A Primer on the Stock Market

There are few prices followed as widely and closely as the price of stock. In this section we are going to answer a number of questions concerning stock.  As a jump start to the work you may want to visit the e-trade site where you can get some background information as well as access to a stock market game.

• What are stocks?
• Why would you own them?
• How do you make money owning stock?
• Where are the stocks bought and sold?
• How do you read stock market information?  
• What are the stock market indexes?
• How do you account for inflation?
• What are mutual funds?
• How do you follow the stock markets?

What are stocks?

Corporate stock is an equity instrument providing the holder with a share of ownership which includes voting rights in the issuing corporation corporation. Stated somewhat differently, a corporation sells a piece of paper that gives the holder of the paper a share in the ownership of the company, which in turn gives the holder the right to vote on company policies. 

Why would you own stock?

It is generally not for the ownership right.  The reality, though is quite different since companies usually issue thousand or millions of shares so one vote is as close to meaningless as you can get.  There are situations, however, where BIG investors control enough of the shares to gain possession of a controlling vote and then ownership has real meaning.  In recent years it has been the pension funds and mutual funds that have received the most press for the rapid growth in their holdings of corporate stock and the ability of the big ones such as TIAA and Fidelity to have gained some influence in the corporate board room.

If you are not going to be able to control the company, why would you buy a piece of it?   The answer is simple enough; investors buy stocks because they think that they can make money by doing it, and the more money they think that they can make, the more they will buy.

How do you make money owning stock?

If you want to see how your return on the investment looks and how it will be affected by exchange rate movements, you should check out the web sites below.

• What is the return on my stock dividend?
• How do exchange rates affect my return on stock?

Where are the stocks bought and sold?

The market where the price of stock is determined is called the stock market.  The most famous is the New York Stock Exchange where shares of many of the country's largest corporations are exchanged. If you want to buy stocks in a younger company with national recognition, then you might very well find the stock listed on NASDAQ, while the stock in a smaller, local company would be listed in a regional market. All of these markets are secondary markets, markets where existing financial assets are exchanged. 

In addition to these domestic exchanges, there are also a number of international exchanges that gained notoriety in 1997-98.  In the 1990s American investors were increasingly moving their investments overseas to tap into the growth that was taking place in places such as Asia and Latin America.  In 1997, however, the stock market in Thailand dropped precipitously which triggered a chain reaction - a modern version of the domino theory.  As investors bailed out of foreign stocks, the prices in other South East Asian began to fall and then the contagion spread to Latin America and prices plummeted there.  Now we will turn our attention to individual stock prices and the stock market indexes that provide a guide to the performance of the entire market. 

How do you read stock market information?

Once you know which market a particular stock is traded in, you can follow it in the Wall Street Journal (WSJ) or on many of the stock quote web sites. [CNN,  Alta Vista,  Yardeni, Yahoo].   You may also want to check out our own index. 

What you will find is a summary of the activity in a particular stock for a given day. This will include information on price (actual price, change from previous day, range in prices over the past year), the volume of trades, and expected dividend earnings.  In the WSJ the data are presented in a table that looks very much like the following. 

• 52 Weeks Hi: the highest price for the stock in the past year
• Lo: the lowest price for the stock in the last year
• Stock: the abbreviated name of the issuing company: AT&T is the company issuing the stock.
• Sym: the symbol for the stock - what you would enter into the various on-line quote sites
• Div: the expected dividend.  The owner of this stock can expect to earn $1.32 in dividends for each share owned.
• Yield: the expected dividend as a percentage of the current price.  The owner will receive $1.32 for the stock which costs $58.75 which is a rate of return of 2.2 percent. 
• PE: The ratio of the price of the stock to the expected earnings per share.  The price per share is twenty times the expected earnings per share.  This is sometimes used as a measure of the extent to which the stock is over or under priced.  A high price - earnings ratio means that the investor is paying a high price for the expected profit that the company will make.
• Vol: the number of shares traded in 10s.  On this day 3,667,700 shares were traded.
• Hi: the highest price for the stock that day
• Lo: the lowest price for the stock that day
• Net Chg: the change in the price of the stock between yesterday's and today's closing.

