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- Understanding Finance
The Stock Market- A Big Bad World
For new investors looking to assert themselves in the world of shares, the stock market can hold a dazzling resemblance to civilised gambling. It seems as if businessmen invest their money on the hope of making returns, on the hope that the value of the stock they invest in will appreciate. If it goes up, you book your profits, but if it goes down, you make a loss. It seems that people are willing to risk their money on a hunch, on the hope that they will become rich. For the younger generation, they view the stock market as a medium to gain huge amounts of money, over the short term. However, it is often the patient long term investors, who make the most amounts of money, with the least amounts of risk.
When people refer to the term share, it is basically referring to a share of the ownership in the company. The benefits of buying a share of the stock is that you will receive dividends on the ratio of stock that you own and you are entitled to a percentage of the assets of that company. But this raises this question, why would large multi-million dollar companies want to allow the public to invest in their stock? The answer is simple and it is what drives the world economy, money.
Most companies originally start off with private investors, and will only go public once they are making enough money, and feel the need to expand their business. Let’s put this concept into practice.
Imagine you want to start a new insurance company. Your total expenses for the full year are 10 million dollars. However you expect to make a profit of 2 million dollars in your first year. This is a return of 20%. The only problem you face is that you don’t have the money to launch the business, and you do not want to take a loan as interest accrues. Because of the circumstances, you decide to make the decision to allow people to invest in the company. As the owner of the company, you are in charge of making the decision on the initial price of the company. You are entitled to set the initial price of the company at a figure that reflects the future value of your company. So if you set the price at 10 million, investors are likely to make a 20% return, but if you set the price at 50 million, investors will make a 4% return. The number of shares issued, directly correlate with the price of the shares, so the more shares, the lower the price.
The ownership of the stock is another aspect worth considering. As the owner of the company you would want to own the largest percentage of stock in the company, so you are essentially in charge of executive decisions. One of the problems faced by having private investors is that if they want to sell the stock, they will have to find another investor, which could potentially prove difficult. This problem is quite easily solved by a stock market. Stocks available in public companies are traded at a stock exchange, such as the ASX (Australian Stock Exchange). Shares listed on the stock exchange can be traded online (with a small fee) or through a stock broker. Because of these online mediums for trading stocks, it causes the price of stocks to fluctuate quite drastically. The price of a stock can easily be affected by the media, news announcements and a host of other factors. For example, if reports indicate a dip in the demand of the product sold by a company, it is likely investors will sell some of this stock, causing the price of the share to slip.
However, for companies to legally trade shares on the stock market, it is required that they become a corporation. A corporation is quite different to a partnership of sole proprietorship. A corporation can be defined as a person that doesn’t exist. The corporation is registered by the government and it is allowed to own assets, sue, be sued, and mainly, it has a stock that can be traded. Shareholders in the corporation all hold a percentage of ownership in the company, regardless of the value of their shares. Each corporation is required by law, to have a board of directors which are chosen by the shareholders. Another reasons that corporations are formed, is to reduce the liability or shareholders, so that all the shareholders take the fall. The benefit however for shareholders, is that they will receive a portion of the companies dividends every year. Also, if the stock appreciates from the cost price, the investors stand to gain a significant sum of money.
However, the potential for investors to earn money is largely based upon the stock price. The moment a stock is listed, the price is subject to change from the free market forces. Stock prices are largely influenced on the supply and demand of their product, which correlates with the corporations’ earnings and profits. The trick to trading stocks is very simple, buy cheap, sell expensive. The easiest way to do this is by investing in blue chips, stocks which have a successful record and have established themselves in the market. Such companies are highly likely to grow and you over the long term, you are able to make large profits which are generally risk-free. However, a riskier investment strategy involves trying to pick the next upcoming company, and sell the stock when the price jackpots.