Have you ever wondered: Exactly what are stocks? What does it mean to invest in stocks? Where is my money actually going? Is it like gambling money in a casino?
Many professionals in the finance industry – advisors, planners, media, etc – seem to love complexity. In some cases it can’t be avoided, but in many cases it can.
Whether it can be avoided or not, it’s a good idea for you as an investor to have a basic knowledge of terms and concepts. Otherwise, you will just do what someone suggests rather than understanding and making informed decisions for yourself.
So I want to spend just a few minutes on a foundational topic… What exactly are stocks?
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What Are Stocks?
When you start thinking about investing, the one word you’re more likely to hear most is “stocks” (and to a lesser extent, bonds).
A stock represents ownership stake in a business
Let’s say you start a business with a partner and each of you owns one half of the company. You’d be a 50% owner and so would your partner.
There are many different types of business entities (including sole proprietorships, partnerships, LLCs, and more) but once a business reaches a certain size, you’ll commonly see businesses structured as a “corporation”. Organizing a business as a corporation allows it to issue stock to the owners.
Corporations issue stock to represent the ownership of the business
In the 50/50 partnership example, the two partners would own the exact same number of stock shares. The “shares” mean their ownership portion of the business. This two-person partnership example would be a private company – owned by just these two people.
Sometimes though a company might decide to “go public” to raise money from a wider pool of people. This money is sometimes used so the founders can trade part of their ownership for cash, but many times the money is used by the corporation to invest back into itself and accelerate further growth.
Buying stock in a public company makes you an owner of the business
If you own even a single share of stock, it makes you one of the owners of that company. It does. Really.
Let’s say the two-person company decides they want to raise money from the public to ramp up growth and take on some new projects. Perhaps they decide to sell 50% of the company to interested people in the public. They would list these shares and make them available through a public market (like the New York Stock Exchange [NYSE]).
In this continued example, each partner would drop down to 25% ownership. So 25% remains with owner 1, 25% with owner 2, and now 50% goes to the public. In theory the public 50% could be purchased by a single person, but almost always it is sold in smaller blocks to investors – like you.
Ownership has benefits, but also risks
As an owner of stock in a publicly traded company you have many rights – including the right to share in any growth. If the company does well, the value of the stock generally rises. You also have the right to vote on certain corporate (like board members), and the right to a share of the profits via dividends.
Not all companies pay dividends – some just invest all the profits right back into the growth of the business. But when the board decides to pay dividends, the amount of profit they allocate to dividends is divided by the number of shares and then paid out to shareholders.
If the company you invest in doesn’t do well, it likely won’t pay dividends. In fact, companies that start to do poorly tend to lose value – meaning the share prices go down. That’s the risk in being an owner. You participate in the downside too if a company does poorly.
That’s why it is important to diversify your investing. Never invest in a single company. Always invest in a group of them. That way if one company does poorly, it will be balanced by the other stock’s you own.
Dividends are a big part of income investing
When financial professionals talk about income investing they frequently focus on bonds. But stocks that pay dividends are another great source of income from your investing.
In the image at the top of this post – captured February 29th, 2016 – you can see that Walmart stock was trading at $66.89 per share. If you bought one share you would literally then be an owner in Walmart.
You can also see that the current dividend yield is shown as 2.99%. That means that Walmart decided to share profits and the amount they’re currently sharing works out to almost 3% – or about $2 per share per year. Maybe $2 doesn’t sound like much to you, but that 3% share of profits is over-and-above stock price changes. It’s been a long time since we’ve seen 3% return on bank accounts or even many bonds.
So that’s actually a nice bit of income. Plus, that isn’t your total gain – you get to share in growth via stock price increase if the company does well.
Portfolio income: Here’s why dividends are so important
Why Invest In Stocks?
Now that you have an answer to what are stocks, why should you consider investing in them?
While the past is certainly no guarantee of the future, historically stocks have returned about 10% per year. That is combination of growth in prices and dividends paid out.
At 10% per year your money would double about every seven years! Given that rate of return, $1,000 would turn into $8,000 in 21 years.
If you start early and invest consistently, you could easily become an automatic millionaire by investing in stocks.
As a fee-only financial advisor, I can help you clarify your dreams and priorities, then develop an actionable plan to achieve your goals. Having a financial plan for your life includes much more than just investing, but intelligent investing is definitely part of the solution. Reach out and let's talk about how I can help you maximize your money to achieve the life of your dreams.