Basic Finance Bootcamp Lesson #2: Introduction to the Stock Market
Today we continue with our basic finance bootcamp. Remember that the purpose of this boot camp is to get everyone caught up to speed on basic financial terminology, etc.so we all speak the same language for our more sophisticated posts/discussions. If I miss something you would like to know about in this bootcamp, please let me know. So, without further ado, let’s get into the meat of this stuff and start with an introduction to the stock market.
When many people think about the world of investments, the term “stock market” comes to mind. But what, exactly, is a stock? A stock designates an ownership interest (or equity interest) in a company. When a company needs more money—often to support growth–than its founders are able to raise personally, it might do what is called an initial public offering, or IPO, and sell shares of what is referred to more specifically as its common stock to the public, i.e., individual investors and institutional investors, such as pension funds, insurance companies, and mutual funds.
The primary and secondary markets
The firm receives the cash it needs, and the investors are now part owners of the firm, based on the percentage of the total shares they hold. When these new securities are sold to the public, it is referred to as a primary market transaction. Only institutional investors and the most well-connected and wealthy individual investors usually get to be players in IPOs. Fortunately for the rest of us, after the IPO takes place, these original investors are willing to sell part of their stock to other investors in what is called the secondary market. The secondary market refers to the market in which investors buy and sell the stock from each other. The New York Stock Exchange (NYSE) is probably one of the best known physical arenas for secondary market transactions although most trading takes place via computer networks nowadays.
In contrast to primary market transactions, when you purchase shares in the secondary market, the investor who is selling the shares receives the money you pay, not the corporation whose shares you’re purchasing. Nevertheless, the corporation itself would like its shares to sell at the highest price possible in the secondary market. This makes it easier to raise money in the future. Too, the company’s founders and other members of its management team are usually stockholders themselves. As with most things, the price that the shares sell for is set by supply and demand. If investors expect the company to do well, they will want to become part owners of the company, and this will drive the price of the stock up; if a company is thought to be having some difficulties, the price will fall.
Let’s suppose you think Abbott Laboratories (ABT) is a good company and would like to become a part owner (shareholder) in it so that you can share in the profits. Before you can do so, you need to establish an account with a brokerage firm. This basically entails filling out the necessary paperwork and making an initial deposit into your newly created account. Once you’ve done this, you can simply contact your broker—by phone or online—and place an order to buy however many shares of ABT you want. Much like a real estate broker, your stock broker serves as the middleman in the transaction.
The standard order size is in round lots. For most stocks, a round lot refers to 100 shares, but you can place an order to buy 60 shares, 110 shares, 215 shares, or any number you wish. Theoretically, you can even buy just 1 share, although this would not be cost effective since the commission you pay to buy a single share would be a high percentage of your investment. For illustration purposes, let’s assume you decide to purchase 100 shares of ABT and that you enter it with your broker as a market order, which simply means you will buy it at the prevailing price. (We’ll provide a detailed discussion of other types of orders you can place in another blog post.)
Abbott Laboratories’ stock sells on the New York Stock Exchange, so your broker’s representative will send the order electronically to the NYSE where it will be matched with another investor’s sell order and executed. You will receive confirmation of your purchase and the price at which you purchased the stock within seconds. Of course, you can check beforehand to find out the approximate price of the stock before you place your order to buy it, but the prices of actively traded stocks like ABT are continuously changing. They change in small increments, however, so you needn’t worry that you’ll be paying much more than a few cents a share more for the stock when your order gets executed—and you may even buy it for pennies less.
Now that you have purchased 100 shares of ABT—let’s say for $33.33 a share—you are an owner of the company—a very tiny owner, given that ABT has over 1.5 billion shares outstanding. Typically, your actual shares of the stock are held in street name, which means that they are registered in your broker’s name, and your broker records your ownership of 100 shares of ABT in your account.
You can, however, request that you be the registered owner, in which case the shares themselves will be transferred into your name. Although there are circumstances under which you might want to do this, leaving the shares in street name is the most convenient thing to do. Your broker will provide you with regular statements regarding your holdings, sweep any dividend income you receive from your stock investments into an account that pays a minimal amount of interest, and forward any information it receives about the company to you.
And, if and when you choose to sell some or all of your 100 shares of ABT, you can simply contact your broker and place a sell order. If the shares are registered in your name, you will need to transfer them to your broker before the sale can be executed.
As with any real (as opposed to financial) asset in which you might invest, your wealth will increase if ABT does well, but you also stand to lose money—even the entire $3,333 plus commissions that you paid to buy the stock—if the firm does poorly. Let’s be optimistic and assume that Abbott Labs produces solid profits and is expected to continue to do well. Others will want to buy it, and its stock price will rise. Let’s say it increases to $36 a share within the next 6 months. You could choose to sell your shares at that point and pocket your profit of $267 (along with any dividend payments you’ve received) if you wish. Or you may decide to continue holding the stock if you think its future potential is good.
Which brings up another point. As a stockholder of the firm, you have the right to receive dividend payments based on your percentage ownership of the outstanding shares of the corporation if Abbott’s board of directors declares dividends. Not all firms pay common stock dividends, and dividends are not a legal obligation of the firm. As it happens, ABT does pay common stock dividends; it currently pays an annual dividend of $0.52 per share.
Dividends are paid quarterly, as is the case with most firms, which means that unless the dividend amount changes, your first dividend check will be for $13. As mentioned previously, unless you’ve indicated otherwise, this will be deposited into your sweep account at your brokerage firm. This account functions like a savings account, and you can withdraw the cash, along with any interest earned on it, at any time.
So, what kind of return can you expect to earn from your investment in 100 shares of ABT? Your annual return will be in the form of the dividend payments you receive and the stock price appreciation/depreciation that occurs during the year. So, for illustration purposes, if you receive $52 in dividends during the year and the stock price of ABT has risen to, say, $38 by the end of the year, you will have made $52 (dividends) + $467 (capital gains). Ignoring commissions, this translates to a return on your original investment of $3,333 of 15.6%. If you invest in a firm that does not pay dividends, the return on your investment will depend solely on the increase in the price of your stock (or lack thereof).
As a common stockholder of ABT, you also have a residual right. This is the right to receive a proportionate share of the firm’s assets after all other claims have been paid in the event ABT goes bankrupt or is otherwise liquidated. The amount you’ll receive when a firm declares bankruptcy is usually zilch, however.
Another major right of common shareholders is the right to vote. You can elect the members of the board of directors of the firm and vote on a number of other items, such as a potential merger agreement, a proposal submitted by another shareholder, or an amendment to the articles of incorporation, including whether or not additional shares can be authorized. Authorized shares are the maximum number of shares that can be sold.
Unless you have requested otherwise, if your shares of ABT are held in street name, your broker will forward shareholder meeting notifications to you, as well as Abbott Laboratories’ proxy statement, which provides details on the individuals seeking a seat on Abbott’s board of directors and any other matters that require a shareholder vote.
Usually 1 share = 1 vote, although many firms allow cumulative voting for the board of director seats, which means you could cast all your 100 votes for one individual if you wish. You needn’t attend a shareholder meeting to vote. A proxy card is included with the proxy statement. This is essentially a ballot that you fill out and submit. Many shareholders don’t want to take the time to read the proxy statement and vote, so this material often finds itself in the cylindrical file (aka trash can). The choice is yours.
So, that’s it for today’s bootcamp lesson. Hopefully this was useful to some of you. Tomorrow, we will talk about a special class of stocks known as preferred stocks. Sound exciting? Well, it’s not that exciting, but it is important to know about. Please leave me your feedback and share this article with others if you thought it was useful.