How do Stock Works

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Chapter 2 : How do Stocks Work?

How do stocks work? arrow_upward

  • Stocks in publicly traded companies are bought and sold at a stock market (also known as a stock exchange).
  • For example, In the New York Stock Exchange, you can buy a share in a stock when a company first decides to trade itself on the stock market - that is, at flotation or privatization; or you can buy through the stock market once the shares are in circulation and being traded.
  • To buy or sell a stock you go to a stockbroker who does business with the stock exchange on your behalf.
  • Once you have bought your shares your broker can hold them electronically in a nominee account on your behalf, or you can hold them as paper certificates.
  • When you have bought or sold the shares, your transaction is usually completed (or settled) electronically.
  • This system links banks, stockbrokers and company registrars together.

  • Initial Public Offering (IPO) arrow_upward

  • An initial public offering (IPO) refers to the first time a company publicly sells shares of its stock on the open market.
  • It is also known as "going public."

  • How it Works/Example

  • The proceeds from the sale of stock shares in an initial public offering provide the issuing company with capital.
  • For this reason, many start-up companies issue IPOs because they're seeking a source of capital to fund growth.
  • IPOs are introduced to the market by an underwriting investment bank, which aids the issuing company by soliciting potential investors.
  • In addition, the underwriter helps the issuing company to settle on the price at which the stock should be offered to investors.
  • IPOs represent the first time an issuing company will financially benefit from the public sale of its stock.
  • Following the IPO, shares trade between buyers and sellers on the open market, whereby the underlying company receives no compensation.
  • Why it Matters

  • For a company, the capital earned from selling its shares to the public act can act as a major boost for business' growth, making the idea of an initial public offering attractive.
  • For investors, IPOs are a significantly higher risk as opposed to a currently traded stock. A lack of historical data combined with a usually limited history behind the company can make purchasing recently issued shares more risky.

  • How risky are stocks? arrow_upward

  • Investing in stocks carries an element of risk because prices can go down as well as up.
  • The price of stocks is a function of demand, which is based on investors' perceptions of the company's future earnings prospects.
  • The choice of stock - income or growth - is usually a question of the investor's attitude to risk.
  • Income stocks are generally safer and are preferred by more conservative investors.
  • Growth stocks are inherently more risky, but offer far greater potential for wealth accumulation through capital gains in the stock price.
  • Of course, until you sell your holding, these gains will not be realized.
  • As an investor, you should assess your appetite for risk and, based on this, select the stocks with which you are comfortable.

  • Market Risk

  • Market risk is the fluctuation of returns caused by the macroeconomic factors that affect all risky assets.
  • Market Risk is also referred to as systematic risk or non-diversifiable risk.
  • Market risk is comprised of the “unknown unknowns” that occur as a result of everyday life.
  • It can also be thought of as the opportunity cost of putting money at risk.
  • It is unavoidable in all risky investments.

  • How to take care of Market Risk

  • Every investor faces market risk as a securities market follows economic indicators, recessions and the normal business cycle.
  • The most basic strategy for minimizing market risk is diversification.
  • A well-diversified portfolio consists of securities from various industries, asset classes and countries with varying degrees of risk.
  • The specific risks will offset each other but some market risk will always remain.
  • Because of market efficiency, you will not be compensated for the additional risks that arise from failure to diversify your portfolio.
  • This is extremely important for those who may have a large holding of one stock as part of an employer-sponsored incentive plan.
  • Specific risk exposes you to adverse events on a company or industry level in addition to adverse events on a global, economic level.

  • Political Risk

  • Political risk is the risk of financial, market or personnel losses because of political decisions or disruptions.
  • Also known as "geopolitical risk."
  • There are many environmental factors facing business. 
  • Besides market-based causes, business can be affected by political decisions or changes.
  • For example, political decisions by governmental leaders about taxes, currency valuation, trade tariffs or barriers, investment, wage levels, labor laws, environmental regulations and development priorities, can affect the business conditions and profitability.
  • Similarly, non-economic factors can affect a business. For example, political disruptions such as terrorism, riots, coups, civil wars, international wars, and even political elections that may change the ruling government, can dramatically affect businesses’ ability to operate.
  • Political risks are faced equally by investors in international businesses and investment fund portfolios. 
  • These political risks are part of the estimation and disclosure of risk factors, usually found in a company or portfolio's prospectus.

  • How to take care of Political Risk

  • Political risk can affect the operations and profitability of a business as directly and quickly as any financial, physical, or market risk factor.  
  • The impact of political risk is considered to be long-term because the risk rises over time, given the greater potential for events and changes over time. 
  • Although political risk is extremely difficult to quantify, companies and investors must examine and understand the potential for political risks by closely examining the location's history, political institutions, and political forces at work in the region.

  • Thank You from Kimavi arrow_upward

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