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Understanding Stocks — minus the maths

Investing May 19, 2020

Stocks? What comes to your mind when you hear the word "stocks"? To me, it means part ownership of a company.

Here comes the big jargon: Stocks or shares, also known as equity, is a security that represents fractional ownership in a corporation or company. A unit of stock is called a share.

A share is to stock what a metre is to length.

A simplified explanation would be a stock is similar to a pizza. When you and nine of your friends contribute equally to buy a pizza, everyone has a piece of the pizza — say the pizza has ten parts. This means everyone has a slice of the pizza.

Photo by The Nix Company / Unsplash

This is similar to the way stocks work. Everyone with a share owns a piece of the company—the more shares of a company you buy, the more piece of the company you own.

This is a simplified example. Stocks are a bit more complex than that.

Stock is a security —a negotiable financial instrument (mostly paper) that holds monetary value. Here the value of the stocks is in the company's value, i.e. the more valuable the company is, the more valuable the stock is.

HOW STOCKS COME ABOUT

When companies want to get funds, there are two primary ways they do so. They can either borrow, which is called debt financing or issue ownership (equity) in exchange for money, which is called equity financing.

Let's say I own a bakery and sell all my goods without delivery services. After some years, I decide to open up another branch some miles away, but I don't have enough money for that. What do I do?

  • Option A: I give up and do not expand
  • Option B: I borrow money from a bank, friends or relatives
  • Option C: I collect money from people, and we become co-owners of the bakery — proportional to the money they give me.

A is definitely not an option if I truly want to expand. Option B is debt financing. I must pay back the money I borrowed. Option C is equity financing. We become owners of the bakery.

However, because we are bakery owners does not mean owners can come and take a loaf of bread for free or come to take my oven or any asset(machine, tool, or ingredient, as the case may be). Owners can only have a share of the profit we make — when we distribute the profit.

Another point to understand is that because you are part of the bakery's owners, you do not have control, i.e. you do not have a say in the day-to-day running of the bakery. You don't dictate the number of pieces of bread produced or the flavour used. It is the board of directors or the heads of the bakery who have a say. As a part-owner, you only get the chance to elect board members. Your voting power is proportional to the number of shares you own of the bakery, so the more shares you own, the larger your voting power; hence you can influence how the bakery runs.

WHERE TO BUY STOCKS

Stocks are traded (bought and sold) on exchanges. Exchanges are simply markets. Different countries have exchanges where companies are traded. The major world exchanges or stock markets are

  • New York Stock Exchange NYSE
  • NASDAQ
  • London Stock Exchange LSE
  • Tokyo Stock Exchange
  • Shanghai Stock Exchange
  • Hong Kong Stock Exchange

With the advent of the internet, you can buy and sell from anywhere in the world. There are apps such as Robinhood, Acorns, TD Ameritrade, Bamboo, Chaka, Trove etc., where you can trade.

BUYING STOCKS

There are two ways to purchase stocks: Using a brokerage and through DIPs.

  • Using a brokerage: This is the most common method. Brokerages are intermediaries between the purchasers and the sellers. They execute orders to trade stocks on behalf of others. Brokerage comes in two forms full-service and discount.
  • DIPs: Some companies offer direct investment plans that allow shareholders to purchase directly from the company, usually at a lower price.

A person with shares in a company is referred to as a company shareholder.

An initial public offer (IPO) is when a company first issues its shares to the public. A person buying shares when a company issues them initially is buying those shares in the primary market. When a person buys shares from another individual and not directly from the company, the person buys from the secondary market.

The Dutch East India Company issued the first common stock in 1602.

HOW DO YOU MAKE MONEY

When you buy a company's stock, you buy it to make money (profit). There are two ways to go about it:

  • Capital gains: This means an increase in the price of the share. Say you bought a company's stock at $10.99, then after a period, its price increased to $15.00. That is a profit of $4.01. The yield is referred to as capital gain.
  • Dividends: Remember the bakery story? So let's say the bakery makes a profit, and the board of directors can decide to distribute part of the profit to part-owners periodically (quarterly, biannually, or annually). The profit distributed to all shareholders is called dividends.
Companies are not obligated to pay dividends.

TYPES OF STOCKS

There are two main types of stock: common and preferred.

Common stock — sometimes referred to as ordinary shares, entitles the owner to vote at shareholders' meetings and to receive any dividends paid out by the corporation.

Preferred stockholders generally do not have voting rights, though they have a higher claim on assets and earnings than the common stockholders. Owners of preferred shares receive dividends (a fixed amount) before common shareholders and have higher priority than ordinary shareholders should the company go bankrupt.

WHAT CAUSES THE FLUCTUATION OF PRICES

In an efficient market, prices of goods and services are determined by the forces of demand and supply. Similarly, in the stock market, stock prices are determined by forces of demand and supply. While this is easy to understand, it is quite challenging to understand why people like a stock or dislike a stock.

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Photo by energepic.com from Pexels

A company's stock price does not necessarily reflect the value of the company; instead, it is a reflection of what investors think the company is worth.

Another factor is the earnings of a company. Earnings are the profit a company makes. In essence, a company without profit would collapse in the long run. An increase or anticipated increase in earnings makes the price increase. Company earnings are reported every quarter.

HOW TO CHOOSE A STOCK

When one decides to buy shares of a company, there are many reasons to select specific companies from the exhaustive list of companies in the stock exchange market. Most causes are personal, but ultimately, it is to make money or profit from it. There are ways of selecting stocks based on what an individual wants. The major methods to analyse if a company's stock is worth it are:

  • Technical analysis: This is evaluating investments and identifying trading opportunities in price trends and patterns seen on charts. Technical analysts believe past trading activity, and price changes of the security can be valuable indicators of the security's future price movements.
  • Fundamental analysis: Fundamental analysis evaluates a stock's real or "fair market" value, also called intrinsic value. Fundamental analysts search for stocks that are currently trading at prices that are higher or lower than their actual value.
Past performance does not guarantee future performance.
  • Qualitative analysis: Qualitative analysis uses subjective judgment based on "soft" or non-quantifiable data such as the expertise of the management, the labour relations, the industry's cycle, etc. Qualitative analysis deals with intangible and inexact information that can be difficult to collect and measure.
Qualitative analysis is more like "listening to your gut."
  • Quantitative analysis: This technique uses mathematical and statistical modelling, measurement, and research to understand behaviour. Quantitative analysts aim to represent a given reality in terms of a numerical value.

To get a better picture of a company's performance, analysts also evaluate information that is not easily quantifiable or reduced to numeric values, such as reputation or employee morale.

WHY BUY STOCKS

As discussed in ways to build wealth, there is a need to beat inflation. Historically, stock returns have beaten inflation and given one of the highest returns in the financial sector. Look at the graph below.

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Graph showing the compounded annual return of a dollar from 1926 to 2013

From the graph, a dollar put into stocks would have returned almost a thousand dollars, a return of 8.1% against inflation at 3.0%.

CONCLUSION

In this piece, I try to write about stock for beginners — like absolute beginners, no numbers, and I try to limit the jargon to the minimum. Here is a summary:

  • Stocks are a security that shows ownership in the underlying assets of a company.
  • Stocks are an excellent way to beat inflation with returns from either capital gains, dividends paid or a combination of both.
  • There are different ways to pick stocks based on individual needs.

Last piece of advice:

Read more and shun the news.

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