apply for deposit insurance with the FDIC before you can accept deposits from the public.
Checking Accounts
Banks offer lots of financial products for their depositors. The checking account is one of the most common ones. It's convenient because it lets you buy things without having to worry about carrying the cash -- or using a credit card and paying its interest. While most checking accounts do not pay interest, some do -- these are referred to asnegotiable order of withdrawal(NOW) accounts. Some say that checks have been around since about 352 B.C. in the Roman Empire. It appears that checks really started becoming popular in Holland in the 1500 to 1600s. Dutch "cashiers" provided an alternative to keeping large amounts of cash at home and agreed to hold depositors' money for safekeeping. For a fee, they would pay the
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depositors' debts from the account based on a note that the depositor would write -- sounds a lot like a check! Today's banks do the same thing. It became a little more complicated when lots of banks became involved and money needed to be shifted from one bank to the next. To make things easier, banks now have a system of check "clearinghouses." Banks either send checks through the Federal Reserve or use a private clearinghouse to transfer the funds and clear the check. Here is a diagram of how that works.
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