Introduction to stocks
I believe everyone would love to be a business owner who never shows up at work. Just imagine it, you are sitting on a beach in Maui and your company is growing as you are sipping your Mojito. How does one do it? Easy, he collects dividends! This situation might sound like a dream, but in reality, this dream might be closer than you think.
You might have guessed by now, we are talking about owning stocks. This financial instrument is one of the major tools invented for building wealth and they are a part of nearly any investment portfolio. If you ever want to own stocks, you need to have a solid understanding of the stock market.
In this small, simple and compact tutorial, I will do my best as I’ll be explaining what stocks are, how many types of stocks are there and finally, we’ll talk about how stocks are traded, what might cause price change and how you would buy stocks.
1. Stocks – what are they?
The definition – simply put, a stock is a share in the ownership company, stocks represents a claim on the company’s assets and earnings. If you ever acquire more stock of a certain company, the stake in the said company will be greater. Some synonyms for stocks are shares and
equity and they all mean the same thing.
2. Owning a stock
When you are owning a stake in a company, it means you are one of the many owners who are also referred to as shareholders and you, as others as well, have a claim to everything the company owns. For example, if you own ten stocks of Apple (famous tech company) that means you technically own a very tiny piece of the company jet, their famous Apple logo and every contract the company has. Also, as an owner you are entitled to your share of the company’s earnings as well as any voting rights attached to a stock.
A stock is represented by a special document called „stock certificate“. This is a proof of your ownership. Since today almost everything is electronical, you won’t actually receive this document as brokerage keeps these records on their servers. In the past, when a person wanted to sell his or her shares, he or she physically took the certificate to the brokerage. Now, everything is so much easier as we can trade with a click of a mouse.
Being a shareholder does not mean you have any day-to-day running of the business. For example, if you own a stock of Apple, that does not you can take a free iPhone or if you own a stock of a Google, again, that does not mean you can call CEO of Alphabet (former Google) and suggest him how to run a company.
For the ordinary shareholder, like you and I, not the being able to manage any day-to-day activities of a certain company is not such a big deal. After all, our goal is to lay down on a beach in Maui and drink Mojito, right?
With that being said, the management of the company is supposed to increase the value of a company for shareholders. If this doesn’t happen, in theory, shareholders have the right to remove or substitute the management team.
The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In the case of liquidation, you’ll receive what’s left after all the creditors have been paid.
One unavoidable, and by my opinion, extremely important feature of a stock is limited liability. Limited liability means that you, as an owner a stock are not personally liable if the company can not pay its debts. Other companies such as a partnership or sole proprietorships are set up that is they go bankrupt, the creditors can come after their personal assets. Personal assets are your physical assets such as your car, your house or even that big, fancy LED TV in the living room. Owning a stock means that, no matter what, the maximum value you can lose is the value of your investment. Remember that ten shares of Apple you won we talked about? If Apple goes bankrupt, which is highly unlikely, creditors can never come after your personal assets.
3. Debt vs. equity – what is the difference?
Why would a company that is making a profit issue a stock and share that profit with thousands of other investors when they can keep all the profits for themselves. The reasoning behind this is because a company needs the money to grow. When I say grow, I mean investing in new equipment, new facilities, new products, etc. First of all, a company can borrow money in two different ways. It can take a loan from the bank or it can issue bonds. Both of the methods mentioned above fit under the umbrella of debt financing. We’ll talk more about debt financing. On the other hand, when a company issues a stock, that is called equity financing. Issuing a stock is much more advantageous to a company than issuing a bond because a company is not required to pay back the money or make any interest payment whatsoever. All that shareholders get in return is possible dividends and hope that they can sell the share at a bigger price and thus, make money. The first sale of a stock, which is issued by the private company is called the initial public offering or IPO.
The crucial difference between a company that is financing itself through debt and equity is that when you buy a bond, you are guaranteed the return of your money, at least the principal along with all the interest payments. Now, when it comes to equity investments, you become the owner of the company. By becoming the owner (no matter how small), you assume the risk of company possibly going bankrupt. As an owner, your claim on assets is lower than that of creditors. Shareholders can earn a lot of money if the money is successful, but hey also might lose all of their invested money if the company goes bankrupt.
4. Is there any risk?
First of all, there is no guarantee at all when it comes to individual stocks. Some companies pay out dividends, and some do not. There is no obligation whatsoever to pay out dividends even for those companies that has usually paid them. Oh no, how will an investor make money in that case? An investor can make their money only through appreciation in the market. On the other hand, any stock may flunk down, in which case you lose all of your investment.
This all sounds a bit negative, but there is a bright side to (almost) every story. Taking a greater risk usually demands a greater return on your investment. This is the main reason why stock have historically outperformed other investments such as bonds or savings accounts.
5. What type of stocks are there?
In the market, there are two main types of stocks; common stocks and preferred stocks. I’ll explain common stocks first.
