Basic Concepts of Investing with Stocks

What is a Stock?

When a company needs to raise capital, it has two choices: 1) Borrow the money, or 2) Sell a stake in the company (shares of stock). A stock is much more than a name, and symbol, that shows up on your brokerage statement each month. It represents ownership in a company. When you own a share of stock in a company, you own a portion (however small that may be) of the profits generated each time that company sells one of its products or services.

Your stock can be registered in one of two ways: 1) Certificate form (stock certificate will be mailed to you in your name), or 2) Street name (the name of your brokerage company). Most stock is held in Street name.

Try to think of yourself as an owner rather than just a stockholder. Browse through the company’s annual report, keep up with news related to the company and be sure you understand what the company does. This thought process will make stock ownership more exciting and much more educational.

How Stock Markets Work

The importance of stock markets to the American way of life cannot be overstated. These markets facilitate the buying and selling of stocks issued by corporations – both large and small. The most well-known stock markets in the U.S. are the New York Stock Exchange (NYSE), also known as “The Big Board”, and the NASDAQ.

Before we discuss how these markets work, it’s important to understand why stock markets are so important to the normal functioning of business. Via primary market activities and secondary market activities, stock markets make it possible for corporations to raise capital to operate, or expand their businesses.

Primary Market

The primary market is a term that encompasses a corporation’s very first issuance of its stock for sale to the public. This process is referred to as an initial public offering (IPO). When a corporation needs to raise capital to invest in its business, it will approach an investment bank such as Goldman Sachs or J.P. Morgan. These investment banks act as financial intermediaries between the corporation and, typically, large institutional investors. Essentially, the investment bank’s job is to move capital, or money, from those who have it to invest to those that need it. The primary market is where the proceeds from the sale of stock go directly to the corporation selling the stock.

If you are the average, individual investor it is unlikely that you have participated in the primary market. IPOs are generally distributed to large institutional clients of the investment banks. These clients can include mutual fund companies, private equity funds and hedge funds among others. Small investors typically participate in secondary market activities only.

Secondary Market

The primary market would not work very well if it were not for the secondary market. The secondary market provides liquidity --- or a way to buy and sell --- for a corporation’s stock. For instance, it’s quite easy these days to go online and buy or sell your shares of Disney or any other common stock that you might own. That is because the NYSE, NASDAQ and other exchanges provide a great deal of liquidity for the publicly traded stocks of corporations. On the other hand, it would be much more difficult for you to try and sell a fine piece of artwork or a family heirloom. Why? Because the number of interested buyers for those items is likely to be small, thus there isn’t much liquidity.

When you buy and sell shares of stock through your broker, you are participating in the secondary market and the proceeds from the sale of the stock go to you, not the corporation.

Anatomy of a Stock Trade

  1. Jen decides that she wants to buy 100 shares of Disney (DIS) stock and calls her stockbroker to place the order.
  2. Her broker looks up the most recent stock quote (or price) for Disney’s stock via an electronic market data system. In this case, the quotes would be provided by the NYSE over high-speed data lines.
  3. Jen’s broker then sends the order to the floor of the NYSE. Orders can be sent to the floor in two ways: 1) electronically to a booth on the perimeter of the exchange floor, or 2) touch screen order management system.
  4. A Floor Broker is given the order in printed form or via a wireless data and voice terminal.
  5. The Floor Broker competes with other buyers and sellers of Disney stock in an effort to get the best price for Jen.
  6. After the transaction is executed, the specialist (essentially a referee) for Disney’s stock sends notice of the transaction to Jen’s broker, as well as the seller’s broker.
  7. The transaction is reported by computer and appears on the consolidated tape within seconds.

The settlement process for this trade will take three days. After which, Jen will be the registered owner of the Disney stock and the seller will be provided with a payment from Jen’s account.

The following video, while dated, is interesting and visually illustrates what was explained above.