How Do Stocks Work?
The idea that investment is the most surefire way to financial freedom is no secret to many and investing in stocks remains one of the most popular and safest options available.
However, if you're fairly new to investing, the idea of investing in stocks might seem overwhelming at first, and if you are currently in that place, know that you're definitely not alone.
Just as with starting anything new, you'd want to learn before jumping in, and you've come to the right place.
In this guide to stock investing, you'll learn how to understand stocks and the basics of stock investing that will get you ahead of the curve.
By the end of this guide, you'd have learned about:
- What are stocks?
- Why invest in stocks
- How does the stock market work?
- How to identify the right stocks to invest in
- Mitigating the risks in stock investing
And more. Let us begin this guide with the basics: what are stocks?
What are Stocks?
A stock is a type of financial security that enables us to own a fraction of a company/corporation. A stock represents the ownership or equity interest of a company, and the equity is established on a per-share basis.
Companies issue stock shares to raise financial capital for the company, while investors (and traders/speculators) purchase these stocks with the hope that they'll generate some form of future profits.
Owning a stock means that you (as a stakeholder or stockholder) own a portion of the company equal to the number of shares held as a proportion of the company's total outstanding shares.
For example, let's say company A issued 1,000 stock shares worth $100 each ($100,000 outstanding shares), and you purchase ten shares worth $1,000. In this example, your investment is worth $1,000, and you technically own 1% ($1,000/$100,000 x 100%) of the company.
The owners of stock shares are referred to as stockholders or shareholders and technically have a 1% ownership stake in the company.
Why Businesses Issue Stock Shares
Many businesses started out small, from the founder's garage or other small beginnings.
Many of these small businesses would fail during the first few years of operations, but some flourish into established companies that are able to generate profits.
Yet, sooner or later, these established businesses would also hit a plateau, but if they stop growing, they'll lose to their competitors. At this time, to grow further, the business will need to raise more capital.
Selling Shares as a Way to Raise Capital
Basically, all businesses have two main options to raise more money:
1. Borrowing money from lenders or debt financing
2. Selling its assets or equity financing
Selling shares is a form of equity financing.
Companies can get equity financing from venture capital firms or angel investors, which is a viable option taken by many startups. However, selling shares to the public through a process called initial public offering (IPO) would allow the business to gain access to a much larger capital pool.
Private vs. Publicly-Traded Company
Before an IPO, the company is considered a private firm whose ownership is held by the original founder (or a small group of owners.)
However, once the company undergoes an IPO, it changes its status into a publicly-traded company whose shares will be owned by a potentially massive number of the general public.
After the IPO, this company's shares are listed on a stock exchange (more on this later), and the price of these shares fluctuates according to trading volumes and other factors.
Different Types of Stocks
Before investing in stocks, it's crucial to understand that there are two different types of stocks traded: common stocks and preferred stocks. One type might suit your financial objectives better than the other, so it's important to understand the differences between the two.
The main difference between the two is voting rights. Common shares usually carry voting rights, enabling the owner to have a say in board meetings, elections, and other corporate meetings.
Preferred shares, on the other hand, typically don't have voting rights, but they have priority over common shares to receive dividends (hence the name "preferred.")
In the event of a liquidation, preferred shareholders are also prioritized to receive assets over common shareholders.
From an investment point of view, shareholders owning common stocks have a higher return potential than those with preferred stocks. However, common shareholders also face an increased risk of losing their money when the business has gone awry (i.e., in the event of bankruptcy).
Classification of common stocks
Some companies further divide their common stocks into different classes. This is mainly done to further differentiate shareholders' voting rights and dividend privileges across the different classes.
For example, a company may adopt the dual-class structure for its common stocks, dividing the stocks into class A and class B. The class A stocks can be designated two votes per share, while the class B stocks have one vote per share.
If necessary, the company can adopt multiple-class share structures, for example, with classes A, B, C, and D.
