What is a stock?
A stock is a share of ownership in a company. By selling stock, a company receives an influx of cash to invest in the growth of the business. By purchasing a stock, buyers get to share in the potential financial success of the company.
Owning stocks in companies provides one of the most appealing combinations of risk and reward for those seeking growth in the value of their investment portfolio.
An April 2022 Gallup survey showed that 58% of American adults reported that they owned stock.
The same survey shows that higher levels of education and income tend to correlate with stock ownership.
Is this because rich people own stocks or do stocks make people rich?
Yes and yes, but we’ll get to that later. First, let’s talk more about what a stock is.
Perhaps you’ve heard that it takes money to make money. Well, this happens to be the basic reason stocks were invented in the first place.
The First Stocks
In 1602 the Dutch East India Trading Company (DEITC) used the sale of stock certificates to finance voyages to the East Indies for the purchase of spices, among other goods.
There was a burgeoning demand for goods from this part of the world, but a very limited fleet available to ship these items from one part of the world to the other.
Since voyages took ages to plan and execute, it would take years for DEITC to gradually build its shipping fleet up to a level that would meet the overwhelming demand of the market.
Frustratingly enough, the opportunity for sales was clearly available, but DEITC was physically unable to take advantage of the demand on its own steam.
Enter the use of stock certificates.
Under the stock arrangement, the buyer of stock provided cash for specific voyages and, in exchange, shared in the profits with DEITC upon the ship’s return.
As it turned out, this arrangement was quite lucrative for all parties involved. In the latter half of the 17th century, stockholders in DEITC received yields of anywhere from 12%-40% annually.
For perspective, the S&P 500 has averaged an annual return of 10.314% from its inception through September 2022, and that’s a really solid rate of return.
So, on life went and the Dutch became an economic powerhouse in the world for centuries. They even helped finance the American Revolution.
Nuts & Bolts
With centuries of practice under our belts now, stock ownership has become exceptionally common and available to just about anyone that wants it.
There is no end to the number of companies that could benefit from additional cash flow, nor to the number of people seeking opportunities to improve their own financial circumstances through smart investing.
Perhaps the easiest way to explain how stocks work is to look at an example.
Let’s assume ABC Company was just started a year or two ago by a couple of enterprising engineers that have figured out a way to charge electric cars five times more quickly than the fastest chargers available on the market currently.
They’ve done the research, patented their design, built prototypes, and are ready for production.
There’s just one problem.
Production requires an enormous capital investment that the ABC guys simply can’t produce on their own.
Lucky for our friends at ABC, there is an endless line of people eager to give cash to the company in exchange for a share of their future profits.
So, ABC executives meet with investment bankers to estimate the value of the company and set up an Initial Public Offering or IPO.
Among other things, an IPO sets the number of shares the company will sell, the share price, and the date the shares will be sold.
The price and number of shares will be set based on what ABC and their investment bank think the company is worth and what they believe people will be willing to pay for it.
On IPO day, ABC sells its shares and rakes in a windfall of cash to build its factory.
Here’s the thing to remember though, ABC gets its money at the IPO. The sale of their shares after the IPO between other parties won’t change how much money they raise initially.
That’s because stock is an asset that you can buy, sell, or exchange with other parties like you can any other physical property.
Just like you might buy a house at one price and sell it to another party at another, you can buy and sell stock as you please.
The platform where these sales and purchases take place is known as a stock exchange. In the United States, we have two primary exchanges; the New York Stock Exchange (NYSE) and the National Association of Securities Dealers and Automated Quotations (NASDAQ).
While NASDAQ is based in New York, there isn’t a physical trading floor like at the NYSE. The NASDAQ is an electronic stock exchange.
How is a Stock Priced?
After the IPO, stocks are priced at any given moment according to the value at which someone is willing to buy the stock and the value at which someone is willing to sell it.
This part is hard for some people to grasp, but you read it correctly. A stock’s price may or may not have much to do with the actual value of a company at a given moment.
In fact, the price is rarely an accurate reflection of a company’s actual worth at a given time.
