6 Introductory Lessons on Stocks

Overview: Owning a share of stock is owning a portion of an entire company, hence why stocks are often referred to as “equities”, referring to shareholders’ ownership of a portion of a company’s overall equity.  Decades ago, when one bought a share of stock they would actually receive a physical certificate exhibiting his or her ownership of that share of the company.  Today, most trading occurs electronically through online brokerages.  The group of individuals or investment firms that own stocks in a company are referred to as the company’s shareholders.

The overall stock market is made up several exchanges, such as the New York Stock Exchange (NYSE) and Nasdaq.  The price of stocks on these exchanges are based on the supply and demand for those stocks.  It is important to remember that, in addition to market trends such as continued growth in a particular industry or other factors that might affect an individual business, psychological factors can also have a significant impact on demand and prices and cause prices to increase beyond their market value.  When a “correction” – normally defined as a decrease of around 10 percent from a recent peak – occurs in the overall stock market, experts may attribute it to an overvaluation of equities among other potential causes of investor uneasiness.

Common vs. Preferred Stock: There are two types of stocks that a company will offer shareholders: common stock and preferred stock.  Most everyday investors that purchase equities are likely purchasing common stock, which is the most common type of stock issued by companies.  Common stockholders are normally given voting rights in the company, whereas preferred stockholders do not have voting rights, but have a a greater stake in the company.  Common stockholders are also not guaranteed to receive dividends on their shares.  In general, common stock is riskier with more potential for growth than preferred stock, which is less volatile but has less room for capital growth.  (Note: This follows the general rule of thumb that investments with greater risk have greater potential for returns through higher yields, in the case of bonds, or capital growth).

Trading: The most common place to purchase equities is through a public exchange, such as the New York Stock Exchange (NYSE), where companies list their shares for buying and selling. One can generally purchase equities through a brokerage that acts as the intermediary between the company and the individuals or investment firms that are buying or selling the stock. As such, although you are investing directly in a company by purchasing a share of its stock, everyday individual investors are seldom buying stock directly from the company. One should always remember that the brokerage firms that handle these transactions normally charge a fee for stock trades and investors should factor in that cost considering any decisions on trading equities. One can invest in the equities not only by purchasing stocks from an individual company, but also through index funds and Exchange Traded Funds (ETFs), both of which will be discussed in further detail in future posts. Stocks and ETFs can be traded via limit orders, in which the seller and/or purchaser sets a limit – either a “not-to-exceed” or “no less than” price – that must be met before the trade is executed. When submitting a limit order, investors can choose a time horizon during which their proposed price limit will remain valid, such as for the remainder of the day or for 60 days, for example. Equities can also be purchased via a market order, in which no limit is set by the buyer and/or seller and the trade will be conducted immediately at the current price of the equity in the market. One can generally trade equities on public exchanges during the hours of 9:00am to 4:00pm during the work week.

Potential Earnings and Income: Income and earnings from equities come from two sources: 1) the potential growth in the value of that stock, known as “capital gains“, and 2) income from dividends which are normally paid out to shareholders on a quarterly basis.  Dividends represent a portion of the some of company’s profits, which are returned to the company’s owners, i.e. its shareholders. Investors can elect to either reinvest their dividends in additional shares automatically or have those dividends routed to a separate holding account for a future decision.

Risk and Diversification:  There is no asset class in which you can invest without risk.  The risks of purchasing individual equities comes with risk that originates from both the overall volatility of the stock market as well as the risk that an individual company could see decreased earnings or even go bankrupt.  When a company goes bankrupt, accept the most risk since they own a portion of the company. Regular shareholders will not get paid until after creditors, such as banks or bondholders, and preferred share holders, meaning there is no guarantee that they will receive the value of their stake in the company. For further reading on the subject or corporate bankruptcy, consult the below list of further online reading.  Some of the risk of investing in individual securities can be partially mitigated through diversification, for example by focusing on investments that track an entire index(as opposed to one company), such as the Standard & Poor (S&P) 500 index.  This approach still poses investment risk market trends and volatility,  which can affect not only individual companies or a single index, but also the entire stock market.

Alternative Methods:

Short-Sale of (“Shorting”) a Stock (or other asset): Taking a short position on an asset, or “shorting”, refers to any transaction through which the investor can profit from the decrease in the value of the asset.  To conduct such a transaction normally investors will borrow stocks and immediately sell them, with the expectation that the value of the asset will decrease in value and they will be able to purchase it back at a lower price later before returning it to the lender.  If the price of the stock decreases as expected, the investor profits from the decrease in value, after having borrowed and sold the stock at the higher price,  bought it back at a lower price, and then returned the stock to the lender.  Investors will “short” an asset when they anticipate the value of the stock to decrease in the future, i.e. betting against that asset.

To provide a simple example, an investor “shorting” one share of a certain company borrows and immediately sells that share to another investor at a value of $10.  A few months later, the stock decreases to $8 and the investor purchases the stock at that price and then returns it to the borrower.  The investor has just profited $2 – the difference between the original price the later purchase price – from shorting the stock and buying it later at a lower value.

Shorting stocks is generally considered to be much riskier than taking a “long position”,  i.e. buying and holding a stock in the expectation that its value will increase, and therefore may not be advisable for the everyday investor trying to plan for retirement.  Short selling is a more advanced approach to investing as it involves making market predictions, which most investors, even the experts, have a hard time doing.  Future posts and discussions on equity investing will focus instead on long-term approaches to successful investing through diversification and asset allocation, risk management, and methods for reducing fees and taxes.

SUMMARY OF LESSONS:

  1. Overview: Investing in a share of stock is purchasing and owning a portion of an entire company.
  2. Earnings/Income: Potential earnings from equities come from both the potential growth of the value of the stock, known as “capital gains”, as well as the dividends paid out to shareholders by the company.
  3. Trading: Stocks are traded on stock exchanges in which investors can purchase equities by choosing individual companies or through other mechanisms such as index funds and exchange-traded funds (ETFs).
  4. Risk and Diversification: Investing in equities involves risk from volatility in the overall market as well as risks related to the failures of the individual company, which includes the possibility that a company can go bankrupt.  Diversification can help mitigate, but not eliminate, investment risk (more to follow in future posts).
  5. Valuation of Stocks: In addition to market and business variables, psychological factors can affect the demand for stocks.
  6. Alternative Equity Investment Approaches: Alternative approaches to equity investing, such as “shorting” stocks, are more advanced and likely pose greater risk to everyday investors.

Copyright © 2018 Finance and Investment Basics.

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