Stocks: What are They and Should you Invest in Them?
Stocks are are a great way to grow your money, especially when inflation is concerned
Before you start investing, it’s important to know what you’re investing in. Most of the time, that will be these little things called To steer you in the right direction and make your money work for you, here’s an overview of everything you need to know before investing in stocks.
What is a stock?
In a nutshell, a stock represents ownership of a company which you can purchase through the stock exchange. When you own a unit of stock (also known as equities), you hold within the company. This means that you have ownership over a portion of the business and have access to the profits based on the amount of stock you hold.
So, if a company has issued 1,000 stocks and you own one stock, then you basically own 1% of the company. This means that the amount of ownership is determined by the number of stocks you own compared to the total amount of stocks issued by the company.
Stocks are the key to investing and will more often than not, constitute the majority of an individual investors' portfolios. Companies issuing stocks are tightly regulated to prevent fraud and are easily bought through stock exchanges.
Corporations issue stocks to raise capital from private investors (like us) to operate their business, fund projects and ultimately grow as a company. In return, shareholders get access to a portion of the earnings based on the amount of stock ownership you hold. So there you have it – a trade off.
What’s more, is that shareholders have the right to vote at the company’s general assembly, receive dividends (the company’s profits) if they are distributed, and sell your stocks to someone else. It is when you sell the stocks onto someone else that the potential return lies. You always want to sell the stock for higher than you bought it for, so that you can make a return on the capital gains.
Why do companies issue stocks?
To put it simply, stocks exist to fundraise. Companies choose to raise money to grow their business, to expand their products and services, and/or to pay off debt, by issuing stocks. But a company can only issue stocks if it’s gone public.
When a company first opens its stocks to the public, it’s called the Initial Public Offering (IPO). This means the company can raise money from public investors. After the IPO, stockholders can then resell their shares on the open stock exchange.
However, not all companies are listed on the stock exchange. An IPO can only be initiated when a company reaches unicorn status – a valuation of $1 billion. This explains why the independent local boutique won’t be listed on the stock exchange, but why the more renowned companies in the world – Amazon, Tesla, Bumble, Google, Ford etc – are.
The digital revolution means stocks can be traded 24 hours a day.
The advantage of companies issuing stock is that it quickly generates significant portions of capital to the business, which is beneficial to both the returns of early investors and the company as a whole.
How do you trade stocks?
Stocks are bought and sold through the stock exchange – a system which was designed to help businesses raise the capital they need. It acts as a central hub where individual and institutional investors meet to buy and sell stocks. It’s designed in a way that makes trading accessible and easy, and facilitates liquidity within the marketplace.
Back in the day, a stock exchange was predominantly found in physical locations which involved traders shouting bid and offer prices. But with the technological revolution and with the trend towards digital processes, trades are now made electronically. This evolution has made the stock market even more transparent and a whole lot easier for us as individual investors. What’s more, they can be traded seamlessly 24 hours a day, creating real-time transactions.
Most countries have their own stock exchanges:
- USA: New York Stock Exchange (NYSE)
- USA: National Association of Securities Dealers Automated Quotations (NASDAQ)
- United Kingdom: London Stock Exchange (LSE)
- China: Shanghai Stock Exchange (SSE)
- Hong Kong: Hong Kong Stock Exchange (HKEX)
- Japan: Tokyo Stock Exchange (TSE)
- India: Bombay Stock Exchange (BSE)
- Canada: Toronto Stock Exchange (TSX)
How do you make money when investing in stocks?
You can reap the financial benefits of investing in stocks in two ways: dividends and capital gains.
Dividends are regular payments of the company’s profits to shareholders. Not all companies decide to pay out dividends to shareholders who purchase stocks, but those who do, typically pay on a quarterly basis. How much you gain in dividends is dependent on the amount of stocks you own in the company.
However, it’s important to note that not all companies pay out dividends. Some companies choose to reinvest the profit directly back into the company itself. So it’s up to you to decide whether the companies you invest in, have to meet the criteria of paying out dividends.
