Stocks: The Basics
Learning about investing is a lot like learning how to ride a bike. At first, it may look intimidating or complicated; dangers seem to be everywhere. That's why it's important to learn the basics. After a good amount of practice and learning, you can take the training wheels off and start riding. While riding, there will be good days and bad days, and, while learning to ride doesn’t guarantee you a spot in the Tour De France, it can get you where you need to be faster and more efficiently. Let’s start with the basics and look at one of the most common investments: stocks.
A stock represents partial ownership of a company. When you buy stock, you're buying a piece or share of a company. By owning a share (and being a shareholder) you own a small fraction of the company's assets and have a claim on its future earnings. There are two ways you can make money by investing in stock.
The first is through stock appreciation. If an investor bought the stock at 1 price and the price went up, the investor could make money by selling the stock to another investor at a higher price.
The second way is through a dividend. Dividends are periodic payments issued by some stocks. They’re a way for a company to give a portion of its earnings to shareholders.
Here’s how stocks work: suppose we have a company that makes bikes called Max’s Bike Shop. The owner, Max, knows that his bikes are very well built and wants to expand his company so that he can sell bikes around the world.
To do this, the company needs to raise money, or capital. There are a few ways the company could do this. Max could take out a loan, but that would mean taking on a significant amount of debt. Alternatively, Max could issue shares of stock. By issuing shares of stock, known as a company going public, Max can raise money without going into debt. Instead, Max will sell shares of ownership (stock) to investors (you) who have a claim on future earnings.
Let’s meet a typical investor: you. Normally, investors have a little extra cash that they are willing to put into the market in order to receive better returns than a savings account. However, stocks are “riskier” than savings accounts since stocks do not guarantee a fixed return each year. You understand these risks but realize that proper research can mitigate some of these risks. After analyzing Max’s Bike Shop, you come to the conclusion that it’s a promising company that’s likely to grow (more on fundamental analysis later). Because of your research, you believe that buying a share would be a good investment. Now, you have to actually pay for the share. So how much does a share cost?
Suppose Max wants to raise $1,000,000 and issues 1,000 shares of stock. Since each share represents a fraction of the company’s worth, we divide $1,000,000 by 1000 shares to give a price per share of $1,000. Therefore, each share would be initially valued at $1,000 at Max’s Initial Public Offering, or IPO. Now, you can buy a share of Max’s Bike Shop on the open market through an online broker at a price of $1,000 per share.
Now what happens to your investment? Well, it’s largely out of your control and in the hands of Max. If his company does well and profits increase, the value of the company is likely to go up. As a result, the stock price may increase as well. If this happens, you could now turn a profit on your investment by selling your share to another investor on the stock market. However, if Max makes some bad decisions for the company, the value of Max’s Bike Shop could go down along with the stock price (say to $500). If you decide to sell at this lower price, you would lose $500 a share and would take a loss on your initial investment.
Overall, the goal of basic investing is to buy low and sell high. We want to buy Max’s stock at the lowest possible price (perhaps in its IPO) and sell when we feel that it has reached a higher value that represents its growth. However, stocks do not always go up (shocker). Often they stay the same, shoot down, or recover all within a short period of time. Because of this, stocks are considered “riskier” investments than bonds or savings accounts. However, investors keep coming back to the stock market because, with this increased risk, comes greater returns and the opportunity to grow with the companies you invest in.
That’s it for this article. Be sure to review any vocabulary and check out the Discussion Topics for an application of the material.
Visual: How Stocks Work
Discussion Topics
value investing
brokerages
p/e ratios
short-selling
bonds
Sources:
*All rights of content are reserved to the TD Ameritrade Education Center*
“What is Stock?” Investopedia, investopedia.com/terms/s/stock.asp
https://www.investopedia.com/terms/s/stock.asp
*Disclosure: These articles are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility and we do not provide personalized investment advice. It is crucial that you conduct your own research. Please consult your financial or tax professional prior to making an investment.