TodayForward

The Dow is Down More than 1,200 Points in Less than a Month - Are You Taking It in Stride?

The Dow Jones Industrial Average is down more than 1,200 points since its intraday peak on April 26th, and an appropriate question is whether you're taking it in stride or if the temptation to push the panic button is creeping into your mind.  When the market sinks more than 10%, Wall Street calls it a 'correction', and now we officially have one.  While the causes of this recent decline vary based on whom you ask, we find the entire discussion irrelevant.  Here's why:

Oracles, Seers, and Fortune Tellers

The fact remains that no one can accurately predict the movements of the market.  As we have explained previously, until you can explain the decisions of the billions of global market participants, you simply cannot know what will happen in the future.  Thus, oracles, seers, and fortune tellers that go by the titles of Chief Investment Strategist, Lead Economist, Hedge Fund Manager, and the like are no better able to assess what's coming next.

If the Future is Uncertain...

Accepting this fact, it is pretty simple to know what to do, and the answer isn't 'do nothing'.  Whenever the stock market takes a tumble, it is a good time to assess where you are with your portfolio, and what we mean by this is to consider not just how your assets are allocated, but where you are with your job, insurance coverages, emergency fund, and so on.  The reason for this is your investments - even long term investments for retirement - don't live inside of a vacuum.  They are an important part of your overall financial health.

Wide Lens Investment Management

To better weather a storm in the stock market, you need to review and ensure that you are covering all of your bases with particular attention paid to job security, insurance coverages, emergency reserves, and your ability to tolerate risk.  This is what we like to call 'Wide Lens Investment Management' because instead of taking the narrow view and only examining an investment portfolio, this method incorporates other important factors that can affect your investments.

T. Rowe Price has the slogan of 'Invest with Confidence'.  We like to think that confidence is a byproduct of knowing you have a secure job, appropriate insurance, and sufficient cash for an emergency because you can be as confident in your portfolio as you'd like, but that won't help if you're exposed in other areas of your finances.  It's nice to have a well put together portfolio, but many other issues must be addressed first.

How We Do It

On our site, we help you put together an asset allocation model, just like many other investment sites, but we do it with a wide lens.  We require you to complete an emergency fund plan first so we can better understand your cash position and ability to handle a job loss or short-term disability.  Once that is complete, you can then put together a retirement investment plan that will provide you with an asset allocation model.

Again, we use a wide lens because we don't just take into account your time horizon and risk tolerance, but we also assess your ability to withstand a major financial emergency and put that in view with the market's current valuation relative to long-term averages.  If you're light on your emergency fund, we'll suggest you hold cash in your retirement portfolio to cover the difference.  When the market looks expensive (as it has for some time now), we dial down exposure to stocks.  

The goal of our software is to deliver an asset allocation that is appropriate in light of your entire financial picture and to help smooth out some of the bumps along the way.  We don't worry about returns because returns are a function of your risk tolerance (never the other way around).  If you can 'Invest with Confidence', we're betting that your returns will be more than sufficient and you won't have quite the stomach ache when times are tough - like today.

If you would like to get a wide lens view of your portfolio, feel free to setup an account with us at TodayForward.  It's free for now, as we're still in our second round of testing.

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Add to Emergency Fund or Contribute to a Roth IRA

Everyone has limited resources and unlimited wants, and one of the most common questions is whether to add to an emergency fund or contribute to a Roth IRA.  While the answer varies from person to person, for most people, contributing to a Roth IRA is usually the better move.  The reason for this has everything to do with the nature of the Roth IRA.

Contributions are Tax and Penalty Free

With a Roth IRA, your contributions can be withdrawn tax and penalty free.  When the Roth was created in 1998, legislators wanted to be sure greater flexibility was afforded to Americans in an effort to increase retirement readiness.  The result was a retirement account that included liquidity features that were far better than its predecessor, the Traditional IRA.