5. 1. Common stocks
Common stocks would be best explained by saying that is common. When people talk about stocks, they are usually referring to this type. In fact, the majority of stock is issued in this form. Actually, if you didn’t notice we talked about common stocks so far. Common stocks represent a certain stake in a company and a claim on a portion of profits. This portion on profits, as you already know, is called dividend.
Over the long term, the common stock yields a higher return than almost any other investment. Of course, when talking about higher yield, they entail the most risk. If a company goes bankrupt, the common shareholders will not receive the money, as bondholders, creditors, and preferred shareholders are paid first.
5. 2. Preferred stocks
Preferred stocks represent some degree of ownership in a certain company, but they don’t usually come with the same voting rights and it depends on the company that is issuing the stock. When an investor buys a preferred stock, he or she has a fixed dividend. Another important feature of a preferred stock is that in a case of a bankruptcy, preferred shareholders are paid off before the common shareholder. Don’t forget that preferred stocks are also callable which means the company has the option to purchase the shares from shareholder at any time for any reason, usually the reasoning behind this is so called premium.
5. 3. Different classes of stocks
Stocks come in two main forms; common and preferred stocks. However, companies can also introduce different classes of stocks. The most common reason behind this is because the company wants that voting power remains with a certain group. A simple example, one class of share would be held by a group of investors who are given five votes per share and on the other hand, a second class would be issued to the majority investors who are given one vote per share. It is good to know that classes of stocks are traditionally designed as Class A and Class B.
6. Trading stocks
Most stocks are traded on stock exchanges, which are places where potential buyers and sellers meet and decide on a price. There are two types on locations; physical and online locations. You’ve probably seen pictures of a physical trading floor, the best example I can think of is the movie “The Wolf of Wall Street”. In the physical location, potential buyers and sellers yell, scream, wave and signal to each other. In online locations, whole exchange is virtual, composed of a network of servers and computers where transactions are made electronically.
You can think of a stock market as a very sophisticated farmers’ market that is linking potential buyers and sellers.
Before we move onto some of the biggest exchanges, you should know the difference between the primary market and a secondary market. The primary market is where securities are created by mean of an IPO or initial public offering, while, in the secondary market, investors trade already issued securities without any involvement of the issuing companies. When people are talking about the stock market, they are most likely referring to the secondary market.
Now, let us start off with the biggest stock exchange in the world, the New York Stock Exchange or NYSE for short.
6. 1. The New York Stock Exchange
The biggest and most prestigious stock exchange in the world is the New York Stock Exchange (NYSE). It also referred to as the “Big Board” and it was founded over 200 years ago. Currently, the NYSE houses some of the largest companies stocks in America such as General Electric, McDonald’s, Citigroup, Coca-Cola, Gillette, Wal-mart, and others.
6. 2. The Nasdaq
The second type of exchange is the virtual one that is also called over-the-counter market, of which the Nasdaq is the most popular. Nasdaq does not have any central location for brokers whatsoever. Since every transaction that is done there is virtual, trading is done through computers and telecommunications network of dealers. Today, Nasdaq is home to several big tech companies such as Microsoft, Cisco, Intel, Dell, Oracle and many others.
6. 3. Other exchanges
We’ve talked about the two largest stock markets in the U.S., the third one is American Stock Exchange or AMEX. Actually, AMEX used to be an alternative to NYSE, but that role is filled by Nasdaq today and in fact, the National Association of Securities Dealers (NASD), bought AMEX in 1998. Almost all trading done now on the AMEX is in small-caps stocks which we will talk about later and derivatives.
Of course, there are many stock markets in the world, but undoubtedly the largest ones are in the U.S. The two other main financial centers are in London, which is the home to London Stock Exchange (LSE) and Hong Kong which is the home of the Hong Kong Stock Exchange. The last place that is worth mentioning is the over-the-counter bulletin board (OTCBB). To recap, Nasdaq is an over-the-counter market, but the term OTCBB often refers to small public companies that don’t meet the listing requirements of any of the bigger and more regulated markets. The OTCBB is home to the dreaded penny stocks which are very risky.
7. Why do stocks change the price?
If only the answer to this questions was simple, everybody would be rich in no time but, unfortunately, it is not simple at all. We all know that stock change price due to market forces. There are two market forces that change the price of the stock, supply and demand. A quick example. If more people want to buy a stock that sell it, then the price moves up.
Understanding supply and demand is easy enough. What is difficult, almost impossible is why people like a particular stock and dislike another stock. This can usually be explained by what news comes out, positive or negative. There are so many answers to this questions, but only one thing is sure, if you ask any investor, he will have his own ideas and strategies.
That being said, most theories explain the price movement as what investors feel a company is worth. You can value the company by its market capitalization, which is calculated as the stock price multiplied by the number of shares outstanding. This seems pretty simple, so let’s complicate it a bit. The price of a stock doesn’t only reflect a company’s current value, growth that investors expect in the future are also a relevant factor.
Of course, the most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes. As we know by now, a company can’t survive without earnings. If you think about it, it makes sense as a company isn’t going to stay in the business if it’s not selling anything. Public companies are required to report their earnings four times a year.
