What is a Stock?

September 07, 2018

Alan and Jason and I are often asked for our thoughts on “The Market.”  Do you think The Market is too high?  Do you think The Market will crash?  Where will The Market go from here?  I’m sure all financial professionals are asked similar questions all the time.  It is certainly understandable – the media refers to The Market as if it were a sentient being.  This is misleading.  The stock market isn’t a single thing.  It is a collection of thousands of stocks that represent ownership in very real businesses. 

More and more, stock ownership is an abstract concept.  In a 401(k) or mutual fund or ETF there are many layers between the investor and the company in which the investor owns shares.  In the past, stock ownership was represented by a certificate, a tangible symbol.  Today, stock certificates are uncommon.  Ownership is represented by some ones and zeroes on a distant computer and the only tangible evidence an investor has is the occasional statement.  Nevertheless, when you own a share of stock, you own a piece of a business, entitling you to a proportional share of earnings and proportional voice in how the company is managed. 

Today, most publicly traded companies issue millions, or even billions, of shares of stock, so each share represents a very small percentage of ownership.  To understand the concept, consider a business with two owners, each holding 50% of the company.  Obviously, each owner would have a say in how the company is managed, and they would split the profits between them.  Publicly traded stocks work the same way, except the owners number in the thousands, and the percentage owned is tiny.

When a company issues stock, it is selling shares of ownership.  In turn, the company uses the money raised to expand and grow the business.  Most companies don’t sell stock to the public as their first method of funding their business.  Start-ups are typically funded by the founder’s personal funds, friends and family, bank loans, and/or venture capital before they access the equity markets.  Issuing stock to the public is a very complicated process, requiring specialized lawyers, investment bankers, and accountants.  Documents must be submitted to the Securities and Exchange Commission and other regulators before shares may be issued, and companies must make ongoing disclosures to the regulators as well. 

Once the company receives all the needed approvals, and the stock is issued, it can begin to trade on an exchange.  The exchange facilitates buying and selling between third parties.  This is where things start to get murky.  The prices of stocks on the exchange are determined by bids and asks, in other word, stocks change hands when the price someone is willing to pay for a stock meets the price at which someone is willing to sell that stock.  As a result, stock prices can fluctuate wildly for any reason or no reason at all simply based on investor psychology.  In the long run, however, the price will likely reflect the true value of the business, so well-managed, profitable businesses are likely to do well. 

When people talk about The Market, they are often referring to stock indexes like the Dow Jones Industrial Average or the S&P 500 Index.  A stock market index is a collection of stocks designed to reflect the performance of the overall market.  The Dow Jones Industrial average uses only 30 stocks to do this.  The S&P 500 uses 500.  For the most part, they do an adequate job of reflecting the overall market.  However, individual stocks can and will vary in their performance compared to the indexes.  Economic scenarios that are good for one company or industry may be terrible for another, so the performance of some stocks will diverge from the performance of the index.  Blunders by management may cause a stock to fall even as indexes rise just as shrewd moves by management may have the opposite effect.

For more information, you can listen to the podcast of Smart Money Management radio show on this topic, along with others, at www.alderferbergen.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 

Stock investing involves risk including loss of principal.

Securities and financial planning offered through LPL Financial, a registered investment advisor.  Member FINRA/SIPC