Stocks 101

What's a stock?

A share of stock is a partial ownership of a company which entitles the shareholder to a fraction of any profits paid (dividends) and sometimes to vote for members of the board of directors and other issues which affect the company.  There are in fact legal documents which declare this ownership for every shareholder, but most investors never see these certificates - they're usually kept by the broker or mutual fund company so that investors can buy and sell shares quickly and not have to wait for actual physical shipments to take place.

Why is a stock worth money?

A given share of stock is worth money because the company in question is either making a profit and returning that profit to shareholders in the form of dividend payments, OR the company is using its profits to successfully grow in size and is therefore likely to start paying dividends at some point in the future.  Often a company is doing both: paying some dividends now and growing at the same time, thus promising even greater dividends in the future.

Why do stock prices fluctuate?

Here's where it gets interesting.  Up to this point a share of stock may sound like an investor loaning money in return for future payments from the company.  However, a stock is less predictable than a bond (the instrument by which a company borrows from investors) because dividend payments to stockholders can fluctuate as profits fluctuate, and because a share of stock has no expiration date.  So whereas every bond has a predefined payment schedule with a definite ending date, a share of stock in a company can pay dividends indefinitely, provided the company persists and remains profitable.

In order to know how much a share of stock is really "worth", one would have to know exactly how profitable a company is going to be from here to eternity, which is impossible.  Thus, at any given moment there are thousands of investors making thousands of different estimates of how profitable a company is going to be and how much the stock should therefore be worth.  Investors who think that a stock is worth more than its current price might buy some shares in order to collect the dividend payments at a bargain price, or they may anticipate that other investors will also buy shares in that company and drive the share price up, at which point one could sell the shares and pocket a short-term profit.

Income, expenses, tax laws, and the economy at large are constantly fluctuating, meaning that stock prices are always changing as investors deal with the non-stop flood of news and financial data.  Companies invent new products which make older products obsolete; consumer tastes change; labor or raw materials needed for manufacturing become more expensive; small investors pull out of the market en masse during economically hard times or pour money into the market during boom times - the number of factors at play is enormous.

What is a mutual fund?

A mutual fund is a company that charges a small fee to buy, hold, and sell stocks (and sometimes bonds) for investors who can't or don't want to bother with choosing which individual stocks to buy.  The primary advantage of a mutual fund is the safety and convenience of automatic diversification.  With one purchase, your savings are spread over dozens of companies, meaning you won't suffer badly if one or two companies go bust.  Of course this also means that exceptionally high returns by a few companies will be tempered by the more average returns of the other stocks in the portfolio.

Many employer-sponsored retirement accounts, including some 401(k) and most 403(b) accounts, limit their employees' investment choices to a family of mutual funds that invest in various combinations of equities (stocks) and bonds.  This means that in the event of an economic catastrophe where stocks and long-term bonds both lose value, the safest refuge for many retirement accounts is in very short-term bond funds known as Money Market accounts, which are as close to cash as one can get without having actual cash.

Mutual funds of stocks come in two flavors.  An actively managed mutual fund tries to select stocks which will be more profitable than the average stock market, while an index fund simply buys every stock in a particular category with no regard to future profitability.  Managed funds tend to charge higher fees, and unfortunately tend to under-perform the market more often than not.  The few successful managed funds eventually run out of above-average stocks to buy because more and more investors flock to them, resulting in a huge market-lagging fund with high fees.  I prefer index funds because of the smaller fees and more predictable market-matching returns.

Mutual funds do not adjust to market conditions, meaning they don't pull out of stocks in bear markets.  Indeed most fund managers aren't allowed to do anything other than invest in the particular category of stocks stipulated in the fund's description - if managers were allowed to sell all of their stocks in anticipation of a crash, then one manager could in theory trigger a market crash himself by starting a sell-off.  Nearly all mutual funds gain money in bull markets and lose money in bear markets, and that means it's still up to the individual investor to pull his money out of a mutual fund if he thinks the overall stock market is going to fall significantly.

What's an ETF?

Exchange traded funds (ETFs) are relatively new on the investing scene.  They combine the automatic diversification of mutual funds with the convenience of instantaneous buying and selling through a broker just like individual stocks.  Whereas money sent to a mutual fund doesn't get invested for a day or two, and a withdrawal can take at least that long, an ETF can be bought or sold in a matter of seconds.

ETFs are my preferred investment vehicles.  Most of them are low-fee index funds, and they allow me to nimbly dip in and out of the market as needed during periods of high price volatility.