The Basics of Understanding the Financial News

The Basics of Understanding the Financial News



Max writes in:

One thing I have always struggled with is understanding the money news. Whenever the money news comes on it sounds like the people on TV or the radio start speaking gibberish. What is the stock market, I mean, what actually is it? What is Dow Jones? What is NASDAQ? What do all of the numbers mean? I feel like you have to have an encyclopedia just to understand what is happening!

I actually agree with you. When news reports discuss most of the issues of the day, they either provide enough background so that people can understand (to a degree) what’s going on or they rely on very big news stories of the recent past that people who have been following the news for the last month will have enough background to understand the latest story. With financial news (and, to a lesser extent, sports news), that’s simply not the case. People in the media assume a surprising amount of knowledge from their listeners/readers/viewers.

I think the reason for this is that they assume that the people for whom the segment has any value at all will know what they’re talking about, and for those that don’t, the segment is just a short piece that doesn’t really have any meaning and they’ll just sit through it.

That’s a shame, though, because burying financial news in a bunch of lingo makes it inaccessible to a lot of the American public. Even if you’re not an investor, it’s never bad to at least understand what they’re talking about and how it’s potentially relevant to you.

In this article, I’m going to try to explain most of what they’re talking about on those news reports in simple language. I’m going to simplify a few things solely for the purpose of not going down a deep rabbit hole of specific laws and instead stick to what a layperson should know in order to understand the stock market.

So, let’s start from the very basics: what exactly is a stock market?

What Is a Stock Market?

A stock market is simply a place where people get together to trade shares of stock. Some people might be there to buy shares, while others are there to sell them.

A share of stock is simply a tiny fraction of ownership of a company. Let’s say that Coca-Cola has issued 10 million shares of stock over the years. If you own one share of Coca-Cola, then you own 1/10,000,000 of Coca-Cola. That’s not really enough to do much in terms of managing the company, but it is enough (in some companies) to give you at least some tiny voice in how the company is run and, more importantly, it means you’ll receive dividend payments.

A dividend payment is just a very small payment given out by a company to the owner of each and every share of that company. If Coca-Cola pays out a $0.10 dividend, then every single person owning a share of Coca-Cola stock will receive $0.10. Many companies pay a quarterly dividend, meaning they make this kind of payment every three months. Some companies don’t pay dividends, while others vary their dividend amounts quite a bit over time.

So, one way that wealthy people earn an income without having to work for that income is that they own lots of shares of stock. Let’s say one person owns 1,000,000 shares of Coca-Cola. If they make a dividend payment of $0.10 every three months, that person is receiving $100,000 from Coca-Cola every three months automatically. That’s a pretty sweet deal.

Because of those two factors – the dividends you’ll probably earn in the future as long as you own that share and the potential to have some voice in how the company is run – a share of stock has value in and of itself. If you buy a share of Coca-Cola stock for $50, it’s probably going to hold most of that value and has a good chance of rising in value. People will always want to buy it because it ensures that dividend over the long haul.

Individual shares of stock rise and fall in value all the time. If a company’s future looks bright, then the value of the shares of that company are likely to go up. If a company’s future doesn’t look bright, then the value of the shares of that company are likely to fall.

How exactly does that happen? Well, if a company’s future looks bright, the people at the stock market who might be selling shares of that company will want more money for that share. If the Coca-Cola Corporation issues a report on their earnings and it says that more people are buying Coke products than ever before and that the Coca-Cola Corporation earned record profits, then the people who own shares in Coca-Cola are going to want more money for that share to sell it. The reverse is true if a company’s future looks a bit bleak; people are likely to be willing to sell for less in order to dump a potential loser that won’t earn as much dividends in the future or might even become valueless if the company fails.

All of this action happens at a stock market. A stock market, as I noted earlier, is a place where people go to buy and sell shares of stock.

A stock exchange is basically an organized stock market, where the group running the stock exchange verifies the people who are able to buy and sell there (to ensure everyone’s honest) and also typically decides whether the shares of a particular company can be bought and sold there (to keep out fake companies and minimize scams).

In general, when you use the phrase “the stock market,” you’re actually referring to a bunch of stock exchanges and smaller markets where people actually do the trading.

