The Stock Market Game
The beginning investor will usually enter the stock market through a stock mutual fund because of the added safety. But before sticking even a toe in the often cold and cruel Wall Street waters, the novices should learn a few of basic mechanics of the market.
When someone buys stock in a company, they buy a piece of that company. It’s not possible to buy shares of just any company. It has to be a “publicly traded company” or “stock company.” That means the company at some time in the past sold shares to the public.
The company raised money by issuing those shares. If it issued 1 million shares at $10 a share, then it raised $10 million, less any costs involved in the issuing process.
The stock first issued by the company is sold in the “primary market.” That means the money paid for those shares goes directly to the company. However, by far the most activity takes place in the “secondary market.” In that market, investors trade the shares between one another – hoping the price will rise so money can be made – and the company gets no direct benefits from such trading.
The investor should understand that the stock market presents an added risk not faced in other investments such as bank certificates of deposit and money market mutual funds. In a stock, the investor puts his “principal at risk.” That means that part or all of the money spent to buy stock can be lost.
If you put $1,000 in a bank or money fund, chances are good your original $1,000 plus interest will be there the next month, the next year or 10 years from now. But if you spend $1,000 to buy 100 shares of a $10 stock, you might find the price dropping to $9 a share the next day, which means you have lost $100 overnight and your “equity” (value of your shares) is now $900 instead of $1,000. That’s called “loss of principal.”
Of course, that $100 loss is only a ‘paper loss” until you actually sell your shares. You hope the price will eventually rise above $10 a share, so that you have a “paper gain.” Another name for paper gains and losses are “unrealized” gains and losses. Actual gains or losses resulting from the sale of the stock are called “realized” gains and losses.
What drives prices up or down? The mechanism that drives the market is anxiety. When the buyer of a stock is more anxious than the seller, then the price is likely to go up. That’s because the buyer is more willing to meet the seller’s price while the seller is trying to get as high a price as he can. When the seller is more anxious than the buyer then the price of the stock is likely to drop.
Many factors contribute to market anxiety. I won’t get into market analysis today, but if a company is earning a good profit, people will generally want to buy its shares. If its earnings are failing, then people will want to sell their shares. So, for the most part, the stock of profitable companies rises and the stock of unprofitable companies falls. But keep in mind it’s not quite that simple – many more factors come into play.
Stock market prices are controlled less by individual investors than by “institutional investors.” These are mutual funds, pension funds, insurance companies, bank trust departments and university endowment funds that buy and sell stock in large quantities – often blocks of shares worth millions of dollars. They can have great influence on prices and the general direction of the market through their trading strategies.
Quite often the market will drop after a sharp rise. This often is caused by “profit-takers,” generally institutional investors who want to make a quick return to enrich their clients and keep them happy. So they take their money and run on some of their stock holdings.
Individual investors can take some tips from institutional investors. It’s often quite difficult for an individual investor – particularly an inexperienced one – to take two important steps: sell to take profits, and sell to cut losses.
Selling to take profits or losses is difficult because one can’t always be sure that the stock price is not going to rise after the stock is sold. In either case, remorse can be the result. But there is one key lesson to learn in the stock market: never look back.
Answer the following questions:
1. What is the benefit of a mutual fund compared to individual stocks?
2. Why do companies issue shares to the public?
3. What’s the difference between the “primary market” and the “secondary market”?
4. What are “realized” vs. “unrealized” gains and losses?
5. According to the author, what drives stock prices? How does that work?
6. What groups have a large influence on stock prices? Why?
7. Why do “profit-takers” sometimes cause the stock market to go down temporarily?