Classification of common stocks provides companies with better control over their strategic direction, agility, and ability to innovate.
Why Invest in Stocks?
Stock shares remain a popular investment instrument due to the fact that, at the moment, they have a relatively high ROI that exceeds most other prominent instruments such as real estate and bonds.
This is because, other than the standard price appreciation that you would get on other asset classes (i.e., real estate), stocks offer another way to achieve ROI in the form of dividends.
Dividends are payments made by the company to its shareholders (or stockholders.) Dividend payments typically represent a portion of the company's current year's net earnings. In some cases, companies may also pay special dividends to shareholders, for example, from asset sales.
In cases of whale investors with significant ownership stakes, they may also look at the voting rights provided by stock ownerships as a potential way to achieve ROI. However, this is rarely a focal point for most investors with relatively uninfluential ownership stakes.
In an ideal stock investing scenario, the investor would profit from both high dividend yield and high price appreciation. Yet, in practice, not all stocks pay dividends every year, and there are always cases when the stock decreases in price rather than increases.
This is why maintaining a diversified portfolio is important in stock investing. Smart investors should invest in a variety of companies in different industries, sectors, and geographic locations.
How Does a Stock Exchange Work?
A stock exchange is, simply put, a secure and legal place where stock trading is done in a systematic and organized way. A stock exchange is technically a type of secondary market where investors and traders can buy and sell stock shares they already own.
How to Make Money from Stock Investing
Now that we've understood how stock ownership and the stock exchange work, we can see that there is more than one way we can profit from stock investing.
Yet, despite all the different stock investing methods available, we can generally differentiate them into just three basic methodologies. You can either stick with a single method or use all three in your stock investment strategy, and they are:
- Selling at a profit: the classic stock investing strategy is based on price appreciation, and the goal is to buy stock shares when they are undervalued and then sell them when the price has gone up (the classic buy low, sell high).
- Collecting dividends: as we've discussed above, companies may pay cash dividends to their shareholders, and collecting dividends can be an effective way to make money from stock investing. Dividend payments are typically issued quarterly.
- Short selling: short selling is typically achieved by borrowing stock shares from a stockbroker (or other lenders), selling them on the stock market, and then buying the same stock later when the price has dropped. Essentially, in short-selling, we are betting that the stock will decrease in value, the opposite of the buy low, sell high strategy.
With only these three methodologies, theoretically, there are always ways to make a profit from a specific stock share, whether it's currently trending up or down in value. However, knowing which approach you should take at any given moment can be very difficult in practice.
Primary vs. Secondary markets
When a company issues stock shares for the first time on an IPO and sells these shares directly to investors, this specific transaction occurs on the primary market.
A key distinction of the primary market is that 100% of proceeds from the sale of stock shares go to the company that issued the stock shares, only accounting for the bank's processing fees.
If any of the investors who purchased the stock during the IPO later decide to sell their stock shares, then they must do so on a secondary market, including a stock exchange.
Any transactions on the secondary market happen between investors or traders, and typically the company that issued the stock isn't directly involved. The proceeds of each sale would go to the selling investor, not to the company that issued the stock or the underwriting bank.
Another key difference to consider is that the stock's initial market price on the primary market can be set beforehand, while prices in the secondary market (i.e., stock exchanges) would fluctuate depending on supply and demand forces.
Fluctuation of Stock Prices
Prices of stock shares traded in the stock exchange (secondary markets) would fluctuate, determined by the basic forces of supply and demand. This price volatility is one of the factors driving the popularity of stock shares as an investment instrument, inviting a lot of traders to speculate on stock investing.
When the demand for a stock dwindles, for example, or when the company fails to pay dividends, its price goes down. On the other hand, if the majority of traders and investors believe that the company is doing well and is rushing to buy the stock, then the stock's price will rise.
