Understanding how stocks work

Companies issue stock to raise money to fund a variety of
initiatives, including expansion, the development of new
products, the acquisition of other companies, or to pay off
debt. In an action called an initial public offering (IPO), a
company opens sale of its stock to investors.

An investment banker helps underwrite the public stock
offering. By underwrite, I mean that the investment banker
helps the company determine when to go public and what
price the stock should be at that time.

When the stock begins selling, the price can rise or fall from
its set price depending on whether investors believe that the
stock was fairly and accurately priced. Often, the price of an
IPO soars during the first few days of trading, but then can
later fall back to earth.

After the IPO, stock prices will continue to fluctuate, based
on what investors are willing to accept when they buy or sell
the stock. In simple terms, stock prices are a matter of supply
and demand. If everyone wants a stock, its price rises,
sometimes sharply. If, on the other hand, investors are fearful
that, for example, the company’s management is faltering
and has taken on too much debt to sustain strong growth,
they may begin selling in noticeable volume. Mass sales can
drive the price down. In addition to specific company issues,
the price can drop for other reasons, including bad news for
the entire industry or a general downturn in the overall
economy.

Stocks are bought and sold on stock exchanges, such as the
New York Stock Exchange, Nasdaq, and the American Stock
Exchange. Companies that don’t have the cash reserves necessary
to be listed on one of the exchanges are traded overthe-
counter, which means that they receive less scrutiny from
analysts and large investors such as mutual fund managers.
In addition, professional analysts who are paid to watch companies
and their stocks can give a thumbs-up or a thumbsdown
to a stock, which in turn can send stock prices soaring
or plummeting. These stock analysts sit in brokerage firms
on New York’s fabled Wall Street and various cities’ Main
Streets. The analyst’s job is to watch closely the actions of
public companies and their managers and the results those
actions produce.

By carefully monitoring news about a company’s earnings,
corporate strategies, new products and services, and legal and
regulatory problems and victories, analysts give stocks a
buy,
sell, or hold rating. Such opinions can have a wide-sweeping
impact on the price of a stock, at least in the short-term.
Rumblings, real or imagined, can send the price of a stock,
or the stock market overall, tumbling downward or soaring
skyward.

The price of stock goes up and down — a phenomenon
known as volatility — but if the news creating the stir is shortterm,
panic is an overreaction. You don’t want to sell a stock
when its price is down, only to see it make a miraculous recovery
a few days, weeks, or even months down the road.
Smart investors who have done their research and are invested
for the longer-term won’t be impacted by short-term price
dips or panics. Unless of course, you use the opportunity to
buy a stock you’ve already researched and were going to buy
anyway. The old adage — buy low, sell high — holds as true
today as it did 75 years ago.

How low can stock prices go? In October 1987, stock prices
tumbled by 22.6%. This decline meant that the value of a
$10,000 investment dropped to $7,740. Many stocks recovered,
but some did not.

You can lose all your money with a stock investment, and
that risk is why you need to analyze your choices carefully.
The three most basic types of risks associated with stock
investments are
 You may lose money.
 Your stocks may not perform as well as other, similar
stocks.
 A loss may threaten your financial goals.
Stock investing carries certain risks, but they can be minimized
by careful investment selection and by diversification,
a technique for building a balanced portfolio.