In my post From Zero to Millionaire I talked about 5 phases that you work through to go from nothing to having financial freedom. The exact order varies from person to person and the amount of time each person spends in each phase varies. The phases also overlap. But anyone that reaches financial security will pass through each one. The five phases are Make More Money, Save It, Pay Off the Debt, Invest, and Create. I talked a little about each of those, but there is a lot more. It would take books and books worth of information to truly cover each one well. Perhaps I’ll do that one day. Today I want to talk about the fourth one, investing.
This is a very basic introduction to investing. The goal here is to get you thinking about what is involved and how it works. I don’t recommend opening an account after reading only this post. This post should just give you a starting place as you learn more about it.
What is investing?
Investing is putting your money to work with the idea that you will receive profit later. This could be using your money to pay for college on the idea that you’ll be able to get a higher paying job in the future, or maybe using your savings to start a business. In the context of this site. I’ll usually mean buying stocks in the stock market on the idea that company will share the profits through dividends and stock price growth so that later on you’ll have more money than what you invested. That’s the part I’m going to talk about today.
What are stocks?
I’ll start with an example. If you start a company, you own 100% of the company. Say your company needs money to grow, so you decide to bring in a friend that knows the business. You agree to give your friend 50% of the company for the money they invest. Now each of you own half the company. Another way to put it is that the ownership of the company is in two parts. One part owned by you and one part owned by your friend. Each of you has one of the two shares in the company. So each of you has the rights to one share of the future profits to the company. Each share of the company is stock in the company. In this example the company is divided up into 2 equal parts.
For large companies like Coca-Cola the company is divided up into millions of parts. Each part is sold as a stock. So when you buy a stock you are part owner in the company. The stock represents ownership in the company.
What is the stock market?
Some companies are publicly traded. This means that the stock in the company can be bought and sold by the general public through one of a few exchanges. The stock market is where you go to buy and sell shares in the publicly traded companies. Another term for it is stock exchange. Most industrialized countries have at least one stock exchange. Investopedia has a great article on what a stock market is. The US has several including the New York Stock Exchange and NASDAQ. The London Stock Exchange Group, The Japan Exchange Group and The Shanghai Stock Exchange round out the largest five in the world. At each of these exchanges you can buy and sell stocks in different companies as well as corporate and government bonds and other securities. Each exchange has different companies listed so you may have to look in different places to buy the specific stocks that you want.
Why would I want to buy stocks?
As part owner in the company you are entitled to a portion of the future earnings of the company. So theoretically when the company makes money you either get some of it or the value of what you own goes up. Sometimes both. Companies sometimes pay out a portion of the profits as a dividend. Usually the rest is reinvested back into the company to help it grow. So as part owner of the company you get a dividend check and the value of the share of stock that you own goes up as the company grows. For most well established companies it’s a little of both.
Different companies do have different plans. Different industries, business classifications and security types have different laws and customs on how this works. Some will pay higher dividends, but have little to no growth. Others focus on growth and may pay no dividend. For example, a local utility company may not be growing much since they serve a defined, limited area. So they will typically give a higher percentage of their profits back to the owners. On the other side is a brand new company in a new industry. Like Google when they first started. They have a lot of room to grow, so instead of giving the owners a dividend they put all of the profits back into helping the company grow in different ways. But that’s a subject for a different post.
The main reason to buy stock is because you can make significant money in the long term. Those gains can also be fairly safe. It is dependent on proper research to find good companies that are worth more than the price of the stock would suggest.
How much is a stock worth?
There are two answers to this question. The first is theoretical. The second is what happens in real life. Theoretically a stock is worth the value of the company divided up by the total number of shares of stock. Then an adjustment is made based on what is expected in the future. Some of these are easy to calculate. The value of the company tends to be all of the assets minus all of the liabilities. That number is called the liquidation value. That’s what you’d have if you sold everything the company had. Stocks aren’t priced based solely on the liquidation value since companies typically make money. So the price usually includes anticipated earnings. This part is harder to calculate. It also is a little different for different people. But in broad generalizations established companies tend to trade for about 20 times what they earn per year. So a company that makes 2 dollars for every share of stock the company has will tend to trade for about $40 per share. This, of course, varies by industry and many other factors.
