How are stocks issued into the primary market? Securities transactions take place in the capital market, an arena where companies and governments raise long-term funds by selling stocks and bonds and other securities. The primary market is the part of the capital market that deals specifically with new bond and stock issues.

As you learned in Chapter 15, the first sale of stock to the public by a company is called an initial public offering (IPO). An investment bank, such as Goldman Sachs (often referred to as the underwriter), helps the company to raise money by issuing and selling securities in the primary market and serves as an intermediary between the company issuing the stock and the investors who purchase it. Before the sale of the stock, investment bankers, specialists who assist in the sale of new securities, prepare financial documents that must be filed with the SEC. A prospectus is one of the required documents. A prospectus is a formal legal document that provides details about an investment. The prospectus helps investors make informed decisions about the new investment. The investment bankers also determine what the best timing is for the public sale and determine the initial selling price of the stock. The advising investment bank, along with several other investment banks, forms a group or syndicate to underwrite the IPO; that is, they take the responsibility and risk of selling their allotment of the issue. The syndicate then purchases the stock and sells it to the public. It can take months or years to successfully structure an initial public stock offering. Investment banks use the time before the offering to generate interest in the stock so it sells for more than what the members of the syndicate paid for it.

The initial buyers of an IPO are mostly large institutional buyers, such as insurance companies and large corporate pension plans, and a few high-profile individuals. The underwriters want to sell the issue as quickly as possible to receive a return on their purchase. Because institutional buyers are more likely to buy large quantities of the IPO, it is ultimately more efficient to sell to them than to sell the IPO in little pieces to individual investors. A small portion of the IPO is actually available to individual investors, but because the quantity is limited, these shares are generally hard to get.

How are stocks exchanged after the IPO? After the IPO, those investors who bought shares may eventually want to sell them. The subsequent sale of stock after an IPO is done in the secondary market. The secondary market refers to the market in which investors purchase securities from other investors rather than directly from an issuing company. We’ll discuss the actual process of buying and selling securities later, but for now, let’s look a bit more closely as to what kinds of stocks are available.

Are all stocks the same? There are two main types of stocks that companies issue: common and preferred. Common stock is a class of ownership in which the stockholders have the right to elect a board of directors and vote on corporate policy. They are also entitled to dividends, if the company chooses to pay a dividend. A dividend is a distribution of a portion of the company’s earnings as determined by its board of directors. Common stockholders have the least priority as far as ownership and repayment in the event a company goes out of business. Preferred stock is a class of ownership in which the preferred stockholders have a claim to assets before common stockholders if a company goes out of business. In addition, preferred stockholders receive a fixed dividend that must be paid before any dividends are paid to common stockholders. Preferred shareholders, however, do not have voting privileges.

Stocks can also be categorized based on the type of company and expected growth and return of the investment, as illustrated in Figure 16.3:

Figure 16.3

Types of Stocks

• Income stocks are issued by companies that pay large dividends, such as utility companies like Duke Energy, Exelon Corporation, and Exxon Mobil Corporation. Investors who are looking for reliable income from their investments and not appreciation (an increase) in the value of their shares often invest in income stocks.

• Blue chip stocks are issued by companies that have a long history of consistent growth and stability. Blue chip companies pay regular dividends and maintain reasonably steady share prices. General Electric, IBM, The Walt Disney Company, and 3M are examples of companies that are considered blue chip stocks.

• Growth stocks are stocks that are expected to generate revenues and earnings that increase at a faster rate than that of an average company. These stocks pay little or no dividends. Instead, the firms retain their earnings and reinvest them in new projects that fuel the continued growth of the firms. Investors that buy growth stocks hope that their value will increase. Growth stocks tend to be riskier than other stocks because these companies often do not have proven track records. Tesla, Trulia, and Google can be considered growth stocks.

• Value stocks are stocks that are viewed as being priced lower than what they should be based on the earnings and financial performance of the companies that issue them. The prices of these stocks have the potential to increase when the market adjusts for their incorrect valuation. Value stocks lie at the opposite end of the spectrum as growth stocks.