It’s all about how much someone is willing to pay.
This is one factor, among many, that makes predicting the value of stocks so incredibly difficult.
When you watch a stock ticker constantly moving up then down, then up up up, and down, then up again, and so on, you’re literally watching people trade the stock.
Why does it go up and down constantly? The same reasons anyone might buy or sell at a given moment.
Here are some that come to mind just so you can see how unpredictable the pricing can be:
- Some guy’s daughter got engaged and he needs to free up some cash for the wedding so he sells.
- The Bureau of Labor Statistics released a report showing that unemployment is higher than expected. This could cause the price to go up or down, actually, depending on the context.
- Another person heard the CEO of XYZ Corp preferred Pepsi over Coke and now he’s not sure he has any faith in the direction the organization is going. He sells.
- A mutual fund manager has to sell 20,000 shares because a lot of people that own her fund sold their shares and the mutual fund needs more liquidity.
- Another mutual fund manager buys 20,000 shares to keep up with the sudden growth in her fund.
- COVID
- Banks have lent a load of money to people to finance mortgages and then compiled these mortgages into securities that they sell to large pensions. Turns out the loans were bad so the securities collapse and take financial stocks with them. The ripple effect puts the whole economy in the ditch. No one saw this coming because rating agencies kept indicating that the investments were solid. Oops. (This is what happened in 2008, btw.)
- Crude oil prices went up, again. Everything drops except for electric car stocks.
- Some kid on reddit notices a bunch of short contracts on AMC and he wants to stick it to the man. He recruits some pals to bid up the price and it shoots “to the moon”.
- Some kid on reddit owes rent and decides having a place to live may be more important than playing stocks. AMC stock falls when all his pals hear that he’s sold and they join the rush to get out.
The causes and subsequent effects are endless which is exactly why predicting stock valuations is impossible.
Maybe I should have just said “it’s complicated” and left it at that. Would have been just as true.
Stocks are also subject to the normal market forces of supply and demand. If the demand for a given stock is high, like TSLA in 2020, the price goes way up because the buyers outpace the sellers.
If a lot of people sell at a given time, the price falls because they’re competing for a smaller pool of buyers.
This is why two companies with the exact same revenue, debt, earnings, etc. could be priced at completely different ends of the spectrum.
Trust me, there’s far less disciplined analysis in the price of stocks than many would like to believe.
Nevertheless, eventually, things will drift, or slam, back into line. These moments of pain are known as corrections, recessions, depressions, or some combination thereof.
In summary, the price of a stock is rarely accurate, but that doesn’t mean there isn’t a lot of opportunity in stocks.
Do All Stocks Pay Dividends?
No.
A dividend is a share of the profit a company gives to its shareholders for a given period of business, usually quarterly.
In fact, the value of a stock is based largely on its dividend.
For example, if Coca-Cola announces that it will pay a dividend of $0.50/share on July 1st, that means Coca-Cola’s stock price will drop exactly $0.50 on July 1st.
The price may quickly change after the market opens, but the value of the dividend will come out of the equity of the company since it has been distributed to the shareholders. That equity is the stock of the company.
Until recently, it was unheard of for a company to issue stock and not accompany it with a regular dividend (unless, perhaps, the company failed to produce a profit).
The whole point of stock ownership is to share in the profitability of a company. The way that has been handled for centuries is through a dividend.
Well, in recent years, companies eager to grow rapidly and execute a higher degree of tax strategy, have re-invested profits into the company instead of paying dividends to their shareholders.
The idea is to grow more now for the sake of a quicker path to profitability in the future.
Stockholders haven’t seemed to mind much. A growing number of people continue to seek out “unicorns” in order to trade the stock for a tidy profit as it quickly increases in value.
Thus, companies have continued the practice and there are many who have existed for years and never paid a dividend (and may not ever do so). Amazon, Google, and Facebook are three that come to mind.
Historically, large companies that pay dividends have performed better overall than those that don’t. However, it’s worth noting that some companies that crash and burn don’t ever have the opportunity to pay a dividend, so maybe the data is a little skewed.
