How Stocks Work

Buchaler & Pelphrey

In our blog, "Can I Invest During Bankruptcy?" we covered all how you can and cannot invest/spend while in bankruptcy, as well as the potential for investing after your case is closed. While it's important to keep your funds on a tight leash, investments can be a great way to kick-start your financial recovery. Keep reading to learn more about the stock market and how it can work in your favor.

The Early Bird Is. . .Tired

When you imagine the stock market, whatever you're thinking is probably a little right and a little wrong. You're probably envisioning a crowded room with stocks flashing across the tickers as stressed people yell over each other.

While that is a part of the stock exchange experience, getting up when the market opens is only a small fraction of the big picture. The early birds on Wall St. buy and sell stocks, but the real work happens elsewhere.

Where Do Stocks Come From?

We've already mentioned stocks, but what are they exactly, and where do they come from? The answer is much more complicated than you might think.

In basic terms, stocks are similar to equity – they represent the value and ownership of a company or corporation. Just as your house accrues value while you own it, a stock will increase and decrease in value over time.

Using home equity as our basis of understanding, think of a stock as your house and the company as the homeowner. You cannot decide the equity or value of your home, but several outside influences decide how much your house is worth.

The housing market, the value of building materials, age of the house, current state of repair, and future buyers have more to say in the value of your house than you do in many ways. If the housing market crashes and the market favors the buyer, your home's value may decrease and vice versa. Inspectors usually look at the current state of the house and its future potential (or the lack thereof) to determine value as well.

In the same way, stocks are influenced by the market and the state of the "house" and "homeowner." A stock's value is determined in a weird combination of two principles: the potential vs. actual value of the company itself and the perceived value.

Potential vs. Actual Value

Companies, like everything else, have value. In this context, a company's value is the sum of its profits, successful sales, upward growth, acquisitions, or mergers. In simple terms, the value is the sum of the company's parts.

On the other hand, potential value is the future. Using the actual value as a base and the market as a lens, investors and researchers can gaze into the company's future. For example, once Microsoft sales exploded in the 90s, investors saw enormous potential value in the company, and stocks increased in value.

However, Microsoft's potential value took a hit when Apple began to bypass its sales and occupy the tech market. Since then, these two tech giants have ebbed and flowed, but the formula for guessing their potential value is more or less the same.

For stocks, their value comes from the current profit margins and numbers pitted against the potential worth of the company. If the potential value wins, the stock will probably go up; if it fails to surpass the actual value, it will go down.

Perceived Value

You might be thinking: "perceived and potential value sound kind of similar," and while they are both projections, one evaluates the future while the other judges the present. Perceived value is what most people guess the value of something is.

For example, if you've been to a carnival, you may have passed a booth where they ask participants to guess the number of jelly beans in a jar. To accomplish this, people at the fair have to make their best guess of the perceived number of jelly beans in the jar based on their intuition, semi-informed experiences, or expert knowledge.

In general, you'll find that the average guess from the masses is not too far off from the truth. Someone always guesses either correctly or within a jelly bean or two. The same can happen with stocks.

People who aren't stock experts or economists don't have industry knowledge that can direct their decision-making – they have to trust their decision-making skills. While this might sound like a terrible idea, a stock's value relies heavily on public perception.

If a company is found to be unethical or becomes the center of a scandal, the stock values could go down. Over the last few years, you may have noticed an emphasis on "transparency" and "honesty." This is because companies who are honest about their business practices or manufacturing may take less of a hit financially and on the stock market.

Experts can present a baseline value that is the sum of extensive research and calculations, but the public won't be keen to buy a stock if they don't feel like it has value.

Boosting the Numbers

Once a stock has value on the market, people can buy it. In some cases, stocks can shoot up in prices because of a business breakthrough, new product, or acquisition. Companies that sell a new product may experience a spike in stock sales upon releasing their product and a slow decline afterward.

Ultimately, the stock market depends heavily on how valuable stocks are to the public. If the public feels like a company has little or no value, they won't invest, and the price of the stock will go down and vice versa.

The more expensive a stock is, the more valuable the company becomes.

Key Takeaway

It's not wrong to invest after bankruptcy, and in some cases, it may be beneficial. The safest and most responsible way to invest after bankruptcy is with the help of a bankruptcy expert and/or financial advisor. They can guide you through the investment process and direct you to the best options for you.

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