You’re probably familiar with a few stock exchanges. The New York Stock Exchange is an enormous stock exchange in New York City. The London Stock Exchange is an enormous stock exchange in London, England. The NASDAQ is another stock exchange, but this one is an electronic exchange, meaning trades on that exchange are done entirely by computer. Many of the world’s largest cities have their own stock exchanges, and they all operate in basically the same way. They allow only a certain number of registered and verified people to buy and sell shares of stock there, and only shares from listed companies can be bought and sold there. (Listed companies means the companies that are allowed to have their shares bought and sold at that particular exchange.)

What Is “The Dow”?

People always want a simple and quick way to judge the relative health of something, like a person’s temperature when evaluating the severity of an illness. In the case of the stock market, that “temperature” is given as something called a “stock market index.”

A stock market index is just a measurement of some slice of the stock market. It’s calculated based on the value of some specific subset of stocks that are bought and sold on the stock market.

“The Dow” refers to the Dow Jones Industrial Average, probably the most well known stock market index in the world. It is made up of a combination of the current value of shares of thirty large public American companies. It is simply the value of the price of one share of stock for each of the thirty companies along with some historical corrections (for situations where companies change how their stocks are issued, thus changing the value of a single share).

Because the Dow has been around for so long – it’s been measured since 1885 – it’s often used as the “default” measurement of the stock market for most people. It’s really useful if you want to do some very long term historical comparisons. However, it has a few glaring problems, the biggest one being that it’s only thirty companies. There are entire industries that are basically unrepresented by any companies in the Dow Jones Industrial Average and many industries are underrepresented or overrepresented in terms of how important they are to America’s economy.

Why Does the Dow Fluctuate So Much? What Do the Numbers Mean?

Often, when the financial news is reported, the newscaster will talk about how the Dow Jones Industrial Average dropped 45 points to finish at 26,514, a drop of two-tenths of a percent.

Very few individuals can get anything actionable or meaningful out of those numbers, to be honest. The only part that might be of interest is the latter part, referring to how much it rose or dropped in a given day. Even then, I don’t consider that actionable information or even anything particularly useful to the vast majority of listeners, as I don’t consider daily fluctuations in the stock market value to mean all that much.

Still, it’s very common to hear about single days where the value rises or drops by 2% or more, and very very common to hear of rises or drops of 1% or more. To put that in perspective, let’s say you had $100,000 in the stock market invested to perfectly match the Dow. That would mean that, on a day with a 2% drop, you lost $2,000. For a lot of people, that’s pretty alarming. $2,000 gone in a day?

The real lesson here is that day-to-day shifts in the stock market are scary, so if your investment strategy is focused on those day-to-day shifts, you might want to be in something more safe. Most people, if they’re invested in the stock market, however, aren’t invested for the next day or two. They’re invested for the next decade or two, and over those very long periods, all of those day to day rises and drops even out pretty nicely and give a relatively smooth upward curve. Unless you’re actively day trading or are a very, very large scale investor, you should not really care what the day-to-day results in the stock market are in terms of your own investments.

Why are they reported, though? Many people perceive the value of the stock market as represented by the Dow and other numbers to be some sign of the health of the American economy. If the stock market is going down, the economy must be bad; if it’s going up, things must be good! That’s not really an accurate viewpoint, particularly on the scale of a single day, but it’s something many people feel.

What Is the “NASDAQ Composite”? What Is the S&P 500?

The NASDAQ Composite and the S&P 500 are two other widely reported American stock market indexes. The NASDAQ Composite is a listing of the composite value of all of the shares listed on the NASDAQ trading exchange, and it has a bit of a tech stock bent to it because the NASDAQ is home to a high proportion of technology stocks. The S&P 500 is an index based on the market capitalization of 500 larger companies listed on the New York Stock Exchange. It’s similar to the Dow Jones Industrial Average, but it includes a wider range of companies and the value is weighted so that larger companies count more toward that number than smaller companies.

