When people think of personal finance, a lot of times one of the first things they think about is stocks.  We hear all sorts of things about the stock market, the DOW Jones, the NASDAQ and Wall Street but very few people have anything but a vague idea about what any of these things actually mean, other than “stock market is down, that is a bad thing.”

So what exactly is a stock?

A “stock”, or “equity” or “share” is the money and other capitol that is raised by a corporation through the issuance and distribution of shares.  Lets break this down a bit because that sentence in and of itself is fairly confusing.  What is basically is, is that corporations sell pieces of themselves to raise money for growth.  These pieces are stock.  If a company does well, it is worth more, thus it’s stock goes up.  They also pay out pieces of company profits to shareholders (people who own shares of stock); this is called dividends.   Its an interesting arrangement because lets say you buy a share of stock in Hewlett Packard.  You now own a piece of everything in HP.  A little piece of every contract, computer, desk,  and pen.  (The skeptics amongst us would even say the workers, but that’s a whole different conversation).Just because you own a share of stock in a company doesn’t mean you get to say what happens in day to day operations, but you do get a vote per share in electing the board of directors.    However, this is a minor detail.  Most people don’t WANT a say in the day to day operations of the company, they just want the company to do well.  As a shareholder you get a piece of the companies profits, and a claim on some of the assets.  The profits are sometimes paid out as dividends or it might be reinvested into the company for growth.  It all depends on the company. 

How is Stock Valued (How is the price decided)?
The value of a stock is loosely based on what investors feel a company is worth.  However this is not the same as the value of a company.  That is what is called its market capitalization…basically, the stock price multiplied by the number of total shares of that company.  Confused?
Well here’s the first grade math formula to clear it up:

Total worth of company = (cost of 1 share of stock) X (total number of shares of stock of that company)

For example, a company that trades at $10 per share and has 10,000 shares is worth $100,000.
What makes things even more complicated is that the price of stock just include what the company is currently worth but ALSO the growth that investors expect in the future. 

A lot of the so called “value” of stock prices are based on the simple concept of supply and demand.  If the stock is in high demand, the price goes up.  If the company seems to be doing poorly, less people want it, so the price goes down.  Not such a hard concept after all!

So how do people know whether the company is doing well or not?  The single most important factor that affects the value of a company is its earnings.  Earnings are the profit a company makes.  This is why public companies have to report their earnings four times a year.  These times of year are called earnings seasons and it has the guys on wall street scurrying around like mice in a cheese factory.  Companies have to (or are supposed to *cough enron cough *) be honest in their reportings.  If a company does well, the price of their stock usually goes up, if they do poorly, it usually goes down.
There are some other factors that can change the value of a stock.  Sometimes there is hype for a company when it hasn’t done anything to prove itself.  The absolute best example of this was the dot com bubble in which online companies that were supposed to make a ton of money …pets.com anyone?…  made absolutely no profit.  Their stocks were artificially high, and then they came down to realistic levels, it left a lot of people out a lot of money.  There are a ton of other factors in stock price, but the fundamentals matter the most.

Nearly everyone has heard someone mention “401k” at some point in their lives.  Chances are if you are reading this you have at least an idea of what it is, and if you don’t, you will soon! 

So what exactly is a 401(k)?

The 401(k) plan is a type of retirement plan that is named after a section of the U.S. Internal Revenue Code.  It is a plan that is employer sponsored that allows you the worker to save income from your paycheck before taxes are taken out by the government.  Now, this doesnt mean you won’t have to pay taxes on it, our kind and generous government simply doesn’t take out taxes right now but when you actually collect your money at retirement. This is what people mean when they say it is tax deferred. 

Generally this money is then put into an account that can be invested in an assortment of mutual funds that can emphasize stocks, bonds, money market investments. Most 401ks are what is called participant-directed meaning that the employee is the one who gets to allocate the money.  There is another, less common scenario called trustee-directed where the employer has trustees who decide how the money will be invested.

Another very important point is that most companys match a portion of the employee contribution.  For example a company might match 1% for every 2% contribution up to 6%.  In this case if the employee contributed 6% per paycheck, the company would contribute 3%. This is one area where the 401k is vastly superior to other traditional retirement plans.

When can you withdraw the money?

There is a long answer, but the short answer is 59½. If you withdraw the money before then there is an extra tax on it of 10% and this is only under very specific circumstances.  Its not meant to be something that you can take money out of because you want to buy a boat or pay off some credit cards or go to south padre island…  It is meant to be something that is saved for retirement.

Whats the deal with the taxes?

The employee does not pay federal income tax on the amount of current income that he or she defers to a 401k.  So if you earn 30,000 in a year, and defer $2000 into a 401k plan, you only pay taxes on $28,000 that year.  Assuming a yearly return of 8% (which is actually lower than the market average over the last 100 years), if you are 25 when you put that money in, by retirement that 2000 will have become $30,000 and only then is it taxed. 

What happens if I leave my job?

Your 401(k) plan can be “rolled over” into the new job’s 401(k) plan, an IRA, or it can be cashed out.  However, cashing out is a terrible idea….all that money could have sat and compounded.