I’m no business magnate, and I’m not wealthy by American standards. But I am an investor — I use some of my money to help earn more money for my future — and many of my investments are in the stock market. And I’m not alone: Millions of Americans invest money for the future, and most of those invest some of their money in stocks. In fact, the stock market has been one of the best vehicles for long-term investment in history.
You’ve certainly heard of stocks and the stock market before, but you may not know a lot about them. Don’t feel bad — the stock market is an incredibly complex place, and there are thousands of professionals who spend their entire careers trying to master its intricacies. You don’t need to become an expert on stocks to know how to make them a part of a successful investment plan, but it would be a great idea to learn about the basics of how they work.
In our last article, we talked about how investing is basically giving your money to business people to help them grow their businesses, with the idea that you can share their profits in exchange for your investment. That’s a pretty informal explanation; the stock market simply formalizes this practice into a system that’s transparent, fair and accessible to everyone.
So how does it work? Well, basically there are two types of companies in this world, private companies and public companies. The words “private” and “public” refers to who owns the companies. Most of the small local organizations that you do business with every day are privately owned companies. The dry cleaner, the doctor’s office and car wash are owned by an individual, a family or a group of partners. That means that those people assume all the risk for their businesses. But when the businesses succeed, they reap all of the profits. Some bigger companies are privately held, too (Chick Fil A is a good example). Even though they are national businesses, they are still owned by a small group of individuals.
Public companies, on the other hand, are mostly large organizations that need a lot of cash to run their large-scale operations. So the owners of these companies have decided to sell portions of their businesses to the general public as a way to raise the money they need. These portions are divided into “shares” or “stocks” that anyone in the public can purchase. A single share usually represents a very tiny percentage of the company (many companies issue hundreds of millions of public stocks). The places where you buy these shares are called “stock exchanges.” Collectively, this system of companies and exchanges is known as the “stock market.”
So why would you buy a stock? If you think that a certain company has a bright future ahead of it, you might want to own a portion of that company, so that you’ll get paid a portion of their earnings (this is called a “dividend”). But dividends aren’t the biggest reason to buy stocks (and not all stocks pay dividends). As a company succeeds and grows, it becomes more attractive to more investors. But since there’s a finite number of shares available, if those investors want to buy a piece of that company, they’re going to have to buy shares from someone who already has them. This creates a supply-and-demand system: The higher the demand is for a stock, the more the investor will be willing to pay for it. So if you’ve bought shares of a company, and it has had great success, you can turn around and sell those shares to another investor for a lot more than you paid for them. And that’s how you make real money in the stock market.
Let’s look at a famous example. Back in 2001, Apple Computer’s stocks were selling for about $9. But the last decade has brought s huge string of successes for Apple, and today the price of that stock is $560. That means that if you bought $100 worth of Apple stock in 2001, that piece of the company would be worth $6,222. That’s a very, very good return on your investment.
As you can see, the stock market presents enormous opportunities for great gains. But for every company like Apple, there are dozens of companies whose stock prices fall over time. That means that there’s just as much opportunity to lose money in the stock market as there is to make money. Sometimes stock prices fall because a company is failing. Sometimes, they fall just because the worldwide community of investors is getting nervous about something — even though a particular company might be healthy, nervous investors have a tendency to drive prices down across the board.
So what should you make of all of this? Well, the first lesson is that if you plan to invest, you need to be investing some of your money in stocks. But the second lesson is that you probably don’t have the knowledge to do that alone. After all, how are you going to determine the difference between a stock that will be a big winner and a big loser? Unless you’re highly trained, you probably can’t. So you need to have highly trained investment professionals helping you to make those decisions.
The third lesson is that you need to invest for the long-term. Some people try to make quick profits on the small fluctuations of stock prices that happen every day (they’re often called “day traders”), but those folks very often lose everything they have in the process. The volatility of the market and the fickle nature of investor confidence can cause a dip down at any point, and if you’re playing a short-term game, that negative dip can wipe you out. But over the long term, the fundamentals of the market win out over the volatile days. Over 10, 20, 30 or 50 years, strong companies are going to perform well, and the value of their stocks is going to grow. If you invest for long-term growth, you can ride out those temporary bumps with confidence, knowing that wise investment in solid companies will win out in the end.
Of course, there’s much, much more to the stock market than these basics. In coming articles, we’ll introduce you to some of the best ways to make stocks and other forms of investment work well for you.
Photo by Dennis Crowly. Used under Creative Commons License.