Cash is King

Though you might think of a Roth IRA as an investment, it's really just a type of account.  What you hold in this account is up to you.  If you are short on your emergency fund and retirement savings, the best bet is to contribute to a Roth IRA, but keep the money in cash.  The reason for this is when an emergency comes up, you won't have to take money out when the market is down (more emergencies come up when the market is down than when it is up).

Preserving Tax Benefits

Investing in cash isn't exciting and it likely won't take you much closer to your retirement goals.  However, it does preserve your tax break.  Roth IRA withdrawals are completely tax free during retirement, and even if you don't invest it in higher yielding assets like stocks or bonds, the tax break will be preserved.  As your financial situation improves and your emergency fund grows, you can start investing more aggressively.

Application:  Roth IRA in Cash

Let's say that Jane needs an emergency fund of $15,000, but currently has $3,000 set aside.  She can save up to $300 per month and decides to put this money into a Roth IRA.  After three years, an emergency comes up and she needs to pull out $5,000.  She can do so without penalty or taxes from the Roth IRA whose balance is just north of $10,800.  She takes $5,000 out, no penalty or taxes are paid, and the emergency is taken care of.

Application:  Roth IRA in Stocks

Wild Bill loves playing the stock market.  He, just like Jane, needs $15,000 set aside, has $3,000 in reserve, and can save $300 per month.  He too decides to contribute $300 per month to a Roth IRA over a three year period, but he will invest it in stock.  Over the three year period, Wild Bill contributed the same amount as Jane, $10,800, to his Roth IRA, but because the market declined, his balance was $5,800 when an emergency came up.  His $5,000 withdrawal to take care of the emergency left him with a balance of just $800 compared to Jane at $5,800.

Wrapping Up

In answering this question of putting money into an emergency fund or a Roth IRA, the Roth is the better option.  It offers tax and penalty free withdrawals of contributions, can be invested in cash, and preserves a major tax advantage to make retiring easier.  The big caveat, however, is that if you're short on an emergency fund and retirement savings, choose cash instead of the markets.  Only after your cash reserves balance has grown to a sufficient level should these funds be invested in more volatile assets.

Critical Thinking

• Investing in cash is certainly better for protecting against an emergency, but the market is usually up more often than not.  Why should cash be held over a stock portfolio in these examples?
• If Jane and Wild Bill had $10,000 instead of $3,000 in their emergency fund, should they take money from their reserves and put them into a Roth IRA or leave the money where it is?
• Once Jane and Wild Bill have reached their emergency fund goal of $15,000 through the Roth IRA, is it safe to invest the entire amount in a portfolio of stocks and bonds?  If not, how much should be put into the markets?

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Total Returns, Best and Worst, and Risk for Stocks, Bonds, and T-Bills from 1926 through 2009

When it comes to building a portfolio, there are three major asset classes - stocks, bonds, and cash.  The most common measures of these asset classes are the S&P 500 index (large cap stocks), Barclay's long-term government bond index, and Barclay's 3-month T-bills index.  Below is a table that shows the average annual total return, best year, worst year, and risk of each of these indices.

	Stocks	Bonds	T-Bills
Avg. Annual Return	9.9%	5.5%	3.8%
Best Year	60.0% 1935	42.1% 1982	14.0% 1981
Worst Year	-41.1% 1931	-12.2% 2009	0.0% 1940
Standard Deviation	19.2%	10.1%	0.6%

As would be expected, moving from left to right shows a declining level of return and risk.  In addition, it's helpful to know that inflation has averaged roughly 3.1% over the same period of time.  This means that the real return (total return minus inflation) are 6.8%, 2.4%, and 0.7% for stocks, bonds, and cash, respectively.

In addition to the standard deviation measure, the best and worst year ranges offer up some valuable information.  Investors have never lost investing in T-bills over the course of a year while stock investors have suffered through substantial losses over time.  Another interesting footnote to this table is that 2009 was the worst year on record for holders of long-term bonds.

