Word of The Day – Stock

Stock – a derivative based on the perceived value of a company

Definition: a share of stock is a specific percentage of the total ownership of a corporation, e.g., one share out of 100,000 shares = .00001 percent ownership

Discussion: Bonds are loans made to a corporate or government entity. Bonds are IOUs that must be repaid. Stocks, on the other hand, are ownership of “a piece of the pie.” The problem with that metaphor is that the “pie,” i.e., the corporation, does not stay the same size; it can contract or expand, literally in an instant.

Any number of things at the company, in its industry, and in the world, can affect a stock’s perceived value and hence, its price, at any moment.

A number of financial indicators are used to estimate a company’s “real” value over time, but in the end, each buyer and seller of the company’s stock sets their own perceived value on that stock, just as each bettor at the track helps determine the overall odds of any horse winning in the next race.

Betting on stock prices to rise or fall is a form of gambling called pari-mutuel betting. Stock prices are basically the “odds” set by investors in a company on the likelihood that company will do better or worse than it has in the past. One can place odds on groups of companies as well by buying and selling exchange traded funds (ETFs) and mutual funds.

Federal government tax law strongly favors this kind of pari-mutuel gambling over other kinds of legalized gambling by the IRS’s treatment of capital gains and losses. Other kinds of winnings from gambling games such as horse races and state lotteries, are taxed at ordinary income tax rates, rates that tend to be much higher than capital gains tax rates.

Related terms: bonds; capital gains taxes

Copyright © 2011 Nancy K. Humphreys