Explaining Stocks

I write because it helps me to understand concepts.  I do think it's neat to have a blog so that I have a medium to share my thoughts, but the main purpose is to give myself a reason to write stuff.  I didn't think anyone really read the things I post.

I have now had multiple people tell me that they read my blog posts, and that they actually enjoy reading them.  Too many of the people that told me this said that they enjoyed reading my writing despite not knowing what I'm talking about.  After hearing that feedback, I took it as a challenge to explain the things that I write about in terms that people can comprehend.

I won't stop writing about heavy finance things, but I want to try to bit by bit explain the fundamental concepts of finance to the non-finance people that grace my website with their presence.

Where to start?  I will first give my rendition of what a stock is.  Establishing what a stock is will give me the foundation to go into detail about lots of other things.

What is a Stock?

A stock is a piece of ownership of a company.  When we say that a stock is publicly traded, it means that the pieces (shares) of that company are able to be bought and sold by anyone in the public marketplace, something that we refer to simply as the market.

Understanding that a stock is a piece of a company should be easy enough, but how and why a stock comes into existence is a little bit more complicated.  It all comes back to money (capital).  Companies need capital to do business.  If a company sells coffee they need money to buy coffee beans, cups, machines, and pay employees and rent space.  That capital can come from lots of different places (which I will have to discuss in another post), but once things are going the company should eventually be able to make enough money selling coffee to pay its expenses and buy more supplies to sell more coffee.  If this business decides that it wants to open another location, the capital that the first location is producing by selling coffee might not be enough to open a second location; they need more capital.  To get this capital, they can choose to sell part of their company on a stock exchange.  When a company chooses to do this, they are going public.  A company consisting of two coffee shops would not likely go public, but for the sake of the example they do decide to go public.  When a company decides to go public they have to be underwritten to determine the price that the public might pay for their shares.  This is where an investment bank comes in; so our coffee company would approach Goldman Sachs and tell them that they want to issue shares to the public in an initial public offering (IPO).  Goldman Sachs will examine the company very closely to try and determine how much the public will pay for shares of this company, and then they will either buy all of the share themselves with the intention to resell them to the public (a bought deal), or they will do their best to sell as many of the shares as they can to the public without giving our coffee company any guarantee that all of their shares will be sold.  This initial sale into the market is referred to as the primary market.  Once these shares have been sold into the market for the first time, they can be bought and sold by anyone in the market.  The market after the first sale is called the secondary market, and that is where most people buy and sell stocks.

So now we have these shares, these pieces of a company, that can be bought and sold by people very easily.  As they are bought and sold by people, the price of these shares will move based on a bunch of factors.  It's like  anything else that can be bought and sold, the more people want to buy it, the more the price will go up.  There is an infinite amount of information that can affect the price of a stock, and there are people researching as much of the information as they can all the time to try and predict where the price of a stock is going to go so that they can make money by buying it at one price and selling it at another.  It is also possible to make money by betting that a stock will go down in price, but that is another story.  I often write about efficient markets, and when you understand how stocks get their prices the idea that markets are efficient makes a lot of sense.  If markets are efficient it just means that all available information has been taken into account in the price of any stock at any given time.  This happens because of all of those people that are out there researching stocks to try and make money; they collectively influence the price of a stock until it ends up at a value that reflects how much all of the people in the market will pay for it based on all of the information that is available.

I feel like that was harder to explain than I wanted it to be.  If you read this explanation and have questions, please ask me,  I love answering questions about this stuff.