What we would like for you to takeaway from this is that risk and return characteristics vary greatly among these three major asset classes.  For this reason, they are a great place to start when deciding how to assemble your investment portfolio.  As we'll see later, finding the right combination of these asset classes is perhaps the most important factor in determining your portfolio's level of risk and return over the long run.

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Annual Returns of Select Indexes - The Callan Chart

One of the most useful tools in understanding returns of various asset classes and categories is known as the Callan Chart (pictured above) that bears a striking resemblance to the Periodic Table most of us have seen in chemistry class.  There are few graphical depictions that drive home the importance of diversification than this chart.  It illustrates the last twenty years of returns measuring eight major indices.

In looking at the Callan Chart, the most important takeaway is that returns vary widely from year to year and that each asset class and category behaves differently.  To put it another way, the importance of diversification is clearly demonstrated.  If you take a few moments to read the back of the chart, you'll learn some interesting facts and figures.

Click here to view the chart from Callan and Associates' website.

Critical Thinking

• In how many of the last 20 years have all asset classes and categories lost money?  Why is this true?
• Which index has been in the bottom half of annual returns most frequently?  Why?
• Do bonds always have positive returns?
• Why have international stocks performed so well over the last decade?

NOTE:  Callan and Associates produces many variations of this chart that include a wide range of indices and are customized for investment firms.  This particular chart is free of charge from their website.

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Trading Stocks on Margin versus Cash

When it comes to trading stocks, they can be bought and sold in two major account types known as cash and margin.  Most of us are familiar with cash accounts as all IRAs are setup this way.  However, with taxable accounts, margin can be employed to enhance returns.  To better understand this, let's walk through these two important account types and work through a couple of examples.

Cash Accounts

The most basic way to trade stocks is in a cash account.  In this type of account, cash is deposited and then trades may be placed using these funds.  Stocks purchased in cash will deliver one-for-one returns based on their performance.

Margin Accounts

With taxable brokerage accounts, margin can be established.  What this means is that a credit line is opened with securities held in the account as collateral.  No interest is charged to the account owner(s) unless money is borrowed.  Also, not all securities can be used as collateral.  Well established stocks are fine, but thinly traded small companies or troubled large companies often are not marginable (meaning they cannot be borrowed against).

Risk and Reward Magnified

The reason many choose to use margin loans to purchase securities is to leverage holdings in an effort to magnify gains.  However, just as gains are magnified, so too are losses.  In addition, the risk trade off isn't exactly even because a margin loan also carries interest charges that vary based on prevailing interest rates.  This is an important fact because the maximum gains are reduced by interest charges, while losses are deepened because of these costs.

Application:  On the Way Up

During the latter part of the 1990s, technology stocks seemed to know no limits.  As a result, many investors elected to use margin loans to leverage their portfolios and increase their returns.  Interest rates were relatively low, and tech stocks were trouncing the overall market.  The chart shows the tech heavy NASDAQ compared to the S&P 500.  As you can see, investing in tech certainly paid with a gain of close to 80% versus the overall market at just shy of 20%.

Let's say an investor had a portfolio with $100,000 invested in the NASDAQ at the beginning of 1999.  Using only cash, he or she would have gained approximately $80,000 (80%) in twelve short months.  However, let's assume that he or she took out a margin loan for $50,000 at the beginning of the year to invest in the NASDAQ and that the loan had an interest rate of 8%.  Over the course of the year, the investor would have gained $120,000 (120%) before interest charges and $116,000 (116%) after interest charges - a huge win for the investor.  The portfolio would be worth $270,000 minus $54,000 for the margin loan for a net value owned by the investor of $216,000.

Application:  On the Way Down

Now that we've seen what margin can do on the upside, let's see what the flip side looks like.  For that, let's follow the same investor from the tech bubble peak through the following year.  Below is a chart that shows the NASDAQ getting crushed with a near 60% loss from March of 2000 through March of the next year.