• Cyclical stocks are issued by companies that produce goods or services that are affected by economic trends. The prices of these stocks tend to go down when the economy is in a recessionary period and go up when the economy is healthy. Examples of cyclical stocks include airlines, automobiles, home building, and travel.

• Defensive stocks are the opposite of cyclical stocks. Defensive stocks are issued by companies that produce staples such as food, drugs, and insurance products and usually maintain their value regardless of the state of the economy.

No one type of stock is considered better than another. Investors have to decide for themselves which type of stock fits best with their financial goals and objectives. A diversified portfolio may include many different kinds of stocks.

How do I choose which stocks to invest in? The answer to this question begins with determining your investment goals and objectives, the time in which you have to achieve your goals and objectives, and your risk tolerance, as shown in Figure 16.4. Once you know those constraints, you’ll be better able to determine what investment strategy best fits your needs.

Figure 16.4

Things to Consider before Investing

Many investors begin investing when they enroll in their 401(k) retirement plan at work. This is a good way to start because the portfolio manager of the 401(k) has narrowed down your investment choices for you. Although there are plenty of professionals to help you, when you start investing on your own, you should research each potential investment for yourself. You should consider a stock’s basic fundamentals, past performance, published analyses, as well as the economy in general and how it could affect the stock:

• Fundamentals. You can start by evaluating a company’s fundamental data, such as its earnings, financial statements, and key ratios (discussed in Chapter 15).

• Past performance. Often it is helpful to know how a company and its stock have performed in the past. You can study financial charts to compare the historical performances of multiple companies and observe trends in the data.

• Published analyses. Additionally, you might want to consider the opinions of industry analysts who independently research and analyze the investment potential of companies.

• Economy. Current events and changes in economic conditions could affect a stock’s price, so you need to be aware of these changes.

All of this information is available in newspapers, on the Internet, or in your public library. Unfortunately, it takes lots of time and research to determine what the right investments are for you. Keep in mind that if the process were easy and straightforward, we’d all be rich! In reality, there is much variability and unpredictability in the market; even with the best analysis, you still might end up with unfavorable results. But, with time on your side, the chance of rebounding from a poor investment outcome is pretty good. Even though the stock market does fluctuate, it has provided a consistent return over a long period of time.

Why is it important to set goals before investing? Assuming you can select companies that you believe will generate a profit based on your research and stock fundamentals, you also need to determine what kind of company meets your investment goals and objectives. Younger investors are often investing to meet long-term goals, such as buying a house or funding a retirement account. Young couples may be investing to fund college accounts for their children. In these instances, investing in companies that are in their growth phases—where investment gains result from the rapid appreciation in a stock’s value—may be the way to go. The downside is that these companies are also more likely to quickly have their stocks lose value, too. However, someone who is 22 and just starting his or her career may be able to withstand temporary downfalls in the prices of the stocks he or she owns.

Someone who is 55 is probably nearing retirement and cannot endure the possibility of “starting over” if his or her portfolio does poorly. This individual might own a mix of growth companies as well as more stable companies that experience strong but steady growth. Companies such as these generally do not experience wild swings in their stock prices and typically offer dividends to their stockholders.

Finally, older and retired investors often invest in companies that are less risky, and that pay high dividends to earn income to help fund their retirement years. Dividends provide another source of income to stockholders beyond appreciation in stock prices. So, for example, a person who is 70 years old and retired and who relies on income from his or her investments cannot afford to lose much money and is thus risk averse. He or she would be wise to invest mostly in companies that offer high dividends and generally experience only mild swings in the prices of their stocks. The world of investing is an ongoing experience; if you choose to invest, it is an experience you should not take lightly. You must be smart about investing and continue to do your research—even if you choose to have someone else guide you in the investment process.

Where are stocks bought and sold? Before the Internet, people could buy stocks only with a stockbroker (or broker), a professional who buys and sells securities on behalf of investors. Stockbrokers also provide advice as to which securities to buy and sell and receive a fee for their services. Today, people can buy and sell stocks directly on the Internet for a small fee through discount brokers such as E*Trade or TD Ameritrade. Discount brokers offer limited advice and guidance and are substantially cheaper than financial services firms, such as Bank of America or JP Morgan, which employ full-service brokers.