What are the stock market indexes?

If you are going to read the stock market data in the newspaper, you had better have good eyes or your glasses because there are thousands of stocks listed on the various exchanges, and the print is a bit small.  In addition to being difficult to read, it is difficult to look at the thousands of stock prices and get any information concerning the average price of stock.  For example, if you wanted to know what was happening to real estate prices, you would probably want some measure of average sale prices of homes in your neighborhood.   The same is true when we look at stocks where you are concerned with the overall level of stock prices.  If there is a general decrease in the price of stock, this is likely to affect your decision to invest in stocks.

Fortunately, the interest in this type of measure was recognized many years ago and today there are a number of measures of the price (value) of stock - the indexes you hear reported on TV's nightly news. In these reports you will usually you will find a statement on the volume of stock exchanged and the average price of the indexes. You also are likely to read headlines such as "Dow Rises; S&P 500, Nasdaq Fall" or "Dow sets new record, passes 9200."

But what is it we are talking about here? As so often is the case, a thorough understanding of the news will require a rather extensive investment of your time, but you will be able to understand the basics with a minimal investment. The various stock market indexes are designed to provide you with some information on the average price of stock on a specific market based on a sample of stocks.  The various indexes are simply weighted averages of a small sample of stocks.  They differ because of differences in the stock market, differences in the companies in the sample, and differences in the weights. Some of the popular indexes would be the Dow Jones, Standard & Poors, and NASDAQ indexes.

The Dow Jones Average (DJA) is the average price of a collection of 65 stocks traded on the New York Stock Exchange which is actually the composite of three separate averages - Industrials (30 companies), Transportation (20 companies), and Utilities (15 companies). For some more detail on the index and some charts tracking the history of the index, you should check out the DJA web site (some historical graphs a current time-series graph).  Companies included in the indexes are: Industrials (Coca-Cola, Eastman Kodak, McDonald's, Boeing, General Motors, and Merck), Transportation (AMR (American Airlines), Southwest Air, Union Pacific, and Delta), and Utilities (American Electric Power Co. and Enron).  The most popular of the Indexes is the Industrial which is usually the index quoted on the nightly news.  In these indexes the weight for each stock price is one so that what we have is a simple, un-weighted average.  The New York Composite, meanwhile, gives the average price for all of the stock traded on the New York Stock Exchange, where the weight for each stock price is the number of shares of the stock. This is more like a price index.

The S&P 500 is an index of the share prices of 500 stocks traded on the New York Stock Exchange compiled by Standard & Poors.  For more detailed information on the S&P indexes you should check out the S&P web site.   According to S&P, "The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value. The "500" is one of the most widely used benchmarks of U.S. equity performance."  The S&P500 can also be decomposed into subgroups that include health care, capital goods, utilities, technology, and financials. Some of the companies included in the index are Boeing Company, Archer-Daniels-Midland, Ford Motor, Coors, Intel, Microsoft, Oracle' Time Warner, General Mills' Nike, Merck, and Proctor & Gamble.

The third is NASDAQ. The NASDAQ Stock Market, is the largest electronic, screen-based market in the world with the capacity to handle share volume in excess of one billion shares a day. Known for its innovative, leading-edge growth companies, NASDAQ has two tiers: the NASDAQ National Market, with NASDAQ's larger companies whose securities are the most actively traded, and the NASDAQ SmallCap Market, with emerging growth companies. For more information on NASDAQ you should visit the NASDAQ web site.  The two primary indicators of performance are the NASDAQ Composite and the NASDAQ 100.  Included on NASDAQ 100 are 3M, Adobe, Biogen, Cisco, Dell, HBO, Microsoft, Netscape, Staples, and Sun Microsystems.  

Summary information on the major indexes can be found in the WSJ in the Stock Market Data Bank.  The headings of the table will look something like the following.