In the real world stock pricing isn’t this straight forward. If it was then stock prices would be very stable and there would be very few stock market bubbles and busts. But real world stock prices are not stable. Sometimes they can be very volatile. And every few years we have booms and busts. In the real world stocks are still priced based on the value of the company and the anticipated future earnings. However, in the short term stock prices are also based on emotion. People get excited on an idea driving up the price of a stock to higher than the company could possibly make. Other times temporary bad news may cause people to sell driving the price down to below what the company is worth. The market is pretty self-correcting over the long term, though. So you can use the company value model to set an ideal price and buy when it goes below that price.
Why do people think the stock market is gambling?
The stock market is volatile. It goes up and down. Seemingly on a whim. The stock price of companies with great ideas fly high then drop suddenly. Then you hear about stock market crashes. All this can make it look like the stock market is just one big casino. With all these ups and downs it really does seem crazy to buy stocks.
The truth of it comes down to research, diversification and patience. Making an error in one of these can make buying stock more of a gamble. All companies that have the stock listed on the US stock exchanges have to publish their financial reports. In these reports you can see where their money is coming from and where it is going. By reading through these reports you can see if the company really is making money. You can also see if the amount of money they’re making justify the price of the stock. The dot com bubble from the early 2000s are an example of research error. What happened there is that the dot com companies were not making any money, but they had ideas that sounded great. People bought the stock driving up the price. When the companies never showed a profit they went bankrupt because they couldn’t pay their bills. The stock crashed. Make sure that the company you buy stock in is actually making money and has a workable plan to continue to make money.
The second error is diversification. Unfortunately you can’t know everything that is going to happen. Enron is a great example of this error. Enron seemed like a good company that was making money, however their financial reports were fraudulent. When it was discovered that they weren’t actually making money and couldn’t sustain the fraud any longer the company collapsed and its stock is now worthless. When buying stocks it’s a good idea to buy several different companies in several industries that make their money in different ways. This way if there is a problem with one company or industry then you don’t lose all of your money. This is a great reason to start your investing by investing in mutual funds. Especially index funds.
Patience is required in the stock market. Prices go up and down constantly. Usually based on the current emotions. In the long run though stock will be worth what the company is worth. Once you have found a good company you don’t want to sell the stock just because the stock takes a dip. Selling a stock when it goes down is how you lose money. For example, between December of 2007 and March of 2009 Coca-Cola stock went from being over $30 per share to under $20 per share. The company didn’t lose a third of its business. It still produced and sold Coke and its other brands all over the world making a nice profit. The price went down because all the other stocks went down and people were selling. The value of the company hadn’t change. Since then the stock has not only returned to $30 per share, but is at over $45 per share. It can be scary to see the value of your stock go down. If you’ve done your research and you know the company is solid then you just need to have the patience to wait until the market corrects itself.
So, what should I buy and when?
The short answer is to buy high value companies when their stock is on sale. I’ll cover this sort of thing in other posts, but you’ll want to estimate what you feel a company is worth. Then buy the stock when it is below that amount. This is easier said than done. It requires research. Read the financial reports of companies that you like. Make sure they are actually making money. Compare their reports to their competitors. Estimate what is a sustainable stock price. Then just watch and wait for the price to come down, if it’s higher than your estimate. Then buy the stock.
Now for a more realistic answer. I usually recommend people start with mutual funds. So if you’ve never owned a stock before and you want to get started I recommend buying a mutual fund. But not just any fund. Buy an index fund. Something like Vanguard’s S&P 500 index fund. Or Fidelity’s S&P 500 index fund. There are a lot of different versions of these with different brokerage firms. These funds invest in the 500 largest companies in the US. That gives you diversification of owning 500 different companies’ stocks as well as stability since these are the largest and most established companies. Some of which have been around for well over a hundred years. Buy it whenever you can and just leave it there to grow until you retire. The value will go up and down each day, but over the long term it will go up more than down.
That’s the basic information about stocks and the stock market. I’ll cover this and different parts in more detail eventually. Have you started investing in stocks yet? What would you like to know or wish you had been told?