Assuming our investor had continued to utilize margin, he or she would have lost roughly 60% and paid interest.  To keep the numbers simple, let's assume that the portfolio balance was $100,000 and the margin loan was $50,000 at an 8% interest rate.  At the peak, our investor held $150,000 worth of the NASDAQ, owning two-thirds of this with the remainder owned through a loan.  After one year, the total portfolio would be worth just $60,000, but the margin loan must still be repaid.  Including interest charges, the margin loan totaled $54,000.

Looking at these figures, we find that our investor owned only $6,000 of the portfolio (net equity) with the other $54,000 being owed to the brokerage company for the margin loan.  In other words, the investor started the year with $100,000 in net equity and finished it with just $6,000 - a net loss of 94%!!!

Wrapping Up

Here's what we've learned:  two account types can be established for most non-retirement accounts - cash and margin.  Cash accounts result in one-for-one returns while margins leverages those returns while magnifying risk.  Marginable securities can be used for collateral to take out a margin loan that carries a variable interest rate and is owed to the brokerage firm.  When things are good, margin greatly enhances returns; when things aren't good, margin can wipe out a portfolio.

Critical Thinking

• When should margin be employed?  When should it be avoided?
• What level of risk tolerance would be required to stomach a margin loan in good times and bad?
• For whom is margin appropriate?  Inappropriate?
• If margin rates are 10%, what level of gain would be required to offset the interest costs?  What are the odds of achieving these kinds of returns over time?
• Is margin best used as a long-term or short-term investment tool?  Why?

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The Difference Between Buying Long and Selling Short

Regardless of the direction of a stock, when the price changes, some will make money while others will lose.  The reason for this is the difference between buying long and selling short.  Our most common conception of investing in stocks is to buy while the price is low and sell when the price is high.  However, there are many investors (typically with a great deal of money at work in the market) that do the reverse - sell high and buy low.

Buying Long

Unless you're an eternal pessimist, buying a stock in the hopes that its share price will appreciate is a good way to invest in the market.  After all, stocks have the greatest return of all major asset classes, averaging anywhere from 8% to 17% depending on the timeframe surveyed.  Since the odds are generally in the investor's favor over time, buying today and waiting for the share price to increase down the road seems to be a good bet.  As a result, the overwhelming majority of investors buy long positions in stocks and hope to receive a good return over a long period of time.

Selling Short

For pessimists and opportunists, selling short is a valuable way to play the market.  As noted above, selling short has the goal of selling shares at a high price and buying them back at a low price.  This begs the question:  How can you sell shares that you don't own?  The answer is that you borrow them.

When you open a brokerage account with a company like Fidelity, E*Trade, or Schwab, buried in the fine print is usually a provision that allows the company to 'lend' your shares to other account holders.  While you don't really lose possession of the shares, your ownership stake allows a short seller to borrow the shares and sell them in the open market.

During this period where the shares are on 'loan', you won't see any changes on your statement, but the short seller will have a short position in the borrowed stock.  During this period of time, the short seller will pay interest to the brokerage company for use of the borrowed stock.  These rates can vary greatly, but usually aren't too far from the prime rate (for large accounts, anyway).

If the stock drops as the short seller hopes, he or she will then 'buy to cover' which will close out the position.  The proceeds from the sale are then taken against the cost of the purchase plus the interest charges.  If the proceeds are greater than the costs, the short seller will make a profit.

