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How Does the Stock Market Work?

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Listen to the stock reports sometime, or try to read that impossibly tiny print they use to list them in most newspapers. They're filled with words and phrases like NASDAQ, the Dow Jones, blue chip stock, and composite index. It's enough to make any potential investor pack up his portfolio and go back to watching soap operas.

First, what exactly is the stock market? The stock market is a generic term that encompasses the trading of securities. This trading takes place in stock exchanges. There are three major stock exchanges in the United States:

  • Formed in 1792, the New York Stock Exchange (NYSE) is the largest organized stock exchange in the United States.
Dollars and Sense

Check out your local newspaper's business page for a “stocks of local interest” column. Read these stock reports daily for a week or two to get a feeling for how the local companies are doing in the market. It's sometimes easier to understand something that can be confusing, such as the stock market, if you look at how it pertains to something with which you're familiar.

  • The American Stock Exchange (AMEX) was known before 1951 as the American Curb Exchange. That's because trading was conducted on the curb of Wall and Broad streets in New York City. The American Stock Exchange has less stringent listing requirements than the NYSE, so it attracts many smaller companies.
  • Another of the major stock exchanges, NASDAQ stands for the National Association of Securities Dealers Automated Quotation System. Unlike the NYSE and the AMEX, there isn't any physical location for the exchange; trading is done by computer. The American Stock Exchange and NASDAQ have merged, but maintain their own names and identities.

The overall performance of the stock market is evaluated in many different ways. The Dow Jones Industrial Average (DJIA) is one measure of the stock market, the standard we hear every day. It consists of three indices that include averages for utilities, industrial, and transportation stocks, as well as the composite averages. Each average reflects the simple mathematical average of the closing prices (prices at the end of the day) and indicates the day-to-day changes in the market prices of stocks in the designated index.

Show Me the Money

The stock market is the organized securities exchange for stock and bond transactions. Securities are investments that represent evidence of debt, ownership of a business, or the legal right to acquire or sell an ownership interest in a business.

Show Me the Money

When market trends move upward, it's called a bull market. It's a bear market when trends move continuously downward.

Show Me the Money

The total return on an investment is the current income (known as the yield) plus the capital gain or loss. When you invest, you take a chance that you'll lose money; that's the investment risk.

Okay, what does that mean? The DJIA is a composite (group) of 30 stocks with a daily average. Tomorrow, if the stocks as an average go up in price, the DJIA goes up. If the average value of these selected stocks goes down, the DJIA goes down. If market trends are moving increasingly upward, as they did in the latter part of the 1990s, it's called a bull market. Market trends that are moving continuously downward, such as they have since the middle of 2001, are called a bear market.

Now that you know the major exchanges and how the market is measured, let's get down to business. How do you make money on this deal? There are two kinds of investment returns: total return and yield. Total return on an investment is the current income, plus the capital gain or loss. Yield is the amount of dividends or interest paid on an investment. These returns can be very different, although many people lump them together as the same thing.

Every investment you make involves a certain level of investment risk, with the chance that you'll lose the money you invest or that the investment won't perform as well as you thought. Investments with the chance for higher returns carry greater risk than those without the return potential.

Although the terminology involved can be a bit baffling, the basic concept of investing isn't all that complicated. You can buy something with your money: a little piece of a company as shares of stock, or some real estate, or something else. Or you can lend your money to an organization and have it agree to pay you back, with interest, over a specified time. When it comes to investing, you can own, or you can loan.



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More on: Family Finances

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Excerpted from The Complete Idiot's Guide to Personal Finance in your 20s and 30s © 2005 by Susan Shelly and Sarah Young Fisher. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

To order this book visit the Idiot's Guide web site or call 1-800-253-6476.


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