A successful voyage of the Dutch East India Company ships brought great profits, but statistically, one sailing ship in three returned home - the others could not withstand storms and pirate raids. It was necessary to assure on paper the responsibility for the ship and to determine how much profit everyone who had rights to the ship would receive. This is how the company became the first stock company in the world - it issued securities in the early seventeenth century. Let's talk today about stocks: why companies need shares, what they give owners and how to multiply capital with the help of them.
A stock is a security that confirms your right to own part of a business. It shows that you have a share in the company and that you have the rights of a shareholder. For example, you can participate in the management of the company or receive dividends. The more shares you own, the more of the company you own. Therefore, "owning a share in a company" and "owning shares" are the same thing.
What Stock Ownership Brings
If you become a shareholder or holder of stock, this means that you are one of the many co-owners of the company. As such, you can claim everything the company owns (though usually only a very small share). Yes, technically this means that you own a tiny piece of every piece of furniture, every trademark, and every contract of the company. As a co-owner, you are entitled to your share of the company's profits, and - in most cases - you get to vote at the general meeting of shareholders. The weight of your vote depends on the type of stock. If you become a shareholder of a public company, this does not mean that you can now directly influence the decisions of its management. Generally, your influence is limited to one vote per share when electing the board of directors at the annual meeting of shareholders. In other words, even if you are a Microsoft shareholder), you cannot call Satya Nadella and explain to him how to run the company.
Management is supposed to strive to increase shareholder returns. If it doesn't, shareholders can vote to change management-at least in theory. In reality, the average investor simply does not have enough shares to have a significant impact on the company. The really big shots - the big institutional investors and billionaire entrepreneurs - make the decisions.
However, investors usually aren't too bothered by the fact that they can't run the company themselves. After all, you want to provide yourself with a steady income without having to work. In that sense, the most important thing for a shareholder is that he is entitled to a portion of the company's profits and its assets.
Profits are sometimes paid out in the form of dividends. The more shares you own, the more profit share you will receive. But you can only exercise your right to a share of the company's assets in one case: if the company goes bankrupt. In the event of liquidation, you will receive your share of what remains after all of the company's debts have been paid. Let's say it again: The most important thing about owning stock is your right to a portion of the company's assets and earnings. Without this, a stock would not be worth the paper it is printed on.
Shares have another extremely important feature: limited liability. This means that as a shareholder, you are not personally liable if the company is unable to pay its debts. Other forms of business organization, such as partnerships, are set up differently: if the partnership goes bankrupt, the creditors have the right to auction off the partners' property - house, car, furniture, etc. If you own stock, in the worst-case scenario you will lose only the value of your investment. Even if the company you own goes bankrupt, you won't risk your assets.
How to Make Money Investing in Stocks?
There are several ways to make a profit:
- Wait for the price of the stock to rise and sell it at a higher price than what you bought it for. For example, in May you bought a company share for 200 dollars, and in September its price went up to 250 dollars. You sell the stock and earn 50 dollars.
- You open a short position to make money on the falling price of the stock. You short a stock and sell it at a high price, i.e. you trade a security that you don't own. When the stock drops in value some time later, you buy it and return it to the lender, the broker. The broker will receive a daily interest from this trade until the short position is closed.
Please note: to work with shorts, you must follow some important rules - learn more about this before you start trading.
Receive a portion of the company's profits through dividends. If your portfolio has shares in a company that distributes a share of its profits to its shareholders, then, as the owner of its securities, you claim income. It is important to note that not all companies pay dividends.
Classification of Stocks
A company can issue two types of stock: common and preferred. Here's the difference:
- The common stock will give you the right to vote at a company's shareholder meeting on one paper, one vote basis. Holders of common stock may receive dividends. Their amount, periodicity, and frequency are set by the issuer itself and are stipulated in the dividend policy. Dividend calendars will help to keep track of payment parameters. It is important to note that, unlike preferred stocks, not all common stocks can be paid dividends. Why should investors do that? Shareholders can make money on price fluctuations, i.e. selling the paper at a higher price. More often than not, such profits will prove more profitable than receiving dividends.
