What is the stock market? An explanation of investing for novices and newcomers to the world of trading public stocks.
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Imagine you've started a business. It's the best lemonade stand in all of the United States. You're making money every summer selling iced lemonade, and you've figured out how to sell hot lemonade tea every winter. You're rolling in profits.
With the money you make from your first stand, you open another one across town. It does great business too, so you expand to the next town and the next. Before you know it, you're in several states and you're looking at Alaska and Hawaii.
What is Stock?
Imagine someone comes to you and tells you that you can double the size of your business by expanding into Canada. Maybe you don't know how to sell warm lemonade to Canadians (they love it), but they're willing to help—if you sell part of your business to them. If they do the hard work and put up the initial money to build the lemonade stands, they're entitled to part of the profit. You supply the blueprints for the lemonade stands and the business in general, and they build the businesses.
Guess what? You've sold stock in your business. Stock is a portion of ownership of a company.
To make this work, you had to figure out what your company is worth. That's a tough problem, but set it aside for a second. You figured out what your business is worth and you sold a percentage of that business—part of your ownership of this lemonade empire—to other investors. They now own part of the company and so do you. Whatever profit you make that you don't turn around and invest back in the business belongs to all of you owners of the company, in proportion to the amount of the company you each own.
What is a Market?
In a few years, your Canadian friends decide to retire to a beach in the Caribbean tax haven of the Cayman Islands. They offer to sell you back their stock. You can choose to buy it at its current value. You could decline, and they'd have to find another buyer to buy it.
How do you know what to buy it for? There's a negotiation. If it's you buying it, that's one thing. If it's another private group, that's another. Alternately, you could take the offer of shares to a larger group of potential buyers and take bids for it. At its heart, a market is a place where buyers and sellers come together to negotiate a price for goods that they want to buy and sell.
What is an IPO?
Suppose you've sold off hundreds of pieces of the company to many, many people. Maybe you've hit up family and friends to help you invest to expand into Mexico and Europe and Brazil and India and China.
Maybe your little lemonade stand business has grown so large that it's too big for you to manage. You need to bring in a professional management team, and the only way to justify all of the work you're doing is to raise enough money to you can expand the business into a worldwide year-round lemonade company.
One way to do this is to allow the general public to buy shares of your company. This generally occurs through an IPO (Initial Public Offering). An IPO is an event where banks work with the owners of the company (the shareholders) to figure out what the company is worth and how many shares of the company are available for average people like the rest of us to buy. Then, one fateful day, anyone can call up his or her broker and ask to buy shares of your lemonade company.
The company ideally gets a new influx of capital, the owners of the company probably get a big paycheck, and hundreds or thousands or hundreds of thousands of people now own tiny chunks of that company you started, and they're all entitled to a small piece of the profits of the company—so you'd better get to work figuring out new markets and new products and new customers!
(The question of whether you should participate in an IPO as a buyer is a very different one.)
What is the Stock Market?
A market is any place where buyers and sellers come together. A stock market is a place where many buyers and sellers of many stocks come together. Once your company has gone public—once any member of the general public can buy it or sell it—then those owners of the company can buy and sell their shares any time they want, as long as they all agree on a few things, like what to call it and what it's worth and where to record the transactions.
Once you have hundreds or thousands or hundreds of thousands of tiny owners, you have to keep things orderly. You're under oversight of agencies such as the Securities and Exchange Commission and must follow specific accounting and reporting guidelines. Buying and selling is regulated because you're affecting millions of people. That's why a stock exchange like the NYSE or the NASDAQ exists: to organize everything.
There's no one single stock market, though in the days of electronic trading it hardly matters to the average investor anymore. It's like the little farmer's market where you first set up your stall to sell freshly-squeezed lemonade, except it's a lot larger and computerized and people buy and sell tiny pieces of countless companies, not lemonade and fresh tomatoes and homemade pies.
The stock market is a convenient way to make all of these transactions happen in an orderly fashion where we can all agree on the results. That's the basic fact you have to remember. There are many, many more details, but for most of us most of the time, it's not much more complicated than that.