Stock Basics

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How Stock Is Created

Companies sell shares of stock to raise funds for a variety of purposes, such as an expansion into new markets or to build new factories. When a company first offers its shares for sale to the public, it does so in what is called an initial public offering (IPO).

Working with a group of brokerage firms known as an underwriting syndicate, the company sets a price for its shares and sells them to investors. After the shares are issued, they begin being traded — that is, bought and sold — in the stock market.

What Is A Stock Exchange?

Stock exchanges are places where brokers and other investors buy and sell stocks to one another. These exchanges provide a physical marketplace where trades occur. First organized in 1792, the New York Stock Exchange (NYSE) is perhaps the most well-known.

Other exchanges include the American Stock Exchange, Pacific Stock Exchange and various others throughout the world, such as the London Stock Exchange. Each exchange sets financial and other requirements to be met by a corporation before its shares may be traded on the exchange.

In addition to stock exchanges, shares are also traded electronically in the over-the-counter (OTC) market. The largest of these electronic markets is the National Association of Securities Dealers Automated Quotations (NASDAQ). The exchanges and the NASDAQ stock exchange play a vital role in our economy by providing investors with liquidity — the ability to easily buy and sell their shares.

Risks Associated With Stock Market Investing

Stock investing has traditionally provided higher returns than other forms of investment. Those higher returns are accompanied by higher risks. Two key risks most associated with stock investments are systematic and unsystematic risk.

• Systematic risk, or market risk, is the risk that your stock investments may decrease in value because of trends or events that affect the market as a whole. While the stock market is composed of thousands of individual companies, the investment environment can cause most or all of them to fall in value simultaneously, even those posting record sales and profits.
  
  To reduce systematic risk, you have to reduce how much you have allocated to stocks. Diversifying across asset classes that do not always move together, such as U.S. Bonds, U.S. large company stocks, U.S. small company stocks and international stocks, can also help reduce systematic risk.
• Unsystematic risk is the business and financial risk associated with a specific company in which you are investing. For example, company profits may decline due to poor financial management, a strike, new competition or by its product becoming obsolete.

You can reduce the effect of unsystematic risk on your portfolio by diversifying your investments. Diversification is achieved by investing in a variety of companies including companies representing different industries, size of companies and location — large, small, domestic and foreign.

An investor may own shares of an oil exploration company and an airline. These companies may react differently to the same scenario. For example, when oil prices rise, the exploration company's profits may increase as oil companies spend more money to find new deposits. But the airline's profits may fall, reflecting the higher cost of fueling its jets.