- The preferred stock allows you to know the amount of the dividend in advance. The dividends will not be paid out of profits only: if a company has incurred losses, it will be paid out of its property or out of its funds. Holders of preferred shares, who did not receive dividends following the results of the previous year, will participate in the voting of shareholders. There is one more peculiarity: in case a company is liquidated, holders of preferred shares will be paid first. In most cases, preferred stocks are less liquid and volatile and can often be less profitable than common stocks. But it's worth looking into why this is the case before investing.
What is a Lot in Stock Trading?
On the stock market, a lot is a unit of measure for a package of shares in a transaction. As an example to understand, you can make the purchase of a package of some product – for example, a box of cakes. A package with 8 pieces is a full lot, but if you only want to buy three items, a lot would be called an incomplete lot.
A lot is the minimum size of the amount of an asset. When you see that a company share is worth 350 dollars, but you are offered to pay 35,000 when buying it, it means that the lot contains 100 shares of the organization.
Finding out how much you have to spend on the purchase is simple: multiply the price of the paper by the lot size. It, by the way, is set by the exchange. Buying a full lot may not suit you - this problem has a solution. There is such a trading mode as a fractional lot. To find out which companies offer it, you need to select the "fractional lot" option on the Exchange website.
What is Depositary Receipt for Stock?
A depository receipt is a certificate that allows you to own a certain amount of stock of a foreign issuer while remaining on the local exchange.
It's important to know the two acronyms:
- ADR - American Depositary Receipts (in general, receipts first appeared in the United States).
- GDRs - Global Depositary Receipts. Thanks to them you will have access to shares on other international exchanges, for example, the London Stock Exchange.
Holders of depository receipts have the same rights as holders of shares. These certificates are bought and sold like securities, but one receipt can be equal to one share or its half, or, on the contrary, to ten pieces. In the end, the function of a depositary receipt is reduced to the right to own a share, which is not traded on the domestic market but is represented on the foreign market.
Why Do Companies Issue Stocks?
The reason why companies start trading their shares is to attract financing. The money a company receives from investors can be spent on any of its needs - buying equipment, raw materials, manufacturing, research, and other business development. In addition, trading in shares helps to value the company. The sum of all of a company's publicly traded shares is a company's market capitalization. This method will show how much a share in a company can be sold for. Roughly speaking, it is the same method of evaluating a company's position and potential as an expert's analysis.
And for shareholders who want to get out of the business, stock trading allows them to transfer their stake to other investors.
Where Can I Buy Shares?
There are two ways to buy stocks - on the stock exchange or off-exchange. Trading on the stock exchange is more transparent - the quotes (prices) of stocks and other securities can be easily tracked. When you buy or sell stocks directly, off-exchange, there is a risk that the prices will be over or understated compared to the market prices. In addition, the exchange carefully evaluates the issuing companies. You're unlikely to find any blatant cheaters there. And other stocks, as a result of checking, are assigned an important attribute - listing level.
Today there are three of them. The first level (or the first quotation list) - the most liquid shares of the most reliable companies on the market.
To get into the second quotation list the requirements are not so high anymore. But all the companies, whose shares claim to be included in the first or the second list, must regularly report to the stock exchange on the results of their activity, as well as publish their reports and all the important information about themselves on the Internet. The third tier is the unlisted part of the list with the lowest requirements. If you are going to buy a Level 3 company or a company that is not listed at all on the exchange, you will have to evaluate its reliability on your own. And that is not easy even for an experienced investor. Information on issuers and their securities can be found, for example, on the website of the New York Stock Exchange.
What Are the Risks of Investing in Stocks and How to Manage Them?
It should be emphasized that investing in stocks does not imply any guarantees. Some companies pay dividends, but many do not. And even those that do routinely pay dividends have no obligations that will make them continue to do so. If a company doesn't pay dividends, the only way for an investor to make money is to sell his shares on the open market when their price goes up. But the company could also go bankrupt, in which case your investment would not be worth a penny.