In the last year the Dow Jones Composite of 65 stocks has fluctuated from 2265.73 to 2960.79.  On the date of the table, the S&P 500 Index ranged from 1098.71 to 1089.67 and closed at 1093.22.  This close was 2.24 points higher than the previous day - a .21 percent increase.  Over the last year the NASDAQ Composite, which closed at 1761.79, rose 376.88 points - 27.21 percent. Since the beginning of the year, the NASDAQ has increased 191.44 points, a 12.19 percent increase.

In addition to investing in stocks in the US markets, you can also invest in foreign stock markets.  In the WSJ you will find a table that has headings similar to what appears below.  The table contains summary data on a number of indexes for countries including Hong Kong where the index is called the Hang Seng.  On the day recorded here, the market closed at 8598 which was down 13.81 points from the day before (NET CHG) - a .16 percent drop (PCT CHG).  Since the beginning of the year the index has fallen 2124 points (YTD NET CHG) which represents a 19.81 percent loss (YTD PCT CHG). [You can certainly see the impact of the Asian Crisis in these numbers].

How do you follow stock prices?

Dramatic swings in the stock market make news and we have had some dramatic swings - 1929, 1987, and 1998 being three of the most notable swings.  Below is a graph of the Composite Index which is an average based on all of the stocks on the new York Stock Exchange.   Between 1955 and 1997 the index increased a remarkable 2000%, rising from 21 to 450.

What is not apparent in the above diagram is the volatility in stock prices - something investors became very aware of in 1998.  In the graph below you can see stock prices went up more often than they went down, but there were some notable declines. The average annual change was 8 percent (blue line), but there were years when the index rose more than 20 percent (1959, 1983, 1986) and years when it declined by more than 20 percent (1974). [The crash of 1987 does not show up in the list because the rebound was quick and large so the annual change was not large].

How important is the index choice?  Does it matter which index you use to judge stock prices?  In the graph below three stock price indexes are compared.  By 1996, the NYSE Composite was nearly 17 times greater than it was in 1955, while the Dow Jones Industrial was approximately 13 times larger. The two composite indexes obviously tend to track each other as you would expect, but the DJ Industrial grew substantially slower over this 40 year period.

How do you account for inflation?

We saw above that the price of stock has tended to rise continuously, but during the period 1955-1996 some of the increase in the price of stock could be attributed to a general increase in the price level.  If we were to 'correct' the stock price data to reflect changes in the level of overall prices we would see a substantially different picture.  In the late 1960s, the real price of stock began a decline that did not end until the early 1980s when it began its latest rise. [The adjustment for inflation would be the same as the one for wages.  You would plug the actual stock market price index (N) and the price index (P) into the formula to get real, inflation-adjusted stock price index (R).  R = N/P ]

What are mutual funds?

Fortunately for the small investor things changed in the 1980s and even small investors now have the opportunity to avoid excessive transactions costs and to fully diversify their portfolios. This can be accomplished by buying into a mutual fund from a company such as Fidelity which is in effect simply a collection of shares of corporate stocks. The institution pays you the equivalent of a dividend with the profits it earns from the dividend payments it receives from ownership of the stock and the profits from the sale of stocks.  Yahoo provides a guide on mutual funds which you may want to check out, or you might want to look at the mutual fund component of the Wall Street Research Net web site. Included on the WSRN site is a useful glossary of terms.   According to the US Securities and Exchange commission, mutual funds offer certain advantages to small investors.

• Mutual funds are managed by professional money managers.
• By owning shares in a mutual fund instead of buying individual stocks or bonds directly, your investment risk is spread out.
• Because your mutual fund buys and sells large amounts of securities at a time, its costs are often lower than what you would pay on your own.

But what is a mutual fund? Very simply it is a company that brings together money from many people and invests it in stocks, bonds, or other securities. Each investor owns shares, which represent a part of these holdings. You can buy some mutual funds by contacting them directly or by working through brokers, banks, financial planners, or insurance agents.  You make money with mutual funds pretty much the same as you would if you bought individual stocks.  There are three ways you will make money with a mutual fund. First there are dividends and interest received by the fund on the securities in their portfolio. Second the fund can sell securities at higher prices and they will have a capital gain which they can disburse to the fund's shareholders. Third, the fund may hold stock that increases in value. 

How do you follow the stock markets?