Mar 16, 2016 6 min read

Several weeks ago in this column, we discussed the fact that until the mid-1980s, most Americans did not own stocks. The reason for this switch was the growth of the 401(k) that replaced defined benefit plans.

In a 401(k), the employees select which investment their account will be placed in. With so many people owning stocks today, either directly or through their 401(k), it is important to understand how the market works.

I often ask a client or prospect this question: If you told a stockbroker that you wanted to buy $100 of Apple stock, how much of your money would Apple get?

How would you answer that question? I am often told that the company would receive all or a large portion of the total. People are often surprised when I tell them that Apple would receive zero. So who gets your money? Some other investor who owns stock that they want to sell.

If the president of Apple needed $250 million to build a new facility, he would summon his chief financial officers to see what options the company had. Basically they would have a choice of three different options. If they had enough extra earnings in the bank, they may decide to use it to pay for their new needs. He could also suggest that they issue 10-year bonds to cover the needed funds. Bonds are borrowing money from investors who would receive interest and get their principal back at maturity in 10 years.

A third option would be to have an initial public offering of stock. In this scenario, Apple would sell newly issued stock and they would receive a large part of the money. Of course there might be a few other choices, such as borrowing from a bank, but this is sufficient for our discussion. Initial public offerings do not happen very often for large established companies.

When we buy stock for our 401(k) and other holdings, we are buying on a secondary market. That means some other investor owns the shares and has decided to sell. You would only want to purchase an investment that would go up in value or pay you a dividend. The person selling the stock may think that the opposite is going to happen. There could be some other reasons that they would want to sell, including just needing to generate some cash, or it may be something they inherited and do not have any interest in.

Why is this important? The stock market may be the greatest auction in the world. If when your stockbroker goes to the area where Apple stock is traded, they will connect with a broker for someone who wishes to sell stock. If there are more buyers than sellers, the price goes up. If there are more sellers than buyers, the price goes down. When we see large swings in the stock market, we can easily know if there are more buyers or sellers. Often people panic and think that they can time the market. No one can do this with any consistency. Your investment is at the mercy of the masses.

The stock market can produce the highest returns, and it can also lose all of your money. It is very liquid: you can convert to cash quickly, but you don’t know how much you will have to liquidate. Your investments must match your risk tolerance because no investment is good if it keeps you from sleeping at night. You must consider your age and when you need the money. Assets needed in the next FEW years might need a safer home.

Swings in the stock market have a different effect on people. If you are young and won’t need the money for years, a down stock market might be a buying time. You dollar-cost average and get more shares for your investment. If you are close to retirement or already retired, a down market can be devastating. You may need to use some of the money today and thus lock in losses and have less to grow back when the market does start going up.

Owning individual stocks can produce the largest return; however, it could also cause you to lose all of your money. If I would have told my grandfather that people would be taking a hundred times more pictures today than his generation, he would not have believed that Kodak went bankrupt. Every Boomer ate Hostess Twinkies and rode in a General Motors car, yet both of them also went bankrupt. The many employees of Enron and other large corporations learned these lessons the hard way.

Most 401(k) plans limit individual company stocks with maybe the exception of the company you work for. Be diversified if you are in the market to help reduce some of the risk. Many investors buy mutual funds to make their stock market selections. There are over 10,000 choices and some are better than others. The two main reasons that people buy mutual funds are to get diversification and professional management. They have an advantage that you can invest smaller amounts of money each month than may be necessary with stocks.

Maybe the worst mutual fund to buy is the one that wins the award for best performance last year. This is because many people read this and start moving large amounts of money into it. Any manager that wins the award had to be a little bit lucky the year they won because of the timing of their trades. Make sure that your investment choices carry the right amount of risk for you, your timeline is accurate and that the plan matches your objectives.

Your Financial Future is written by certified financial planner Gary W. Boatman, MBA and CFP, who also wrote the book, “Your Financial Compass: Safe Passage Through The Turbulent Waters of Taxes, Income Planning and Market Volatility.” If there is an area that you would like to see discussed in the column, send your suggestions to gary@BoatmanWealthManagement.com.