Application:  Buying Long

As an example, let's suppose we purchase 100 shares of XYZ stock for $20 per share.  This means that the shares have a total cost basis of $2,000.  A year later, the shares are worth $40 per share.  This results in a profit as calculated here:

$4,000 sale proceeds  -  $2,000 cost basis  =  $2,000 profit

Application:  Selling Short

Taking the same process in reverse, we sell 100 shares of XYZ stock for $40 per share and receive $4,000 in sale proceeds.  One year later, the stock has fallen to $20 per share and 100 shares are bought to cover for a total of $2,000 in cost basis.  During the holding period, interest was charged in the amount of $180.  This results in a profit shown below:

$4,000 sale proceeds  -  $2,000 cost basis  -  $180 interest  =  $1,820 profit

As you can see from these two calculations, the only difference in the math is the added cost of interest for short selling, but it's the same concept for both - sale proceeds minus costs equals profit.

Wrapping Up

From this article, you should remember that buying long is the most prevalent method of investment in the stock market.  This has many reasons, but the best one is that the market pays quite well over time.  Short selling is simply the reverse of buying long, but with an important difference - short sellers must pay interest on borrowed shares.

Critical Thinking

• If you plan to invest your money for retirement, which investment strategy is best - buying long or selling short?
• Are short sellers more likely to be long-term investors or short-term traders?
• Why do short sellers exist in the marketplace?  Do they serve an important function?
• Often, when a stock on the decline has been sold short in large quantities, short sellers must eventually buy to cover so they can cash in on their profits and stop paying interest.  What will happen to the share price if all of these short sellers buy to cover at the same time?
• At least in theory, stock prices can go up forever, but can only drop to zero.  What is the short seller's maximum profit opportunity?

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Why Stock Prices Change - The Long and Short of It

Here's the long story:  There are millions of investors and billions of participants in the world's economy.  On any given day, each of these individuals make decisions based on the information they have available.  This adds up to many billions of decisions made daily as a result of trillions of pieces of information.  The results of these decisions affect businesses and consequently their stocks.

Of course, not all information is created equally, and not all decisions have the same level of influence.  If a man in India buys a new razor, the company selling that razor made some money, but it's probably not a huge deal.  However, what if the government in India levies a 300% tariff on razors from U.S. companies because they're putting domestic razor manufacturers out of business?  Now that's a little bit higher on the impact scale.

But what if this tariff is unfounded?  What if Indian razor manufacturers were failing because of internal corruption?  Well, the U.S. manufacturers could go to court and have the tariff lifted and if that were the case, as quickly as their shares fell, they would surely rise - perhaps even higher than before the tariff was instituted.

Why would the share price be even higher after all of this?  If the tariff is indeed found to be illegal, and Indian manufacturers are very weak as a result of internal corruption, this means investors would likely bid up the price of U.S. razor companies under the belief that their Indian competitors will be put out of business, thereby expanding the profit opportunity.

In bullet points, here's what happened in this example:

• Pre-tariff:  Indian and U.S. companies compete in India
• Pre-tariff:  Indian companies are struggling financially and ask the government to add a tariff to U.S. razors to boost sales
• Tariff:  The Indian government responds by creating a tariff to protect local jobs; U.S. shares decline, Indian shares climb
• Post-tariff:  The U.S. companies file a grievance and take the issue to court
• Post-tariff:  The court finds that the Indian companies in question are poorly run and have a great deal of corruption.  As a result, the court orders the tariff lifted.  U.S. shares rise above initial prices, Indian shares fall below initial prices

What this story tells us is that prices fluctuate based on information and decisions.  With the size and reach of large companies today, there is a mountain of information to sift through and a multitude of decisions made outside the company that influence share price.  Unless you can account for all of this, you cannot predict share prices and this is why we never care about share price target estimates - you simply cannot make accurate predictions because information and decisions are constantly changing and are rarely, if ever, perfect.

Here's the short story:  When demand for stocks is different than the supply for stocks at a given price point, stock prices change.  Wow, that was easy!

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How to Read a Stock Quote

The image above is a stock quote for Google from Yahoo! Finance.  Just in this little snapshot, there is a great deal of information to sift through that can tell us a little bit about the stock.  We'll work through this example from the top to bottom, left to right so you can learn how to read a stock quote like a pro.

