Stock Market 101

Last week I got into a conversation with one of my peers about the stock market.  The interesting thing about the conversation is that even though I took economics in college and I trade on the market periodically, I had a hard time communicating effectively about what the stock market was and what the three indices represented.  As all of you know, I pride myself on short sweet communication that gets to the point.

That conversation made me sit down and really figure out, how I could communicate clearly about the markets, what they represent, and most of all, do you really need to know what they are to be able to invest?  Let’s start with the last question first.  Most of us will not be too concerned about the overall markets averages.  90% of investors hear about a company and want to invest, so they do.  While the average of the Dow is important for some people, most won’t be too concerned about how the average moves. 

It is important for you to know and understand what the terms that are being used actually mean.  So there are a million (actually, 33,800,000) search results for stock market terms on Google.  So as you can see there is no shortage of ideas and thoughts.  But what I found is that Wikipedia has the most comprehensive information, as long as you have hours to read and click on the links. Over the next few article, I will try to break down some of the most critical aspects of the stock markets, the indexes, and how you as a individual can leverage the information to make educated decisions.

So, the  Dow Jones Industrial Average (DJIA), also referred to as the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is named after Dow and one of his business associates, statistician, Edward Jones. It is an index that shows how 30 large, publicly owned companies based in the United States have traded during a standard trading. The 30 companies are very large, Boeing, ALCOA, and American Express are three of the 30.  For a more detailed list click here.

For the history of Charles Dow and the Dow Jones Industrial Average, click here.

The Industrial portion of the name is largely historical, as many of the modern 30 components have little or nothing to do with traditional heavy industry. The value of the Dow is not the actual average of the prices of its component stocks, but rather the sum of the component prices divided by a divisor, which changes whenever one of the component stocks has a stock split or stock dividend, so as to generate a consistent value for the index.

The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market, meaning that it has over 3,000 components. It is highly followed in the U.S. as an indicator of the performance of stocks of technology companies and growth companies. Since both U.S. and non-U.S. companies are listed on the NASDAQ stock market, the index is not exclusively a U.S. index.  Companies like Apple and Yahoo are on the NASDAQ, for a full list click here. The index focus is U.S.-based companies although there are a few legacy companies with headquarters in other countries.

After the Dow Jones Industrial Average, the S&P 500 is the most widely followed index of large-cap American stocks. It is considered a bellwether for the American economy, and is included in the Indes of Leading Indicators. Many mutual funds, exchange-traded funds, and other funds such as pension funds, are designed to track the performance of the S&P 500 index. Hundreds of billions of US dollars have been invested in this fashion.
So let’s look as some terms often used and associated with the stock markets:

• Dow Jones Industrial Average – This is a compilation of the 30 most traded blue chip stocks. This list is the most widely used for analyzing stock market indexes.  
• NASDAQ – This is a stock exchange consisting primarily of technology companies.
• S&P 500 - Made up of the 500 biggest and most successful U.S. companies.
• Stock – This is the smallest measurable unit of ownership in a company. Shares fall into either the common or preferred categories; companies issue shares of stock in order to raise capital without borrowing money.
• Ask – This is the lowest price that a seller will accept when selling a stock.
• Bear – This refers to an investor who believes the stock market or a particular stock is declining. This is the opposite of a Bull.
• Bid – This is the highest price that a buyer is willing to pay for a stock.
• Broker – A person that buys or sells stocks, bonds, commodities and such in exchange for a fee which is called a commission.
• Bull – An investor who believes the whole market or one individual stock is going to increase in price. This is the opposite of a Bear.

Investing terms – These words and phrases reflect stock market terms for various stock market strategies.   These stock market terms are used to describe specific conditions or analysis.

• Dividend – This is the portion of a company’s profit that is given back to the investors. Such payments are made on either an annual or quarterly basis.
• Book Value - This is the value of a company if assets and common stock equity are added together and all liabilities are subtracted. There is little correlation between the book value and the market value. Book value is used in such fundamental analysis measurements as Price to Book ratio.
• Blue Chip – This term describes a company with a history of strong earning, traditionally increasing dividends and an outstanding balance sheet. Blue Chip stocks include Exxon-Mobile, Coca-Cola and Wal-Mart.
• Market Capitalization – A company's market capitalization, also known as its market cap, is calculated by taking the number of outstanding shares of stock multiplied by the current price per share.
• P/E Ratio – This widely used analysis tool of Price to Earnings Ratio measures now you pay for each dollar of corporate earnings. For example, if you have $45 stocks that report a profit of $3 per share, your P/E ratio is 15; $45 per share divided by $3 earnings per share equals 15. In this ratio the lower the P/E ratio, the better.
• Spread: This stock market term reflects the difference between the Ask and the Bid. 
• Yield – This is the percentage of a dividend paid against the stock price.  For example, if you receive a $4 dividend on a $40 per share stock, your yield is 10%.