How stocks are working

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. Assets
include 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
as equity 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.
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.

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.
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.

A Stock Exchange

The New York Stock Exchange in New York City.

The New York Stock Exchange in New York City.

SPENCER PLATT/GETTY IMAGES

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.

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 a
corporation 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 a sole 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 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

General Motors (GM) holds its annual shareholders' meeting in Detroit in June 2011.

General Motors (GM) holds its annual shareholders' meeting in Detroit in June 2011.

DAN AKERSON/GETTY IMAGES

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 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 on
free 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 much riskier 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.

Stock Averages and Brokers

A trader at the Chicago Board of Trade watches as the Dow Jones Industrial Average, S&P 500 and
NASDAQ Composite Index all fall upon news of soaring gas prices in July 2008.

A trader at the Chicago Board of Trade watches as the Dow Jones Industrial Average, S&P 500 and
NASDAQ Composite Index all fall upon news of soaring gas prices in July 2008.

SCOTT OLSON/GETTY IMAGES

What are those mysterious numbers called the Dow Jones Industrial Average, the S&P 500 and the
NASDAQ Composite Index that are always reported on the evening news? These aren't individual stock
prices, but broad market averages designed to give you a general idea of how companies traded on the
stock market are doing. The Dow Jones Industrial Average is the sum of the value of 30 large American
stocks -- think General Motors, Goodyear or Exxon-Mobil --divided by the number of companies plus any
stock splits. The S&P 500 is the average value of 500 of these large companies. The NASDAQ Composite
is the average of all stocks listed on the NASDAQ exchange (more than 2,800) and includes both
domestic and global companies.

What these averages tell you is the general health of stock prices as a whole. If the economy is doing
well, then the prices of stocks tend to rise en masse in what is known as a bull market. If it's doing
poorly, prices as a group tend to fall in what is called a bear market. A bear market is generally defined
as a sustained decline of more than 20 percent of the Dow Jones Industrial Average [source: CNN
Money].

As an investor, you have several options for buying or selling stock. There are dozens of companies that
are authorized to trade with the major U.S. stock exchanges and even foreign exchanges like the Tokyo
or London Stock Exchanges. If you call an investment house like Merrill Lynch, Charles Schwab or
Morgan Stanley, they'll connect you to a stockbroker who can make your trades for a fee.
As with many other industries, the Internet has revolutionized stock trading, giving anyone with an
online trading account the power to execute their own stock purchases and sales for as low as $7 a
trade.

Stocks that aren't listed on an exchange are sold Over the Counter (OTC). OTC stocks are generally in
smaller, riskier companies. Usually, an OTC stock is stock in a company that doesn't meet the
requirements of an exchange.