| Stock
Basics: Introduction
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Wouldn't
you love to be a business owner without ever having
to show up at work? Imagine if you could sit back,
watch your company grow, and collect the dividend
checks as the money rolls in! This situation might
sound like a pipe dream, but it's closer to reality
than you might think.
As you've probably guessed, we're talking
about owning stocks. This fabulous category of financial
instruments is, without a doubt, one of the greatest
tools ever invented for building wealth. Stocks are
a part, if not the cornerstone, of nearly any investment
portfolio. When you start on your road to financial
freedom, you need to have a solid understanding of
stocks and how they trade on the stock market.
Over the last few decades, the average person's interest
in the stock market has grown exponentially. What
was once a toy of the rich has now turned into the
vehicle of choice for growing wealth. This demand
coupled with advances in trading technology has opened
up the markets so that nowadays nearly anybody can
own stocks.
Despite
their popularity, however, most people don't fully
understand stocks. Much is learned from conversations
around the water cooler with others who also don't
know what they're talking about. Chances are you've
already heard people say things like, "Bob's
cousin made a killing in XYZ company, and now he's
got another hot tip..." or "Watch out with
stocks--you can lose your shirt in a matter of days!"
So much of this misinformation is based on a get-rich-quick
mentality, which was especially prevalent during the
amazing dotcom market in the late 90s. People thought
that stocks were the magic answer to instant wealth
with no risk. The ensuing dotcom crash proved that
this is not the case. Stocks can (and do) create massive
amounts of wealth, but they aren't without risks.
The only solution to this is education. The key to
protecting yourself in the stock market is to understand
where you are putting your money.
It
is for this reason that we've created this tutorial:
to provide the foundation you need to make investment
decisions yourself. We'll start by explaining what
a stock is and the different types of stock, and then
we'll talk about how they are traded, what causes
prices to change, how you buy stocks, and much more… |
| Stock
Basics: What Are Stocks? |
|
The
Definition of a Stock Plain and simple, stock is a
share in the ownership of a company. Stock represents
a claim on the company's assets and earnings. As you
acquire more stock, your ownership stake in the company
becomes greater. Whether you say shares, equity, or
stock, it all means the same thing. |
| Holding
a company's stock means that you are one of the many
owners (shareholders) of a company, and, as such,
you have a claim (albeit usually very small) to everything
the company owns. Yes, this means that technically
you own a tiny sliver of every piece of furniture,
every trademark, and every contract of the company.
As an owner, you are entitled to your share of the
company's earnings as well as any voting rights attached
to the stock.
A
stock is represented by a stock certificate. This
is a fancy piece of paper that is proof of your ownership.
In today's computer age, you won't actually get to
see this document because your brokerage keeps these
records electronically, which is also known as holding
shares "in street name." This is done to
make the shares easier to trade. In Nigeria for instance
such records are kept by the Central Securities Clearing
System (CSCS). In the past when a person wanted to
sell his or her shares, that person physically took
the certificates down to the brokerage. Now, trading
with a click of the mouse or a phone call makes life
easier for everybody.
Being
a shareholder of a public company does not mean you
have a say in the day-to-day running of the business.
Instead, one vote per share to elect the board of
directors at annual meetings is the extent to which
you have a say in the company. For instance, being
a Microsoft shareholder doesn't mean you can call
up Bill Gates and tell him how you think the company
should be run. In the same line of thinking, being
a shareholder of Anheuser Busch doesn't mean you can
walk into the factory and grab a free case of Bud
Light or a free Star Drink from Nigerian Breweries
Plc.
The management of the company is supposed to increase
the value of the firm for shareholders. If this doesn't
happen, the shareholders can vote to have the management
removed--well, this is the theory anyway. In reality,
individual investors like you and I don't own enough
shares to have a material influence on the company.
It's really the big boys like large institutional
investors and billionaire entrepreneurs who make the
decisions.
It
isn't too big a deal that the shareholders are not
the ones managing the company. After all, the idea
is that you don't want to have to work to make money,
right? The importance of being a shareholder is that
you are entitled to a portion of the company’s
profits and have a claim on assets. Profits are sometimes
paid out in the form of dividends. 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 case of liquidation, you'll receive
what's left after all the creditors have been paid.
This last point is worth repeating: the importance
of stock ownership is your claim on assets and earnings.
Without this, the stock wouldn't be worth the paper
it's printed on.
Another
extremely important feature of stock is its limited
liability, which means that, as an owner of a stock,
you are not personally liable if the company is not
able to pay its debts. Other companies such as partnerships
are set up so that if the partnership goes bankrupt
the creditors can come after the partners (shareholders)
personally and sell off their house, car, furniture,
etc. Owning stock means that, no matter what, the
maximum value you can lose is the value of your investment.
Even if a company of which you are a shareholder goes
bankrupt, you can never lose your personal assets. |
| Why
does a company issue stock? Why would the founders
share the profits with thousands of people when they
could keep profits to themselves? The reason is that
at some point every company needs to raise money.
To do this, companies can either borrow it from somebody
or raise it by selling part of the company, which
is known as issuing stock. A company can borrow by
taking a loan from a bank or by issuing bonds. Both
methods fit under the umbrella of "debt financing."
On the other hand, issuing stock is called "equity
financing." Issuing stock is advantageous for
the company because it does not require the company
to pay back the money or make interest payments along
the way. All that the shareholders get in return for
their money is the hope that the shares will some
day be worth more. The first sale of a stock, which
is issued by the private company itself, is called
the initial public offering (IPO). If you want to
know more about how stocks are created, check out
our IPO tutorial.
It
is important that you understand the distinction between
a company financing through debt and financing through
equity. When you buy a debt investment such as a bond,
you are guaranteed the return of your money (the principal)
along with promised interest payments. This isn't
the case with an equity investment. By becoming an
owner, you assume the risk of the company not being
successful. Just as a small business owner isn't guaranteed
a return, neither is a shareholder. As an owner your
claim on assets is lesser than that of creditors.
This means that if a company goes bankrupt and liquidates,
you, as a shareholder, don't get any money until the
banks and bondholders have been paid out; we call
this absolute priority. Shareholders earn a lot if
a company is successful, but they also stand to lose
their entire investment if the company isn't successful. |
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It
must be emphasized that there are no guarantees when
it comes to individual stocks. Some companies pay
out dividends, but many others do not. And there is
no obligation to pay out dividends even for those
firms that have traditionally given them. Without
dividends an investor can make money on a stock only
through its appreciation in the open market. On the
downside, any stock may go bankrupt, in which case
your investment is worth nothing.
Although
risk might sound all negative, there is also a bright
side. Taking-on greater risk demands a greater return
on your investment. This is the reason why stocks
have historically outperformed other investments such
as bonds or savings accounts. Over the long term,
an investment in stocks has historically had an average
return of around 10%-12%. A great proof of the power
of owning equities is General Electric.
There
are two main types of stocks: common stock and preferred
stock.
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