What you are actually buying

Before order books, market makers and trading bots, there is a simpler question: when you buy a share of a company, what do you actually own? The answer decides almost everything else on this site. It explains why stock prices tend to rise over decades, why they bounce around so much from day to day, and why buying and holding a slice of many businesses is a different activity from trading in and out of them.

A share is a slice of a business

A company that sells stock divides its ownership into a fixed number of equal pieces called shares. If a company has 100 million shares outstanding and you own 100, you own one millionth of it. Not one millionth of the stock price: one millionth of the business, its factories, its brands, its debts, and above all its future profits.

Owning that slice gives you three concrete things:

• A claim on profits. After the company pays its employees, suppliers, lenders and taxes, what is left belongs to the shareholders. Management can pay some of it out as dividends (cash sent to every shareholder), use it to buy back shares (which shrinks the share count, so each remaining share owns a bigger slice), or reinvest it in the business in the hope of earning more later.
• A vote. Common shareholders elect the board of directors, who hire and fire the executives. With 100 shares your vote is a rounding error, but large funds that own several percent of a company are listened to.
• Limited liability. If the business fails, your shares can go to zero, but nobody can come after you for the company's debts. The most you can lose is what you paid.

Shareholders are last in line. If a company goes bankrupt, lenders and bondholders are paid back first, and shareholders get whatever is left, which is usually nothing. That position at the back of the queue is exactly why stocks are expected to earn more than bonds over long periods: you are paid extra for taking the risk.

Why a business is worth anything

A business is worth the cash it will produce for its owners over its whole life. That sounds abstract, but you already reason this way about simpler things. A rental flat that clears $10,000 a year after costs is obviously worth more than $10,000, and obviously not worth $10 million. Somewhere in between is a price where the rent you collect is a fair return for the money you tied up.

Two ideas pin that price down. First, money later is worth less than money now, because money now could be earning something in the meantime, and because the future is uncertain. If you want a 9% return a year, a dollar of profit arriving in ten years is worth only about 42 cents today. Second, profits grow (or shrink). A business growing its earnings 15% a year for a decade is a very different thing from one that is standing still.

Put together, the value of a share is the sum of all its future earnings, each one shrunk back to today's money. Analysts call this a discounted cash flow. Real ones have dozens of inputs, but three matter most, and you can play with them below.

Two things should jump out. Most of the value usually comes from profits more than ten years away, which nobody can forecast with confidence. And small changes in your assumptions about growth or the return you require move the answer a lot. Nudge growth from 8% to 10% and the value per share can jump by a fifth or more.

That is the honest reason stock prices move around so much. The business might not change at all between Monday and Friday, but the crowd's collective guess about its growth, and about how much return they demand for holding risk, does. When interest rates rise, investors demand more from stocks too, and the value of distant profits shrinks, which is why fast-growing companies tend to fall hardest when rates go up.

Price and value are different things

The price of a share is simply the last price at which somebody bought it from somebody else. The value is what the future profits are actually worth, which nobody knows for sure. The market price is the best public guess, formed by thousands of buyers and sellers who disagree, and Chapter 6 shows how that guess forms and moves.

Most of the time, in large, heavily traded companies, the price is a pretty good guess, because anyone who spots an obvious mistake can profit by trading on it, and in doing so pushes the price back toward value. That does not mean the price is always right. It means that being reliably smarter than the price is hard, and gets harder the more people are trying.

Stocks, bonds and funds

You will run into three kinds of thing to buy:

• Stocks are ownership. Your return depends on how the business does and on what other people will pay for it later. Big upside, no promise.
• Bonds are loans. You lend a government or company money, it pays you interest on a schedule and returns the principal at the end. The upside is capped at the agreed interest, and the risk is that the borrower cannot pay, or that inflation and rising rates make your fixed payments worth less.
• Funds are baskets. A mutual fund or an exchange-traded fund (ETF) pools money from many people and holds many stocks or bonds. An index fund simply holds everything in an index, such as the 500 large US companies in the S&P 500, in proportion to their size. One share of the fund is a sliver of all of them.

An ETF trades on an exchange through the same order book as a single stock, which is why the next few chapters apply to it too.

Investing, trading and speculating

These words get used interchangeably, but they describe different activities with different economics.

Investing means buying a share of businesses and holding it for years so that you collect your part of what they earn. The key fact about investing is that it is positive-sum. Companies collectively produce profits, pay dividends and grow, so the total pie gets bigger. Every long-term owner can come out ahead at the same time, because the money comes from the businesses, not from each other.

Trading means buying and selling over short periods to profit from price changes. Over a day or a week, a business barely changes. So the gain one trader makes by buying before a rise is, almost exactly, a gain they did not leave to the person who sold to them. Relative to simply holding the market, trading is zero-sum before costs: for every trader who beats the market, someone else trails it by the same amount. After costs (the spread, fees, taxes, and the price you push against yourself), it is negative-sum.

Speculating is betting on a price move with little reference to what the thing is worth: buying because it went up, or because someone online said it will. It can make money, briefly, for some people. It is the same zero-sum game as trading, with less information.

Run it a few times. The traders' results fan out widely: some look like geniuses. But add up all of them and you get exactly what the holder got, minus whatever they paid to trade. The winners' extra came out of the losers' pockets, and the costs went to someone else entirely. In a real market the "someone else" is the market makers, brokers and exchanges you meet in Chapters 4 and 5, and the other side of a retail trade is often a professional with better information and faster tools.

Where this goes next

Once you decide to buy a share, you still have to get it from someone who is willing to sell. That happens in an order book, a live queue of buyers and sellers that sets every price you see. Chapter 2 puts you in front of one.