The risk may seem like a very bad thing, but it has a silver lining. Higher risk implies higher investment returns. That's why stocks have historically outperformed other financial instruments such as bonds or savings accounts. Over the long term, historically, the average return on a stock investment is about 10-12%.
All investment risks can be divided into two broad categories: systematic and nonsystematic. The first is related to stock market conditions and macroeconomic indicators in general; the second is related to the well-being of a specific industry and a specific company.
Non-systematic risks
First of all, we are talking about investment risks associated with the business of an individual company. Suppose you buy shares of a publicly-traded company, ABC, through a broker. Usually, the average investor makes a decision based on the rise in the quotes of the organization's securities, presented on a beautiful chart, on some individual, often poorly motivated preferences of his or her own. Imagine there is a gang of evil dwarfs at the bottom of this chart and a team of good dwarfs at the top. They are tug-of-war, and the stock price is the result of their efforts. On the one hand, there are positive factors: correct management decisions, new projects aimed at the growth of the company's product sales, new contracts, expansion of production, and good credit history. On the other hand, there are management mistakes, a decrease in demand, and an increase in debt burden, which can scare away major shareholders.
This is further aggravated by the risks in the industry in which the company operates. For example, if a company invests in oil or gas, fluctuations in their value on the market will put serious pressure on it. Let's say a company is highly dependent on energy prices, as in the case of air carriers. A strong rise in oil prices will lead to lower profits for airlines and probably even to the bankruptcy of some of them.
Another example of the risks associated with certain sectors is currency fluctuations. The simplest example: is the strengthening of the national currency is unprofitable for exporting companies that sell the bulk of their products abroad and settle their accounts in dollars or euros. In this situation, the growth of such companies' shares may slow down or show negative results at all. It is clear that all these are conditional, "cabinet" scenarios, because in reality there are dozens of change factors, and rarely does one parameter play a decisive role.
The good news is that all these non-systemic risks (company's business and industry risks) can and should be minimized. This can be done by building a well-balanced investment portfolio that buys different asset classes, and shares of different companies from different sectors. A ready constructor is represented by mutual funds or ETFs.
Systematic risks
This category represents the dangers of investing that are absolutely impossible or very difficult to influence, much like controlling the weather, for example. First and foremost, they are associated with investing money in a particular asset class and type. Let's say you invest in the stock market, so you take the risks that go along with it. If you buy bonds, you face the risk of changes in discount rates. There are plenty of such risks, it makes no sense to list them all and know the formulas of their calculation. For the novice investor, it will be helpful to understand basic things:
- Any financial transactions (even the trivial transfer of money) involve risks. You must learn to identify, accept and manage them.
- If risk cannot be avoided, you can reduce its weight, i.e. pick the right balance of assets.
- The higher the potential profitability of an instrument, the higher the risk associated with it. For example, stocks are more volatile assets than bonds.
Here are a few types of investment risks, knowledge of which will help build a competent strategy for investing funds.
- Volatility Risk. We have already explained in general terms how it works and what the correlation is between the potential profit from owning an asset and the risk of its value decline on the stock exchange. When it comes to investing, you should not rely on promises of getting rich quickly and big. It doesn't work that way.
- Inflation Risk. It plays a role mostly in assets with low yields. For example, bond yields may be lower or slightly higher than inflation.
- Credit risks. They are associated with changes in the credit rating of a company or organization issuing a bond. In extreme cases, this is the risk of refusal of the issuer to fulfill its debt obligations.
- Currency risks. These are unfavorable changes in currency exchange rates. Let's say you have invested in foreign stocks, but the exchange rate has strengthened against the dollar. Currency returns can coincide with expectations, but when converted into your currency, they can level out.
- Liquidity risk. There is a type of "non-traditional" shares (such as MLP) when there is a probability that the assets cannot be sold at a fair market value at the right time because of restrictions on an open trade in them.