Line 1:  Name, Market, Symbol

In the first line, you see the name of the company, the market on which the company's stock trades, and the symbol representing the stock in the market.  In this case, we have Google Inc. trading on the NASDAQ market under the symbol GOOG.

Line 2:  Real-Time Data

On Yahoo! Finance, they offer a real-time quote that shows the last trade, the dollar change, percent change, and time of the last trade.  Reading this, we would say, "Last trade for Google was at $557.20 per share, up $7.10 on the day or 1.29% as of 3:21 p.m. Eastern Time."

Column 1:  Last Trade through 1-yr. Target Estimate

Please note that in this example, Yahoo! Finance does not provide real-time data as this is reserved for premium services that we don't subscribe to (that's what online brokers are for).  Here's what we see in this first column:

• Last Trade - Obviously this is delayed, but the last trade was at $558.57.
• Trade Time - The trade time of the last trade quoted above was at 3:06 p.m. Eastern Time.
• Change - This is the dollar and percent change based on the delayed last trade and Google was up $8.47 or 1.54%.
• Previous Close - On the last trading day prior to today, Google closed at $550.10 and this is the number used to measure dollar and percent change.
• Open - Though Google closed at $550.10, it opened at $554.89.  You might assume that where a stock closes is also where it would open, but thanks to after hours trading and pre-open trading, these numbers can be significantly different.  In this case the difference is $4.79.
• Bid - The bid price is the price at which you can sell your shares.  The number '100' to the right of the bid price is known as the lot size.  One lot is equivalent to 100 shares, so in this case, you could sell up to 10,000 shares of Google at a price of $558.42 if yours was the next order in line.  The way to read this is, "Google shares bidding $558.42 by 100."
• Ask - The ask price is the price at which you can buy shares on the market.  As discussed immediately above, the lot size is also provided.  This would be read as, "Google shares asking $558.80 by 100."
• 1y Target Est - This is the one year target estimate for the share price of Google.  It can largely be ignored because it is based on opinions of analysts and if all one year target estimates held true, everyone would be rich as they're often overly optimistic.

Column 2:  Day's Range through Dividend and Yield

In the second column are data that are less relevant to executing a trade and provide the baseline for fundamental and technical stock analysis.  We'll set that conversation aside for the moment, but here is our quick take on the second column:

• Day's Range - Any range offered is a good measure of volatility and can also tell you how a stock's share price is trending.  For a day's range, if the last trade was near the high end of the day's range, the shares have generally trended up for the day.  If it's near the low end, it's trending lower.  In this case, Google's range was from $551.06 to $559.66.
• 52wk Range - Google's share price has ranged from $375.89 to $629.51 over the last year.  Since the last trade was nearer the high end of this range, the shares appear to have strengthened over the last year.
• Volume - This is the day's volume of shares that have traded on the NASDAQ.  Thus far, 2,435,607 shares have changed hands.
• Avg Vol (3m) - Over the last three months, Google's volume has averaged 3,520,640.  With 2.4 million shares having traded at 3:21 p.m., it's a relatively slow day.
• Market Cap - Market capitalization is the total value of the stock and is calculated by multiplying the number of shares outstanding by the share price of the stock.  Google is a behemoth at $177.57 billion in total market capitalization.
• P/E (ttm) - Based on the Google's earnings per share over the last twelve months and its current share price, the stock's price-to-earnings ratio is 25.41.  P/E is a key measure of a stocks valuation and can be used against other stocks in an industry to compare whether a stock is under or overvalued.
• EPS (ttm) - In the last twelve months, Google earned $21.99 per share or to put it another way, for every share of stock owned, $21.99 of earnings is 'owned' by that share.
• Div & Yield - This is where any dividend and yield information would be provided.  Since Google does not pay a dividend, there is no yield.  However, if Google paid an annual dividend of $55.86 per share, this would be a 10% yield as it represents 10% of the shares last trade.

