What is the stock market really and how does it work?

On this Memorial Day weekend, before addressing today's topic, I want to express my gratitude to all those who have served our country, especially those who have made the ultimate sacrifice.
People often ask us what we think of the market. It is certainly understandable that the media refers to the market as if it were a sentient being. It's misleading. The stock market is not a single thing. It is a collection of thousands of stocks that represent ownership of real companies.
Increasingly, shareholding is an abstract concept. In a 401(k) mutual fund or ETF, there are many layers between the investor and the company in which the investor owns shares. In the past, ownership of shares was represented by a certificate, a tangible symbol. Today, stock certificates are rare. Ownership is represented by ones and zeros on a remote computer and the only hard evidence an investor has is an occasional statement. However, when you own a stock, you own part of a company, entitling you to a proportionate share of the profits and a proportionate voice in how the company is run.
Today, most publicly traded companies issue millions, if not billions, of shares, so each share represents a very small percentage of ownership. To understand the concept, consider a business with two owners, each owning 50% of the business. Obviously, each owner would have a say in how the business is run and would share profits between them. Publicly traded stocks work the same way, except the owners number in the thousands and the percentage owned is tiny.
When a company issues stock, it sells ownership shares. In turn, the company uses the money raised to expand and expand its business. Most companies do not sell stock to the public as their primary method of financing their business. Start-ups are typically funded by the founder's personal funds, friends and family, bank loans and/or venture capital before entering the stock markets.
Issuing shares to the public is a very complicated process, requiring specialist lawyers, investment bankers and accountants. Documents must be submitted to the Securities and Exchange Commission and other regulators before shares can be issued, and companies must also provide ongoing information to regulators.
Once the company has received all necessary approvals and the shares are issued, they can begin trading on the stock exchange. The exchange facilitates buying and selling between third parties. This is where things start to get murky. Stock prices on stock exchanges are determined by bids and asks. In other words, stocks change hands when the price someone is willing to pay for a stock matches the price at which someone is willing to sell that stock. As a result, stock prices can fluctuate wildly for any reason or no reason, simply based on investor psychology. In the long run, however, the price will likely reflect the true value of the business, so well-run and profitable businesses are likely to succeed.
When people talk about the market, they often refer to stock indexes like the Dow Jones Industrial Average or the S&P 500. A stock index is a collection of stocks designed to reflect the performance of the entire market. To do this, the Dow Jones Industrial average uses only 30 stocks. The S&P 500 uses 500. For the most part, they adequately reflect the overall market. However, the performance of individual stocks can and will vary relative to the indices. Economic scenarios that are good for one company or sector may be terrible for another, so the performance of some stocks will deviate from that of the index. Management mistakes can cause a stock to fall even as indexes rise, just as wise management decisions can have the opposite effect.
For more information, you can listen to the podcast of the Smart Money Management radio show on this topic, among others, at www.alderferbergen.com.
The opinions expressed herein are provided for general information only and are not intended to provide specific advice or recommendations to any individual.
Securities and financial planning offered by LPL Financial, a registered investment advisor. Member FINRA/SIPC.