For every stock transaction, there must be at least one buyer and one seller (in such cases, the price will stay stagnant.) If there are more sellers of the stock than the buyers, the price will go down and vice versa; if there are more buyers than there are sellers, the price will trend up.
How Share Prices Are Set
Although the stock shares' price on the stock market is driven by the supply and demand principle, in practice, the price is set through an auction process, in which buyers and sellers of the stock shares offer to buy or sell while placing bids on the stock exchange.
A bid refers to the price at which an investor or trader is willing to buy, while an ask (or an offer) is the price at which a seller wishes to sell the stock.
On the stock exchange, a trade is made when the bid and ask amounts coincide.
In this process, obviously, there will be times when the bid and ask don't coincide, creating a condition we call bid-ask spread (or bid-offer spread).
The bid-ask spread represents the difference between the highest bid price of a stock and its lowest offer price.
Since a trade transaction would only occur when either the seller takes the bid price (lowering its offer) or when a buyer accepts the ask/offer price, naturally, the price would fluctuate.
When the number of sellers outnumbers buyers (and so they can't sell their stocks), some sellers may be tempted to accept the lower offers for the stock, and buyers will also lower their bids to force the price down.
On the other hand, when buyers outnumber sellers, the stock shares would become scarcer, and buyers may be willing to raise their prices to acquire the stock faster. In such situations, however, sellers would typically also raise their offers, further increasing the price.
Stock Investing Best Practices
1. Know your risk profile and financial objective
- Risk tolerance: refers to how much money you are willing to risk in stock investing. The higher the risk tolerance, theoretically, the higher the potential profitability.
- Time horizon: how long are you willing to wait for the stock investment to generate profit (or not).
Assess your risk tolerance and time horizon, then identify your investment goals. What do you want to accomplish financially at the moment? How can stock investment help you in achieving these goals?
Understanding your financial goals and your risk profile can significantly help in choosing the right stocks to invest in and in identifying the right investment strategy for you.
2. Stay invested in the long term
The stock market's average ROI is 10% annually, not accounting for inflation. This is a higher average than bonds, real estate, and other major investment instruments.
However, the stock performance will vary day by day, and the volatility will be higher the shorter your time horizon is.
The recommended practice is to invest for the long term rather than the short term, with a diversified stock portfolio, which can potentially net you an average of between 6% of 7% annual increase after accounting for inflation.
3. Maintain a diversified portfolio
Investing in any stock, even the best one, always carries risk and volatility. A stock you've invested in may do well this year only to perform badly the next, and vice versa; some might do very badly this year only to increase 500% the next.
Therefore it's important to keep a diversified portfolio of different companies in a wide variety of industries, sectors, and geographical regions. Mix some high-risk, high-reward stocks with conservative ones.
Having a diversified portfolio may mean a lower potential return, but you'll also be able to minimize your long-term risks.
4. Invest regularly
Not only should you stay invested for a longer time frame, but you should continue to contribute to your investment regularly to maximize compound interest gain.
Fortunately, there are now many investment apps and platforms that can help investors in scheduling their regular contributions. You can, for example, automate the account to take a specific amount each week or each month.
5. Start early
The best time to invest in stocks was 20 years ago, and the best possible time you still have access to is right now.
The earlier you start investing, the more you can maximize the compounding return of the stock investment and the more opportunities you'll have to buy the stock at a lower cost in the long term.
Start as early as possible and continue to grow your investment with regular contributions.
Wrapping Up
Stocks should be a staple in every investment portfolio with their potentially high return that outperforms other major asset classes like real estate.
However, although stocks have a history of high potential ROI, they can expose their investors to a lot of short-term risks. Therefore stocks should be considered as long-term investments rather than short-term speculations, and it's recommended to keep a diversified stock portfolio across different industries and sectors.
Nowadays, maintaining a diversified stock portfolio is not only easier but much more affordable, thanks to a wide variety of ETFs (Exchange Traded Fund) and low-cost index funds.
