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Financial Planning for Scientists, Part 5: Stocks and Stock Markets

This article is part 5 in a series of articles meant to help scientists take control of their finances.

In the last few months, we've discussed why it is important for scientists to think about their financial situation, and we have exchanged a few tips to make saving money a little easier. We also figured out how much money is needed to achieve your financial goals in life. And last month, I outlined the "investment spending" choices of stocks, mutual funds, bonds, certificates of deposit, hard assets, insurance, and derivatives, and promised that we would be looking at them in more detail soon.

This month, we take our first look at stocks. If you remember from last month, we explained that buying a stock is, quite simply, purchasing a stake in a company. We discussed how stocks are probably the most complex of the investment choices we'll be discussing, but that they are also probably the most common form of investment made.

Over the next couple of months, we'll be investigating stocks in detail. We will learn how to pick them, how to build what's known as a "diversified portfolio" of stocks, when to buy them (and when to sell), and all sorts of other good stuff. But today, we'll be starting with some basic theory about stocks.

So what, exactly, is a stock? And what's a stock market?

It'll help to use an example. Let's say you're starting a biotech company and you need cash to buy lab equipment. There are two basic choices as to how you get the cash. The first is to get a loan from a bank. Here, a bank will lend you money and expect you to pay it back, with interest. The second choice is to find some investors willing to give you money for a share of your company. Basically you sell a small piece of your company (including all possible future profits of your company) to an investor.

So your 100% interest in the company has been reduced to, say, 75%. Someone else owns the other 25% of all your future hard work. This 25% stake would be reflected in the shares owned by those investors. Your 75% interest corresponds to the 75, 750, or 7,500,000 shares you own; their interest is the 25, 250, or 2,500,000 shares they own.

A share is the most common form of "stock" bought and sold on the stock market. Now we've learned what a stock is--it's a tradable interest in a company. And we've learned something else--the value of that stock is dependent on what people think the company is worth, and the total amount of shares outstanding. In our example, if you own 2,500,000 shares of a company with 10,000,000 shares outstanding, you're no better off than if you owned 250 shares of a company with 1000 shares outstanding.

Of course, owning these shares doesn't do you much good if you don't have a marketplace in which to sell them. A stock market is that marketplace. It takes all the people that want to buy a share in a company, and all the people that want to sell a share, and gives them a place to do it.

Here's how it works. Anyone who wants to buy or sell shares in a company will "announce" it on the stock market. If I wanted to buy shares in Merck, for example, I would tell the stock exchange that Merck is listed on, "I want to buy 100 shares of Merck. I'm willing to pay up to $80 each for them." The stock exchange would put my request in their system. It would automatically be placed between the person willing to buy Merck at $81 a share and the person willing to buy Merck at $79 a share.

People selling shares would be prioritized the same way. And if there's an overlap between the two, the shares will get traded. In our example, there'd be a list of people willing to sell their shares. The minute someone offers to sell their shares for $81, the person with the "bid" of $81 would buy it, and the remaining "orders" would start at $80. When you buy a stock, that money doesn't go to the company that issued the stock. It goes to the investor, just like yourself, who decided to sell that stock.

Prices move as orders get filled. The price of a stock rises when most buyers are willing to pay more for a stock than the current asking price. They fall when buyers want to pay less. Although the people trading huge quantities of stocks have more impact on the market price than people buying a small amount, that doesn't change the principle. The market determines the price of a stock, not the company that issued the stock or the "experts" at trading houses or stock market think tanks.

A stock price is, however, related to the market perception of the value of a company, which is often determined by the "experts." If the world thinks a company is doing well, that company's stock price will often go up. Although companies don't make money directly when their stock prices go up, they do receive indirect benefits from an increasing stock price. These companies can issue stock at a higher price, employees' stock options get exercised, etc.

So that's what stocks are, and how stock markets work. Next month, we'll be talking about picking stocks--which is as simple (and as difficult) as "buying low and selling high."