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Stock Market Basics

Updated on March 9, 2008

Stock Market Basics

The stock market. Although you may have heard a lot about it, particularly in recent times, when it seems that everyone has become an expert, do you really understand what the stock market is, and what it does? We commonly talk about investing in the stock market, but how is that different from putting money in a savings account?

Logically, the stock market means a market for stocks, that is, a place or a means to buy and sell stocks. In the realm of questions that you always wanted to know, but were afraid to ask, we will first look at what stocks and shares are, and why anyone would even want to buy and sell them. The terms "stocks" and "shares" are often used together, and usually interchangeably - there is a semantic difference between them that is safely ignored for the most part.

Stocks are shares in ownership of a company. They used to be certificates, or pieces of paper, but increasingly they are just electronic records, as far as anyone is concerned. The company will issue these shares to raise money in an initial public offering, or IPO, to create capital for company growth. You may have heard of IPOs, as sometimes they make the headlines. The company must decide on the price of its shares for the initial offer, and, if the general buying public decide that they are too cheap, the price rises rapidly after the IPO, making some lucky people who were first to buy their fortune. After the initial sale, the shares are sold between investors, and the company does not receive any more cash from the trading.

In return for their investment, the shareholders have a certain amount of control over the operation of the company (although unless you are Warren Buffett you probably won't have enough shares to really influence the company's direction), and they also receive income from the company with what are called dividends, paid out of the profits. Note however that not all companies issue dividends, and they are not guaranteed.

As for the difference between shares and stocks, which you will notice from above are very similar in usage? The term stocks usually refers to an overall portfolio of shares in various companies. When you speak of shares, it normally means the holdings in one particular company.

Now that you know what you are buying on the stock market, you need to understand the principles behind their value. In an ideal and static world, the price of a share would reflect the expected income from owning it - with a dividend paying share, this would be the amounts to be paid into the future, discounted to today's values. Discounting is an economic tool which allows for inflation, for instance a pound received now is not the same as a pound promised to be paid in ten years - that has much less value to you.

You may have noticed that the value of stocks fluctuates, and this is a result of people's expectations of the company. For instance, if the company is doing well, the share price rises, as more profits are expected, and they will finish up paid to the shareholders. If there is a problem with the company's productivity, it suggests that the profits will fall, and the share price slumps.

Of course, if it was that easy in practice, and everyone had access to perfect information, they would pay the "right price", and there would be little opportunity to make money in the short term by buying and selling shares. The fact is that everybody's opinion of the future varies continuously, and the price that people are prepared to buy and sell at is constantly moving. This is why public confidence can cause such large and sometimes irrational swings in the market.

The stock market is more an overall idea than a place. If you want to trade in stocks and shares, you actually have to deal through a stock exchange, and there are many of those. Some of the main ones that you may have heard of include the London Stock Exchange (LSE), the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and NASDAQ. Again, there's some interchangeability in terms, and you may hear the LSE referred to as the London stock market, for instance.

However, you are one step removed from actually dealing with the stock exchanges. To buy and sell shares, you will find a stockbroker, who is the intermediary who deals with the public on one side, and the stock exchanges on the other, "broking" the deal. To decide what shares you want to deal in, you can access a great deal of company information on the Internet, and, at least at the start, get a lot of help from studying free information, such as that at www.insightsupport.com.

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