- Reinvestment Risks. Refers to stocks that involve dividend payments, and bonds with coupon yields. When these payments are credited to the account, it is important to reinvest them in time, so they do not lie dead weight and also work.
- Risks associated with political and other events. As it happens, not only economic factors but also political events affect the market's health. If the political situation worsens, especially before the major elections, the markets may react negatively. Such risks are more pronounced in developing countries and regions.
- A general rule of thumb: the higher your expected return on investment, the greater the number of risks you will have to take. The best way out of this situation is to plan investments for a long period when declines in quotes at the moment are compensated by the overall growth of markets.
As a rule, watching drawdowns in financial markets makes an investor nervous and strives to get rid of cheap assets. This is not very rational behavior. Because if you initially have time to spare, it is prudent to wait out the decline. On the contrary, such situations are a good investment opportunity. Over the long haul, markets are very likely to recover and show growth.
How to Choose a Stock
It's difficult for newcomers to choose a stock to buy. The easiest option is to take investment advice from your broker. But if you want to buy on your own, look at such parameters:
- Liquidity, or the ability to sell stock quickly at market price. It is better to buy those stocks that are in high demand. To determine liquidity, look at trading results on any stock exchange. The number of trades is not the best indicator of liquidity. It is worth looking at trading turnover/volume. For example, if one stock had a million dollars trades and the other had 100,000 trades of 1,000, then the second stock is more liquid.
- Price Dynamics. Each stock has two prices: a nominal price and a market price. The par value of a stock is the amount that makes up a certain portion of the share capital: in the example above, the share capital was 100,000 dollars, and the owners of the company issued 100 shares, each of which is worth 1,000 dollars at par. The par value figure is used for bookkeeping purposes; it is not important to the investor. A shareholder is primarily interested in the market price – the price at which a share can be bought on the securities market at any given time. Before buying a stock, observe how its market price has changed over time. If you manage to buy a stock at a time when its price is falling, it is possible that after a while you can make money on the growth of the company's capitalization. But it is a risky decision to focus only on price movements. If the decline continues, the investor will be in the red. It is better to invest in the so-called blue chips – shares of the largest companies with stable yields.
- Dividends. It is worth paying attention to the size of dividends and the stability of their payment. The financial indicators of the company. We know that stock prices rise when business grows, and dividends are paid when there's profit. This means that before you buy a stock, it's important to understand how profitable and sustainable the company is – to do this, you have to study its financial performance in analyst reports. If it is difficult to choose a stock on your own, you can use investments from analysts or recommendations from an Expert Advisor, who will put together a portfolio according to your conditions.
- Multipliers. These are such measures of the performance of companies. They compare different financial parameters. With the help of multipliers, you can understand how objectively a company is valued on the stock exchange. That is, whether its stock is not too expensive. By multipliers, investors often look for undervalued companies - those whose shares are much cheaper on the stock exchange than they should be. This is usually the case when a company's performance is good, but no one has noticed it yet.
Such undervalued companies are bought with the expectation that their stock price will rise in the future. Other investors in the market will also realize how promising the company is and start buying its securities, which will raise their value. The main multipliers are P/E, DEBT/EBITDA, ROE, EV/EBITDA, P/BV, and P/S.
Tips for Beginner Investors
- Do not invest your last money in the stock market. First prepare yourself a reliable rear: from 3 to 6 of your monthly income put on deposit in a reliable bank.
- Remember a direct correlation between risk and reward. If a stock rises sharply (or you think it should), it can fall just as sharply (or just not rise).
- Don't put all your eggs in one basket. If you decide to invest in stocks, choose several companies, preferably from different industries.
- Keep your finger on the pulse of events. If you are part-owner of a company, keep track of what happens to it and the price of its securities.
Conclusion
Stock investments can be used as a powerful tool to increase capital. Of course, you will need knowledge and experience in this area to diversify your portfolio and be able to anticipate rate fluctuations and price movements.