Putting It All Together

In looking at this stock quote, we would say something like, "Google shares last traded at $558.57 at 3:06 pm Eastern Time, a gain of $8.47 or 1.54% on the day.  Its previous close was at $550.10 and opened the day at $554.89.  Currently the shares are bidding $558.42 by 100 and asking $558.80 by 100.  The one year targeted price estimate is $672.67.  In today's trading, Google shares ranged from $551.06 up to $559.66 and have a 52-week range of $375.89 up to $629.51.  Volume today was 2,435,607 shares with average 3 month volume at 3,520,640 shares traded.  Current market cap is $177.57 billion with P/E of 25.41 and earnings per share of $21.99.  No dividend is paid at this time."

Sounds like a mouthful, right?  Fortunately, only parts of this quote are necessary to get the job done.  If you're buying shares, you need only look at the ask.  If you're selling shares, look only at the bid.  If you're simply interested in what the value of your shares are, check the last trade.  The rest of it is good information, but more of a 'nice to know' rather than a 'must know'.

Critical Thinking

• What does the quote above imply?  Is Google having a good day?  How about the last year?
• If the lot sizes were different, let's say the bid size was 10 and the ask size was 1,000, is there upward or downward pressure on the price of the stock?  Why?
• It appears that the volume is below the three month average.  What does this imply about today's trading?
• Google opened higher today than yesterday's close, what events could have caused this to happen?

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The 15 Largest Stock Markets and Exchanges

The United States has the most highly developed capital markets in the world and the size of the U.S. stock market is one of many examples that proves this out.  The combined market capitalization (total dollar value of all stocks) of the NASDAQ OMX and NYSE Euronext is nearly $16 trillion - more than the next six largest exchanges combined.

As you know, stock markets serve an important function in providing a place for the issuance of new shares so companies can finance operations and to provide liquidity and real-time valuation of previously issued stocks for investors.  Having high functioning stock markets and exchanges provides an incredibly valuable service to companies, shareholders, and citizens of the countries that host them.

Below is a list of the largest stock exchanges and markets from data compiled by the World Federation of Exchanges.  As you can see, most are from developed economies, but developing countries such as China, Brazil, and India are rapidly becoming more important centers for the exchange of equities.

1. NYSE Euronext, United States ~ $12.4 trillion
2. Tokyo Stock Exchange, Japan ~ $3.5 trillion
3. NASDAQ OMX, United States ~ $3.5 trillion
4. NYSE Euronext, Europe ~ $2.8 trillion
5. London Stock Exchange, United Kingdom ~ $2.8 trillion
6. Shanghai Stock Exchange, China ~ $2.6 trillion
7. Hong Kong Exchanges, China/Hong Kong ~ $2.3 trillion
8. TSX/Toronto Stock Exchange, Canada ~ $1.8 trillion
9. Bombay Stock Exchange, India ~ $1.4 trillion
10. BM&F Bovespa, Brazil ~ $1.3 trillion
11. Australian Stock Exchange, Australia ~ $1.3 trillion
12. Deutsche Borse, Germany ~ $1.3 trillion
13. BME Spanish Exchanges, Spain ~ $1.3 trillion
14. National Stock Exchange, India ~ $1.2 trillion
15. SIX Swiss Exchange, Switzerland ~ $1.1 trillion

Source:  World Federation of Exchanges as of March 2010. For updated statistics or to view other member exchanges, click here.

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What is a Stock Market? An Overview of Stock Exchanges

The simple answer is that a stock market is a public market where shares of stock can be bought and sold, but this doesn't do enough to answer the question, "What is a stock market?"  Moving the definition a little further along, a stock market is also an important part of the financial system as companies can issue new stock to fund their operations or retire stock to reduce the number of shares outstanding.  Thus, a better definition of a stock market is a public market where shares of stock can be issued, bought, sold, or retired.