That’s enough about dividends, but if you own securities that pay dividends it may be more tax efficient to hold those in retirement accounts. That’s for another post.
Benefits of Stock Ownership
So, why own stocks?
The answer is pretty simple: profit.
There aren’t many ways to diversify your portfolio (more on that in a bit) with higher-paying investments. At least, I don’t know of any that you can buy publicly.
If you are looking to invest and reap a generous profit, ultimately, you will probably need to own stocks.
By owning stocks, particularly those in American companies, you are purchasing a share of the largest economic engine the world has ever known. Sit on the sidelines and you’ll be like the “don’t get mad” people in the E-trade commercials.
There are other publicly available investments like bonds, treasuries, etc., but nothing is going to have the growth potential of stocks.
Risks of Stock Ownership
Well, unless you didn’t pay attention in school, you know that the worst economic periods in our history were correlated with or even caused by steep declines in the prices of stocks.
It’s hard to say which is to blame for causing the other, but misery loves company and seems to always invite the stock market to join in the fun.
If the money that you need to fund retirement, a wedding, or a new home is subjected to such a loss the results could be personally devastating.
Many people have lost everything through careless gambling with stocks.
The high degree of risk associated with stocks is a considerable psychological hindrance for many considering investment options.
Personally, I find this to be unfortunate. To be sure, there are down years for stocks, but the growth far outweighs the downside.
The key is having a strategy to ride out the rough times while reaping the rewards of the good.
This is done in part by 1) staying in the market for years and years, and 2) owning a diverse group of stocks instead of having too much exposure to one.
Time in the Market
The market has ups and downs. History shows that 2 out of every 10 years, the stock market will end a calendar year lower than it started.
Here’s the thing though, for the other 8 years, the value of the overall stock market grows.
Since we’ve already pointed out that you can’t know which years will be up and which years will be down, the best approach is to just stay in stocks for an extended period of time.
Yes, by taking this approach you’ll have to ride out some rough periods, but you’re also guaranteed to participate in the good years.
In summary, if you are willing to take the good with the bad and can hang in there during choppy seasons, you’ll reap great rewards.
The Importance of Diversification
Once upon a time, there was a company named Enron.
They were an energy company based in Houston, TX. Their stock was a high performer and many thought they had roped the moon through their wholesale energy strategies that were all the rage in the early 2000s.
As it turns out, they were filled with a bunch of swindlers and frauds that are now in prison.
Once their misdeeds came to light, the stock naturally tumbled to nearly nothing. Unfortunately, many shareholders, employees included, lost everything.
It was a sad, sad situation, but it highlights the importance of not placing all of one’s investment eggs in a single basket. I’d have a difficult time distinguishing between such an action and putting it all on black at a Las Vegas roulette table.
The wise approach to thoughtful stock investing calls for owning stocks from a wide variety of companies and market sectors. You can accomplish this by buying lots of different stocks, but it’s much easier to buy mutual funds or ETFs.
Mutual funds purchase large varieties of stocks and hold them in a portfolio. Investors can purchase shares in a fund to enjoy the benefits of diversification and of stock market returns.
We’ll do another post on mutual funds, but there are thousands covering a wide variety of investment types, market segments, countries, big companies, small companies, etc.
Conclusion
Stocks certainly have their risks, but the opportunities far outweigh the downsides. There really isn’t a better path to investment growth and, through diversification, anyone can benefit.
If you do decide to dabble in or buy some stocks directly, make sure to keep the overall value of individual stocks below 10% of your total portfolio value. This will insure you stay diversified enough to avoid a disaster from a sudden decline in the value of any one company’s stock.
Also, don’t hold a lot of stock from your employer. Having your income and investment returns tied too heavily to any one company just isn’t wise.
Imagine getting fired at the same time the stock tanks. That’s no bueno amigo.
Finally, be patient. Studies show that people who just leave their investments alone for years and years outperform those that are regularly trying to buy and sell to avoid downturns or take advantage of market booms.