Whether you use a discount broker or full-service broker, the process of buying stock is done through a stock exchange, an organization that facilitates the exchange of stocks and other securities between brokers and traders. One of the largest and most dominant stock exchanges is the New York Stock Exchange (NYSE). In 2007, the NYSE merged with the fully electronic stock exchange Euronext and is now operated by the combined organization NYSE Euronext. In 2013, the Intercontinental Exchange (ICE) acquired NYSE Euronext. Currently, NYSE and Euronext operate as divisions of Intercontinental Exchange (ICE).

The NASDAQ was the world’s first electronic stock exchange and is the world’s second-largest stock exchange.⁴ Some securities might be too small to meet the requirements to be traded on a formal exchange such as the NYSE or NASDAQ. These small securities are traded directly between investment professionals and are referred to as over-the-counter (OTC) stocks.

How are stocks traded? There are two ways securities are traded: on the exchange floor and electronically. A typical trade (purchase or sale of a security) with a broker on the NYSE exchange floor is similar to the process depicted in Figure 16.5. Although most trades are done electronically, the chaotic buying and selling process on the floors of exchanges that you see in movies and on television still goes on.

Figure 16.5

Execution of a Simple Stock Trade on the New York Stock Exchange

Unlike the NYSE, where trades can be made electronically or on the trading floor, the NASDAQ stock exchange has always been completely electronic. NASDAQ lists more than 3,500 companies in 35 countries, and trades stock via a large and immensely reliable coordinated network of computer systems.4 Trades with the NYSE still require a broker to initiate the order. The broker will place the order electronically into the system, and when the order is received, the electronic exchange tries to match a buy order with a similar sell order. After the order has been executed, the broker notifies the buyer and seller of the successful completion of the trade. Figure 16.6 shows the steps involved with an electronic stock trade.

Figure 16.6

Execution of an Electronic Stock Trade

How is a broker selected? The process of selecting a broker can almost be as complicated as the process of selecting a type of investment. Before you decide on a broker, the SEC suggests you do the following:5

• Determine your financial objectives.

• Speak with potential brokers at several firms. Ask each about their education, investment experience, and professional background.

• Inquire about the history of the brokerage firm. You can find out if any disciplinary action has been taken against a firm or a broker online through FINRA BrokerCheck. Your state securities regulator can also tell you if a broker is licensed to do business in your state.

• Understand how the brokers are paid. The type of commission a broker receives might affect the advice that is offered. Also, ask what fees or charges you will be required to pay on the account.

• Ask if a brokerage firm is a member of the Securities Investor Protection Corporation (SIPC). The SIPC gives limited customer protection if a firm goes bankrupt.

Although it is ideal to start investing as early as possible, do not rush into the process. Take the time to do the necessary assessment of your own financial goals and consider the risks you are willing to take to meet those goals.

Is investing in foreign companies possible? You are not limited to investing in U.S. companies. Investing in foreign companies is a recommended strategy for diversifying a portfolio and possibly obtaining higher returns. Because of increased communication capabilities and the relaxation of legal barriers, investing in almost any foreign or international company is possible. There are a few ways to invest in foreign markets. Some stocks of foreign countries trade directly on the U.S. exchanges, or you can open an online stock brokerage account that allows international stock trading. Mutual funds and exchange traded funds, which will be discussed later in this chapter, are easier and less risky ways to add foreign investments to your portfolio.

Can I buy stocks if I don’t have enough cash on hand? Sometimes investors are presented with a great investment opportunity but do not have enough cash on hand to buy the stock. In these cases, the stock can be bought with borrowed funds from a broker. This is referred to as buying on margin. Brokers usually use the value of other assets owned by the investor as collateral for the investment. Buying on margin is very risky and is subject to fairly rigid SEC regulations.

What causes stock prices to change? Stock prices can change rapidly for a variety of reasons.

