Dave's Stock Market Explanation

Jeff asks Dave to explain how the stock market and mutual funds work. Dave says it's a lengthy explanation but gives him the short version.

QUESTION: Jeff on Twitter asks Dave to explain how the stock market and mutual funds work. Dave says it's a lengthy explanation but gives him the short version.

ANSWER: The stock market is a marketplace in which stock is sold. Duh. What is stock? Stock is an ownership portion of a company. If there are 10 shares of stock in my company and 10 different people own it, each one of us owns a tenth of the company. Of course, in publicly traded companies traded on the stock market, it's usually hundreds of thousands of shares—at least tens of thousands of shares. You own one little tiny percentage of a company.

When you own a company, where do you make money? You make money in two places. One is as the actual profits come into the company. When those are paid to the owners in the stock market world, that's called a dividend. The second way you make money if you own a company is if your company becomes worth more. A profitable company is worth more than an unprofitable company. The more profit it makes and the better the business is, the more other people are willing to pay for a share of that company.

If you want to sell a share of stock, you would go to a place to exchange your share of stock for some money. That's called the stock exchange. The largest companies are exchanged in New York on the New York Stock Exchange. You've probably heard of that. It's sometimes called the Big Board. Only the larger companies are there that are bought and sold and that are publicly traded, meaning that you can't buy shares to my company; it's not traded. It's not for sale. Companies like McDonald's, Home Depot, Coca-Cola or Microsoft are traded publicly on the New York Stock Exchange.

Mutual funds are simply a grouping of stocks. If it's a growth stock mutual fund, it's 90 to 200 growth stocks—companies that are growing. If it's an international stock mutual fund, it's 90 to 200 stocks in international companies—companies that are overseas. If it's bond mutual fund, it's a group of corporate bonds that are in there—not stocks at all.

Mutual funds are simply a co-op, if you will, where you and I mutually fund money and it's used to purchase whatever that fund is set up to purchase. Instead of putting $10,000 in one company like buying Wal-Mart stock, you'd be better off to put $10,000 into a growth stock mutual fund that has 90 to 200 different stocks in it, one of which would probably be Wal-Mart. But then if Wal-Mart goes down, your goose isn't cooked. You haven't bet the farm on one horse race. You diversify. You don't leave all your money in one place; you spread it around. That's why I recommend mutual funds versus single stocks. Buying individual stocks is very risky. You can lose everything on them. It's like playing dice in Las Vegas or something. But when you spread it across to 90 to 200 different stocks, now you're kind of riding the wave of the overall American economy.