Stocks

What Is a Stock?
Want to own part of a business without having to show up at its office every day? Or ever? Stock is the vehicle of choice for those who do. Dating back to the Dutch mutual stock corporations of the 16th century, the modern stock market exists as a way for entrepreneurs to finance businesses using money collected from investors. In return for ponying up the dough to finance the company, the investor becomes a part owner of the company. That ownership is represented by stock -- specialized financial "securities," or financial instruments -- that are "secured" by a claim on the assets and profits of a company.

Types of Stock
Common Stock. Common stock is aptly named, as it is the most common form of stock an investor will encounter. It is an ideal investment vehicle for individuals because anyone can own it; there are absolutely no restrictions on who can purchase it. Young, old, savvy, reckless -- heck, even professional mimes are allowed to own stock. [Editor's note: Complaints about this gratuitous and completely unnecessary shot at the fine profession of mime should be directed to the Association of Professional Mimes or, if you're really feeling ornery, the White House.] Common stock is more than just a piece of paper; it represents a proportional share of ownership in a company -- a stake in a real, living, breathing business. By owning stock -- the most amazing wealth-creation vehicle ever conceived (except for inheriting money from a relative you've never heard of) -- you are a part owner of a business.
Shareholders "own" a part of the assets of the company and part of the stream of cash those assets generate. As the company acquires more assets and the stream of cash it generates gets larger, the value of the business increases. This increase in the value of the business is what drives up the value of the stock in that business.

Because they own a part of the business, shareholders get one vote per share of stock to elect the board of directors. The board is a group of individuals who oversee major decisions made by the company. Far from being a perfunctory collection of do-nothings, the board wields a lot of power in corporate America. Boards decide how the money the company makes is spent. Decisions on whether a company will invest in itself, buy other companies, pay a dividend, or repurchase stock are all the purview of the board of directors. Top company management -- who the board hires and fires -- will give some advice, but in the end the board makes the final decision.

As with most things in life, the potential reward from owning stock in a growing business has some possible pitfalls. Shareholders also get a full share of the risk inherent in operating the business. If things go bad, their shares of stock may decrease in value -- or even end up being worthless if the company goes bankrupt. You will learn about selecting stocks -- or businesses -- in Step 6. Analyzing Stocks.

Different Classes of Stock. Occasionally, companies find it necessary for various reasons to concentrate the voting power of a company into a specific class of stock where the majority is owned by a certain set of people. For instance, if a family business needs to raise money by selling equity, sometimes they will create a second class of stock that they control that has 10 votes per share of stock and sell a class of stock that only has one vote per share to others. Does this sound like a bad deal? Many investors believe it is and routinely avoid companies where there are multiple classes of voting stock. This kind of structure is most common in media companies and has been around only since 1987.

When there is more than one kind of stock, they are often designated as Class A or Class B shares. On our Quotes & Data page, this is signified on the New York Stock Exchange and American Stock Exchange by a period and then a letter following the ticker symbol, a shorthand name for the company's shares that brokerages use to facilitate transactions. For instance, Berkshire Hathaway Class A shares trade as BRK.A, whereas Berkshire Class B shares trade as BRK.B. On the Nasdaq stock market, the class of stock becomes a fifth letter in the ticker symbol. For example, Bel Fuse trades under the tickers BELFA (the Class A shares) and BELFB (the Class B shares).

Other Types of Stock. You will learn about preferred stock and Real Estate Investment Trusts (REITs) in Step 5. Bonds.

How Stocks Trade
Probably one of the most confusing aspects of investing is understanding how stocks actually trade. Words such as "bid," "ask," "volume," and "spread" can be quite confusing.

Listed Exchange. The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX, composed of the Boston, Philadelphia, Chicago, and San Francisco Exchanges and now merged with the Nasdaq stock market) are both "listed" exchanges, meaning that brokerage firms contribute individuals known as "specialists" who are responsible for all of the trading in a specific stock. Volume, or the number of shares that trade on a given day, is counted by the specialist and reported to the exchange along with information on the price and size of each trade.
NYSE trades still take place face-to-face in the trading pit (yes, just like in the movies) where buyers and sellers physically converge on the specialist who matches buyers with sellers, but computers play a big part in the process these days. All trades are "auctions." There is no set price, although the last trade is often considered to be the "price" of a stock. In reality, the price is the highest amount any buyer is willing to pay at any given moment. When demand for a certain stock is high, the various buyers bid the price higher to induce sellers to sell. When demand for a stock is low, sellers must sell at lower prices to attract buyers and the price drops.

Over-the-Counter Market. The Nasdaq stock market, the Nasdaq SmallCap, and the OTC Bulletin Board are the three main over-the-counter markets. In an over-the-counter market, brokerages (also known as broker-dealers) act as "market makers" for various stocks. The brokerages interact over a centralized computer system managed by the Nasdaq.

Market makers may match up buyers and sellers directly, but mostly they maintain an inventory of shares to meet the demands of the market. So when you want to sell 100 shares of ABC stock, you don't have to wait for someone else to place an order to buy 100 shares of ABC; the market maker steps in, buys them from you immediately, then sells them when a buyer comes along. Market makers and specialists keep the markets "liquid" each in their own way. You are assured that, except in extraordinary circumstances, you can always buy or sell your shares if the market is open.

"Volume" numbers under the Nasdaq system are often inaccurate. Since most trades are in and out of the market makers accounts, what would be one trade on the NYSE (where buyers and sellers are matched directly) is usually two trades on the Nasdaq.