Many people use the NASDAQ as a quick thumbnail of how technology stocks are doing, and the S&P 500 is often used as a quick thumbnail of the overall stock market, not just the biggest companies like the Dow measures. Again, neither one is really useful on a day-to-day basis for most individual investors, as noted above, but many people still like to hear those numbers.

How Does Any of This Affect My Retirement or My Life?

In all honestly, unless you have enormous stock market investments that you’re moving around on a daily basis, the daily fluctuations of the stock market really doesn’t matter very much at all in terms of your daily life. They’re simply quick snapshots of a very large, very complex market with a lot of volatility.

So why do news services report on the Dow and the NASDAQ every day? Because they provide a very quick snapshot of something that’s very large and full of details and rather difficult to report on in a thorough way, so these basic numbers provide an easy shortcut.

What Is a “Fund”?

The idea of a “fund” comes up quite a bit in financial news flashes. Part of the issue is that there are quite a few kinds of funds; I’ve personally heard the word “fund” used to refer to at least four different things in the last month or two, so I’ll define each of those four things.

Most of the time – but not always – the word “fund” is being used to refer to a mutual fund. A mutual fund is simply a collection of investments run by a company. Other investors – usually, pretty much anyone with a few small restrictions – can buy shares in a mutual fund. It’s an easy way to buy a wide variety of investments with a single purchase, but, of course, the company that runs the mutual fund charges a bit for the service.

For example, VTSAX is a mutual fund. It’s short for the Vanguard Total Stock Market Index Fund. It’s run by the investment firm Vanguard. It’s made up of shares of virtually every publicly traded company in the United States. When you buy a share of VTSAX, you’re effectively buying a tiny sliver of a share of every publicly traded company in the United States. You can buy a share of VTSAX directly from Vanguard by opening an account with them.

An index fund is a specific type of mutual fund. While most mutual funds are managed by the judgment of people, an index fund is one that’s usually governed by a simple set of investment rules defined when the fund is started. This means that it is very easy to manage and thus requires fewer people involved, and that typically means much lower fees for the investor.

A hedge fund is essentially a type of closed mutual fund that highly restricts who can invest in them, the reason for that being is that hedge funds are very high risk investments. They usually are “hedging” for or against some future event, like the failure of a company or the re-emergence of a nearly failed company. They’ll often do things like buy up a ton of shares of a company, take over management of that company, sell off every asset that the company has (often paying out big dividends or selling the assets at a cheap rate to other companies owned by the hedge fund) and spin off new companies of the most successful pieces of that company, and then dump the devalued shares of that company once everything of value has been stripped from it. There is a ton of risk in doing these kinds of things, but the potential returns are enormous.

An institutional fund or a sovereign wealth fund is the invested money of a very large institution of some kind, like a small nation or an Ivy League school. These funds act as closed mutual funds (ones where all of the shares are owned by a large institution or a nation) and the people running them can invest at a very large scale, usually with billions of dollars at their disposal. Typically, the goal here is wealth preservation; they’re not seeking to grow like gangbusters, but ensure that the money stays around and grows at a reasonable rate for a very long time, thus ensuring the long term health of the nation or institution they represent.

Final Thoughts

The thing to remember is that most financial news is not useful in a practical way to individual investors. What such news is aiming at is to provide a quick snapshot of today’s events in the financial world, but most individual investors saving for retirement don’t really care about today’s events as they’re invested for the long haul.

I often think of financial news as being much like sports news, to tell the truth. For the vast majority of us, it’s a form of entertainment; for a small number of us, it’s actionable information. Very few of us are going to take direct action based on the financial news or the sports news, but we might be entertained by it and it might give us a source of conversation topics.

Still, it’s worthwhile to understand what the financial news is talking about, at least in a broad sense, because it does connect to how people save for retirement. If you have money in a 401(k) or 403(b), you probably have money in a mutual fund that is itself invested in the stock market. It’s just that the day-to-day fluctuations of the stock market don’t have a whole lot of meaning for you because your financial goals are very long term. What’s more interesting to you is the average annual returns of your investments over the last decade, not what the Dow did yesterday. It’s the equivalent of evaluating a baseball season based on a single pitch.

Good luck!

The post The Basics of Understanding the Financial News appeared first on The Simple Dollar.

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