The Ferrari, Mark Cuban, and Stock Market Trading

The Ferrari passed me going 60 MPH, passing the “Speed Limit 40” sign.

I was driving on a road I take the to gym everyday. Sure enough, a police car was hiding near the school entrance- and he pulled over the Ferrari. I was by myself, but couldn’t resist laughing at the driver’s bad fortune… probably not my best moment.

Stock market trading is driven by human emotions: fear, greed, and envy (my envy toward the Ferrari, for example). To answer the question: “how does the stock market work?”, you need to ask some basic questions. Here’s one-

When you sell a stock, how much do you receive on your sale?

Well, it depends on how many buyers there are- and what price they will pay. Pretty simple. Now, since entering the brokerage business way back in ’85, I’ve always thought the concept of selling of a stock has been poorly explained.  Mark Cuban’s 2015 LinkedIn post sheds light on this critical investing concept.

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Think about your stock sitting in a shop window: Bid and ask

Let’s say that you own IBM common stock- a publicly traded stock. That means that the securities are registered with the SEC, and that the stock trades on an exchange. Let’s assume NASDAQ (an exchange) reports that IBM is trading at around $150 per share.

To be more specific, stocks trade with a bid and ask price. The bid is what you can currently sell the stock for, and the ask is the price you would pay for a stock. The difference between the bid and ask prices is the spread.

The spread can be thought of as the profit earned by anyone making a market in the stock. It’s as if you put the stock in your shop’s display window at the ask price (say $150). If someone brings the stock into your shop and wants to sell it, they would receive the bid price (say $149.50). With improvements in technology, the spread on a large stock like IBM is very small.

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The movie ticket line: How a bid price is determined

So, what is stock trading? If you want to sell your IBM stock, you’ll receive the bid price. As I’ve mentioned in other posts, we’ve experienced periods of huge volatility in recent years. What that means to you is that the bid price can decline rapidly in a volatile market. That price you receive for your shares may be less (maybe much less) than you anticipated.

Think about a line at a movie theatre. You notice 5 people in line for tickets as you pull up to the theatre. Since the line isn’t long, you decide to park first, rather than let you spouse out to grab a place in line.

After you park and head for the ticket window, there are 20 people in line.

The same thing can happen when you want to sell your stock. With stocks, you have a certain number of people who are willing to buy stock (possibly your stock) at a given price. Say, for instance, that there are currently 50,000 shares at the $149.50 bid price. Those 50,000 shares are similar to a number of people in line at the move theatre.

You get the bid price- which could be anything….

Say that bad news comes out on IBM. Well, those buyers at $149.50 may decide against buying IBM at that price. Say, for instance, that 40,000 of those potential buyers go away. They decide they’d only buy at $145.

You have a market maker who is dealing with buyers and sellers- each of whom may buy or sell a different number of shares. Since 40,000 shares worth of the buyers at $149.50 went away, only 10,000 shares are sold at $149.50. If you weren’t toward the front of line, you won’t receive $149.50.

As more buyers cut the price they are willing to pay for your IBM stock, the bid price declines. Your stock, sadly, is “on sale”.

Understanding how stock prices are determined will help you understand stock dividends, stock splits, and the weighted average shares of common stock calculation.

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Your mutual fund or ETF stocks are in the same boat

This dynamic applies to any investment product that owns stock. Money managers trading huge blocks of stock also impact you- the individual investor. What if the guy in front of you is selling a million shares? How many buyers will there be- and at what price? To get all of those shares sold, the bid price may decline quite a bit.

Which brings us to Mark Cuban, and privately owned companies.

Mark Cuban avoiding the tech bubble bursting 

Mark Cuban is a billionaire investor. There’s a very important point made in his bio: Cuban sold Broadcast.com to Yahoo in 1999 (the height of the tech bubble) for $5.7 billion in Yahoo! stock. Not cash- stock.

So why didn’t Cuban lose everything when the tech bubble exploded?

He diversified.

In fact, I’ve used Cuban’s strategy as a teaching point for years. $5.7 billion in Yahoo! stock- in any stock- sounds impressive. It’s impressive, right up until the time you want to sell it- and you need a bid price for a huge amount of stock.

Important lesson.

Public vs. private markets

Cuban makes this key point in the LinkedIn article referenced above. He compares the early 2000s tech bubble and 2015 investing environment:

“But there is one critical difference. Back then the companies the general public was investing in were public companies. They may have been horrible companies, but being public meant that investors had liquidity to sell their stocks.

The bubble today comes from private investors who are investing in apps and small tech companies.”

A lack of liquidity in private markets may mean far fewer buyers when you want to sell a privately-owned investment.

So, where do you go from here?

Do Your Homework 

Do some homework on the volatility of the stocks you own. Check the beta on your stock. If you own mutual funds, check the fund’s beta. Morningstar is a great resource. Beta is a measure of your stock’s volatility, compared to the broader markets.

 

Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

(email) ken@stltest.net

(you tube channel) kenboydstl

Image: Keith Allison, Mark Cuban, (CC BY-SA 2.0)