Then again, it’s not just the earnings that can change the sentiment towards the stock. If that were the case, it would have been a pretty simple world, wouldn’t it? For example, during the dot-com bubble, dozens of internet companies were valued at billions of dollars in market capitalization without ever making even a single dollar. As you might guess, all these predictions did not hold, and most internet companies went bankrupt never to be seen again. To help them with various predictions of future stock prices, investors have developed literally hundreds of variables, ratios, and indicators. You have heard of some, like price/earnings ratio or P/E ratio, while others have extremely complicated names such as moving average convergence divergence or Chaikin oscillator.
So, after two coffee cups, why do stock prices change? The best answer I can give you, nobody really knows for sure. Some believe that they can predict future stock prices by looking at charts and looking at past price movements, but all we know for sure is the stocks are volatile and they can change price extremely fast.
In summary, here is what we talked about:
1. At the most basic level, supply and demand in the market determine stock price.
2. Market capitalization is calculated as price per share multiplied by the number of shares.
3. In theory, earnings are what affects investors’ valuation of a company. In practice, there are literally hundreds of indicators that investors use to predict the price
4. There are many theories that try to explain the way the stock prices move the way they do. Unfortunately, do this date, there is no theory or a magic formula that can explain everything.
8. How can I buy stocks?
If you read everything up to this point, I salute you! Now you know some of the principles how stocks work, but how do you actually buy them? You can’t just go your local store and ask for ten shares of Google. There are two main ways to purchase a stock:
8. 1. Use a broker
Using a broker is probably the most common method to buy stocks and they come in two different flavors. There are full-service and discount brokerages. Full-service brokerages offer you an expert advice and they can manage your account, but this comes at a price. They charge a lot. On the other hand, there are discount brokerages and they offer little to no personal attention but they are much cheaper.
At one period in the past, only the wealthy could afford a broker since only the expensive, full-service brokers were available. Thanks to the modern marvels of the internet, anybody can afford a discount online broker and invest in the market.
8. 2. DRIPs & DIPs
Dividend reinvestment plans (DRIPs) and direct investment plans (DIPs) are plans by which certain companies allow shareholders to purchase stocks directly from the company. They are not that expensive and they are a great way to invest a small amount of money at regular intervals.
9. Bulls bears and other animals on the farm
On the stock market, the is a whole farm to look at. The bulls are born are in a constant struggle. If you haven’t heard of these terms already, you undoubtedly will.
9. 1. The bulls
A bull market is when everything on the market is great, people are finding jobs, gross domestic product or GDP is growing steadily and price of stocks is rising. Picking stocks during a bull market is a bit easier since everything is going up. Unfortunately, the bull market can’t last forever, though, and sometimes the bull market can lead to dangerous situations in the market if a certain stock becomes overvalued. If a person is optimistic and believes that stocks will go up, he or she is called a “bull”.
9. 3. The bears
On the other hand, the bear market is when everything is going down. The economy is in recession, people can’t find jobs and gross domestic products is falling and finally, stock prices are falling. Bear markets are hard because they make it tough for investors to pick a profitable stock. One solution when stock prices are falling down is to use a technique called short selling. If a person is pessimistic, he or she is called a “bear” and said to have “bearish outlook”.
9. 4. The chickens
Chicken are generally afraid to lose everything. Generally, fear is good, but it can be paralyzing and therefore, they turn to money-market securities to get out of the market entirely. Sure, it’s true that you should never invest in something over which you lose sleep, but on the other hand, you are also never guaranteed to make any money if you don’t take any risk.
9. 5. The pigs
Pigs are a high-risk/high-reward type of investors looking for the “big one” in a short period of time. Pigs usually buy on hot tips and invest in companies without doing their due diligence. They tend to get impatient, greedy and emotional about their investments. Professional traders love the pigs as the it’s often that bulls and bears reap their profits.
9. 6. What type of investor should I be?
There are hundreds upon hundreds of investment styles and strategies out there. Even though there will always exist both bears and bulls, they both can make money with the changing cycles in the market. Even the chicken see some of the money, but the ones who lose in the end are the pigs.
Make sure you don’t get into the real market before you are ready. My advice is to be conservative at first and don’t invest in anything that you don’t understand.
10. What have we learned about stocks?
We’ve learned a lot, let’s recap:
• Stock means you own a part of a company. As an owner, you have the right to claim the assets and earnings of a company as well as voting rights.
• Stocks are equity and bonds are debt.
• With stocks, you can lose all of your investment.
• There are two main types of stocks; preferred and common stocks. The company can also create different classes of stock.
• Stocks are traded on stock markets. The NYSE and Nasdaq are the biggest and most important stock markets in the world.
• Nobody is really sure why stocks change the price, but they change the price according to supply and demand.
• To buy or sell a stock, you can either use a brokerage or a dividend reinvestment plan or DRIP.
• A stock market is a farm, there bulls who make money, bears who make money and pigs who get slaughtered.