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How Does the Stock Market Work?

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When You Own

When you invest your money in a company, or in real estate, or in stamps, or Beanie Babies, you're buying a piece of something that you hope will increase in value and be profitable. While most people think mainly of the stock market in relation to investing, it's not the only investment opportunity.

Stocks are merely investments that represent a piece of ownership in a company. The more shares of stock in one company that you have, the bigger a piece of the company you own. Owning stock makes you a shareholder in the company. The word stock is commonly used interchangeably with the phrase common stock. There are different kinds of stocks, such as blue-chip stock, which refers to stock of well-established companies like General Motors and Exxon, and growth stock, which is that of companies on their way up.

All corporations have stock, but not all corporate shares are sold to the public. A company may sell stock, or little pieces of itself, to raise money. When it sells stock through an initial public offering (IPO), it goes public. When a company goes public, it no longer controls who can purchase its stock.

Show Me the Money

When a company goes public, it offers its common stock for sale to the public. The first time it does so it's known as an initial public offering. After that, it's no longer a privately held company.

Shares of stocks are usually sold in round lots, which are groups of 100. Groups of less than 100 shares are called odd lots.

If you buy stock in the Disney Corporation, for example, you're buying a tiny, tiny piece of a huge company. Shares of stock usually are sold in groups of 100, which are called round lots. Groups of less than 100 shares are called odd lots. If you buy 100 shares of stock from a company that has a million shares of stock outstanding, you can figure that you own one thousandth of the company. Regardless of whether you buy 10 Disney shares or 10,000, you're still a shareholder in the company. As long as the company makes a profit, you're entitled, as a shareholder, to share and benefit from it.

Stocks can make money in two ways. As a shareholder, you may get annual dividends. Hopefully, the price of the stock will also increase so that if you wanted to, you could sell your stock for more than what you bought it for and make a profit. The amount of dividends a corporation pays out is a reflection of the type of company it is. The stock of a growing company will not pay out the dividends that, say, an electric company does. It's important to remember this difference if you're planning to buy shares of a company. Will you receive a good annual income from your stocks, or are you banking on profits that will occur a few years or more down the road?

What happens, though, if somebody comes up with something even more exciting than Mickey and Disney World that captures the collective imagination of the whole world? All of a sudden, people stop visiting Disney parks, watching and buying Disney movies and shows, and purchasing scads of Disney toys, clothes, and other merchandise. If that happens, your Disney stock will take a nosedive. The value will plummet faster than you can watch it fall, and you'll be left alone, wearing your Mickey ears and holding your stock certificates.

Stocks aren't the only type of investment that you can own. Many people buy investment real estate, which they rent out to receive an income or resell for a profit. Or, you can decide to invest in something else that you hope will increase in value, such as baseball cards or McDonald's Happy Meal collectibles. These are called “commodities.”

Those are some of the opportunities you have to own your investments. Now, let's look at the type of investment in which you loan your money.

Show Me the Money

A lending investment is when you loan your money with the understanding that you'll get it back—with interest—after a specified time. Think of a bond as an IOU. When you buy a bond, you're lending your money to the company or government for a specified period of time.

When You Loan

Ownership investments aren't the only option. You also can participate in a lending investment. A lending investment is when you loan your money with the understanding that you'll get it back—with interest—after a specified time.

We most commonly think of bonds as lending investments, and they are the most widely used. There are many flavors of bonds, including municipal bonds, general obligation bonds, revenue bonds, corporate bonds, high-yield bonds, savings bonds, and government agency bonds. But there are other lending investments as well. Some other examples are certificates of deposit, Treasury bills, and notes.

Pocket Change

An important thing to remember about bonds is that when interest rates go up, the value of your bond goes down. When interest rates go down, the value of your bond goes up. When your bond matures, you get your money back.

These are all investments in which you give your money to a particular entity with the understanding that you'll get it back at a certain time, with an agreed-upon amount of interest added. The entity borrowing your money varies from a bank, which generally administers certificates of deposits, to the U.S. government, which offers bonds. Bonds are also offered by corporations. They borrow funds from you, in the form of a bond, giving you interest, which generates income for you.

The conditions, such as the length of time the money will be invested, the amount of interest paid, and so forth, are different for each of these types of lending investments. In most cases, bonds offer a fixed interest rate. That is, the rate remains steady throughout the life of the loan.

If you're holding a bond that pays 5 percent interest and the interest rate jumps to 7 percent, you lose on the value of your bond if you sell it. But if you're earning 7 percent interest on your bond and the interest rate drops to 5 percent, you're still entitled to 7 percent, the agreed-upon rate. In that case, your bond would have increased in value (known as a premium bond) compared to new bonds being issued. Either way, you'll get your initial investment back when the investment matures. Always make sure the bonds you buy have a clear maturity date so that you'll know exactly when you can get your money back.

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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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