Ultimately, though, a stock’s price is derived by the forces of supply and demand. On the one hand, for whatever reasons, if investors like a stock, they will buy more of it, reducing its supply and pushing up its price. On the other hand, if investors don’t like a stock, more investors will sell the stock than buy it, creating a greater supply of it and causing its price to drop.

What influences investor behavior? Why might an investor like a stock one day and not like it another day? In general, most investors will invest if a stock’s price reflects what they think a company is worth or will be worth. (A company’s stock price times total the number of shares it has outstanding determines the firm’s capitalization, or value.)

Often, investors not only look at how a company is currently performing but also consider a company’s expected future growth in anticipation of increased earnings or profits. If investors become concerned that something negative will affect a company’s value, they will sell their shares, and the stock price will fall. Conversely, investors will purchase a stock as a result of good news about a company, and the price of the stock will rise.

For example, Figure 16.7 shows the change in the stock price of Tesla Motors, Inc. during the period of July 1, 2015, to March 15, 2016. During this period, there were some significant events that affected the amount of the stock traded (known as the volume) and its price.

Figure 16.7

Change in Stock Price and Volume of Tesla Motors, Inc. from July 1, 2015, to March 15, 2016

1. August 6, 2015, Tesla lowers is projection on the amount of cars it could produce, causing the stock to drop more than 6 percent.8

2. October 20, 2015, Consumer Reports gives a below-average reliability score, shares drop 10 percent.9

3. November 3, 2015: Tesla announces new leadership. Shares climb 11 percent.10

4. February 10, 2016: A general slip in stock value began around January 1, 2016, which coincided with a decrease in gasoline prices, causing an increased concern for the overall demand for electronic cars. However, the mid-February projection of a 60 to 80 percent increase in vehicle sales causes shares to climb 10 percent.11,12

What else influences stock prices? Stock prices also change in reaction to broader news based on economic forecasts, industry or sector concerns, or global events. How investors react is based on their confidence in the financial markets at the time, which can lead to longer periods in which a stock market increases or decreases in value. Figure 16.8 reflects the percent changes in the closing prices for Ford Motor Company; The Gap, Inc.; McDonald’s Corporation; and Philip Morris over a nine-month period. Even though the companies operate in diverse industries—automotive, retail, and consumer goods—notice that there is something consistent about their stock prices: Each changes daily.

Figure 16.8

Comparison of Stock Performance

In addition, if you look carefully, you might notice some generally similar stock movements that are most likely due to overall market variations—that is, where the market is having an “up” day or “down” day overall due to a significant occurrence such as a news event or a general change in economic conditions. There are also some variations particular to the company or the industry. Notice, for example, the consistency between McDonald’s and Philip Morris, which can be considered defensive stocks, and the similarity between Gap and Ford, which are more consumer stocks and can be affected by economic conditions.

How do you know how the overall market is doing? To see how the markets for stocks are doing overall, investors pay attention to stock market indexes, such as Standard & Poor’s 500 Composite Index (S&P 500), the DJIA, and the NASDAQ 100. An index tracks and measures the combined value of a large group of stocks. Different indexes track different stocks, based on characteristics they share, such as similarity in their sizes or the industries in which they operate:

• The S&P 500 is an index of the 500 largest companies, most of which are American.

• The DJIA is an index of the 30 largest capitalized public companies in the United States. The DJIA composite index initially included only those companies that had some connection to heavy industry, but today that is no longer the case.

• The NASDAQ 100 includes 100 of the largest domestic and international nonfinancial companies listed on NASDAQ. The NASDAQ 100 is distinguished from the DJIA and the S&P 500 by not including financial institutions in the group and including companies incorporated outside the United States.

The S&P 500 and the DJIA are the two most widely watched stock indexes of the three. They are important because what they measure reflects the state of the U.S. economy and sometimes influence.

A bull market indicates increasing investor confidence as the market continues to increase in value. In a bull market, investors are motivated by promises of gains. A bear market, however, indicates decreasing investor confidence as the market continues to decline in value.