Stock Exchange

The most recognizable example of a stock market is the New York Stock Exchange (NYSE) where an auction market exists to match buyers and sellers in individual stocks.  Without grinding through the details, an auction market has an 'auctioneer' known as a specialist who is responsible for maintaining an orderly market in a particular stock.  The specialist's job is to match buyers and sellers through an order book where orders for buys and sells are maintained.  While most of this happens through computers, large orders continue to be taken care of by the specialist and it is estimated this accounts for up to 18% of order flows at the NYSE.

Over-the-Counter

The NASDAQ (National Association of Securities Dealers Automated Quotation) is the top example of an over-the-counter market.  This type of stock market functions differently than an exchange.  In processing buy and sell orders, a number of 'market makers' continuously buy and sell for their own accounts and post prices at which investors can buy and sell.  In any single stock, there can be several market makers competing for order flow and offering various prices.  This is quite different than on an exchange, as a specialist does not buy and sell from its own inventory as market makers do in the over-the-counter market.

New Issues - The Primary Market

If you're a private company like Facebook, you can raise a tremendous amount of capital by 'going public' which means issuing new stock to be traded on an exchange or over-the-counter.  The process for this is rather convoluted, but the basic setup is a company will contract with an investment bank and they will value the shares.  At that point, the investment bank will underwrite the initial public offering meaning that if not all of the shares sell to the public, the bank will purchase the remaining shares at the agreed upon price.  After the shares have been issued, the company (Facebook, for example) would receive the cash and the stock would begin trading either on an exchange or over-the-counter.  The process of issuing new stock and the proceeds of the sale going to the issuing company is said to take place in the primary market.

Buying and Selling - The Secondary Market

After new shares have been issued, they trade on the secondary market where the company receives no further compensation, but investors can buy and sell shares, moving the price of the stock up and down over time.  While the company doesn't receive any direct dollars from the stock, the secondary market continues to serve an important function for investors and the company.  For investors, the secondary market offers liquidity where shares can be sold and converted into cash.  For companies, the continuous trading of shares offers a valuation for the stock which can help them assess what could be gained by issuing additional shares (called a secondary offering).

Retiring

The act of retiring shares may seem a bit silly at first blush, as there doesn't seem to be much to gain.  If you pay good money for shares, it seems foolish to cancel the shares.  Of course, that's from the perspective of an investor.  The company could have a number of motivations for retiring stock which could include bumping up earnings (fewer shares outstanding means a higher earnings per share), taking the company private, or boosting ownership stakes of insiders (fewer shares held by others increases the percentage ownership of major shareholders).  Regardless of the reason, to retire shares, a company purchases the stock in the secondary market and then cancels the shares through a formal process outlined by the Securities Exchange Commission (SEC).  Once retired, the company cannot re-issue without going through a process not unlike when shares are newly issued.

Wrapping Up

In this article, you should have learned that a stock market is more than just a place to buy and sell stock.  It also makes the issuance of new shares possible whose proceeds can be used by the issuing company to fund its business.  In addition, retiring shares changes ownership percentages and can assist companies by increasing earnings per share - a key ratio in the world of stock investing.

Critical Thinking

• When a company issues new shares, what does the company gain?  What does the company lose?
• On the New York Stock Exchange, if a stock has massive numbers of investors selling (like financial stocks after Lehman Brothers collapsed in September of 2008) and only a few willing to buy, how quickly can the share price fall?  Conversely, when a stock has enormous buying demand and few sellers (like Google after its initial public offering), how fast will the stock price rise?  Hint:  lookup price charts of Citibank from September 1st through the 30th of 2008 and Google from August 19, 2004 through December 31st of the same year.
• Earnings per share (EPS) is defined mathematically as [Net Earnings divided by # of Shares Outstanding], if a company with net earnings of $100 has 100 shares outstanding, EPS would equal $1 per share.  What if the company retires 10 shares?  How are net earnings, share outstanding, and EPS affected?

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