2. Capital gains
The other and more commonly known way of making money when investing in stocks, is price increases – also known as capital gains. This means that you sell the stock to another investor at a higher price than what you paid for it yourself. For example, if you bought a stock for $10, but the price of the stock goes up and you sell it for $11, then you make $1. But of course, you can also lose money if the price of the stock goes down while you own it.
How are stock prices determined?
There are many factors that affect the stock price, but in general, the stock price is driven by supply and demand. This means that if there are more people interested in buying the same stock, the price will rise. On the other hand, if there are more people selling than people wanting to buy, the price drops.
This way, the stock price always reflects what investors think the stock, and therefore the company is worth. Stock prices are also affected by four other factors:
1. News about the global economy
20 to 30% of how the stock market develops is influenced by the global economy. When the global economy begins to shrink, activity in businesses and different industries plummet. It’s therefore no surprise then that the stock market decreases in value too when that happens. And vice versa for when the economy grows and expands – stocks correspondingly increase in value too.
2. News about the sector
Industry news always plays its part in determining the stock price. For example, say the beverage industry decides to implement a policy that raises taxes on imports. This will create a lot of uncertainty amongst investors who worry that it will have a negative impact on the beverage brand they’ve invested in. Out of fear, many investors will pull from their investments. And what happens when there’s less demand? The price increases. And vice versa when there’s more demand and people are increasingly buying into a particular stock.
3. News about the company itself
Around 50% of stock prices are determined by news about the company, which is why the media holds such a sway in the financial markets. These include anything that impacts an investors’ perception of the company’s future earnings, including quality of the company's management, performance in their own sector, supply chain and public relations. That’s why staying on top with the market news is key!
4. Market psychology
Herd instinct is prominent in the stock market. What other people think holds a sway over the price of stocks! Think about it: investors confirm each other’s thoughts (both positively and negatively) on how stocks will ultimately perform. So if news has broken that a particular stock is going to fail, people will start panic selling their stock, only for their friends to follow suit. And when people panic sell, the price shoots up.
Is it risky to own stock?
It would be a lie to say that stocks aren’t riddled with risk. Markets take twists and turns, and it’s only natural that stocks will too. It’s how you devise your investment strategy that will determine how risky your investments are. That’s why diversification – spreading your investments across multiple countries, regions and industries – is key. Historically, stocks have outperformed most other investments over the long run, so providing you invest in multiple stocks rather than putting all your eggs in one basket, you can control the amount of risk you can take on.
How do stocks differ from bonds?
Bonds and stocks are distinct and should never be confused with one another. Stocks are issued by companies to raise capital for the businesses, and by investing money into stock, people become shareholders who receive returns in the form of dividends (if issued by the company) and capital gains (the difference between the purchase price and the selling price).
However, bonds are issued by government institutions and businesses who return money in the form of annual interest, and the return of the principal amount invested by the bond’s maturity date. So let’s say the company or government gives back 5% of the £1,000 loaned to them every year. That means the bond investor will get £50 straight into their account every year as an incentive. They will eventually redeem the £1,000 principal investment, but over the 10 year period would have earned £500 in bonds.
But whilst bonds offer a reliable and sturdy income, the return potential is a lot lower. So in some sense, stocks are more risky (especially since they won’t receive anything in the event of bankruptcy), but offer the potential for a higher return in the long run.
Why should you invest in stocks?
Well, to put it short: to make sure your money maintains its value and you get the freedom to live life on your own terms. Because historically, investing in stocks has been a good idea as the stock market increases its value by 7 to 10% on an annual basis (…and yes – this includes years with financial crises such as the IT-bubble etc). And actually, you can’t really afford not to invest. Due to a combination of historically low-interest rates and inflation, your money on your savings account is slowly but surely losing value.
Investing in stocks can help combat this issue, because it gives you an opportunity to grow your money and outpace inflation. And the benefits stretch beyond your own need for financial stability, but enable you to put money into businesses you believe in and which you think are the future. Whether you’re passionate about sustainability, a new tech company, or female founded business, stocks are a great way to help those companies move forward. And if done right, you can use money you already have to make more.
There are many reasons why you should invest in stocks, but most importantly it’s about growing your money. Don’t just let your cash sit, because you have worked hard for your money – now your money has to work hard for you!