Stocks are one of the most popular and best-performing asset classes in the world. Yet, very little is taught at schools and universities about this incredible asset class. In fact, unless you work in banking, studied finance or did an MBA, you will not know much about the stock market. As always, we are here to teach you everything you need to know about stocks. Everything from the terminology to the risks involved and more. So without further ado, let’s make a start.
What Is a Stock?
Let’s begin with defining what a stock is. Stocks represent fractional ownership of a business , which is why they are also called shares. Businesses that are publicly traded on the stock market are easily accessible to investors. Stocks in these companies are referred to as public equity. Investors can also invest in companies that are not publicly traded on the stock market, in which case they invest in private equity. For the purposes of this article, we will be focusing on stocks of publicly traded companies.
Owning stocks or shares in a business gives you a few rights. Depending on the type of stock that you own, you should be able to vote on some company governance matters, such as electing directors or auditors. You might also receive dividends, which are essentially your share from the company’s profits. However, The board of directors of the company may not choose to pay out dividends to the investors.
Types of Stocks
Beyond the categorisation of public and private equity, there are a couple of different types of stocks. Common stocks and preferred stocks. Investors can buy and trade both stock types, but they have some key differences. Common stock represents shares in the business with no preferential treatment. This means that when the company goes into liquidation, common stockholders will be the last in line for payment. They will be lucky to receive anything at all. This is important to know about equity, unlike creditors, equity investors take on this additional risk in return for higher returns. If a company goes into liquidation, creditors get paid first in order of debt seniority, then equity investors. Bear in mind that that in cases of liquidation, there’s usually not enough money to pay the creditors to begin with.
Preferred stocks on the other hand have debt instrument like features. So they’re not pure equity or pure debt but a hybrid of both. Preferred stockholders have priority over common stockholders when it comes to dividend payments and liquidation scenarios. However, not all companies issue preferred stocks. The key takeaway here is that there is more than one type of stock. But common stocks are usually the default type of stocks issued by companies when they first go public.
What Going Public Means
But what does it really mean to go public? It simply means that the company have met all regulatory requirements to issue and sell shares to the public for the purposes of raising capital. There are many ways companies can do that, but knowing the ins and outs of this process is irrelevant. What is relevant is to understand that when a company first issues and sells shares to the public, this is the only time investors are actually giving money to the company in exchange for the shares. In almost all other scenarios, when you decide to buy a share in a business, you are buying it from another investor on the market. The money that you pay for the shares does not go to the company, it goes to the previous owner of the shares. The only other exception is when a company decides to issue more shares, which is not particularly a good thing for shareholders.
Why Stocks are So Popular?
Returns
As we mentioned previously, stocks and shares are amongst the most popular assets. In fact, almost all institutional investors have the majority of their portfolios in stocks. The reason behind that is the performance relative to other asset classes. Historical data shows that over long periods of time, stocks tend to outperform bonds, real estate, and commodities. We presented before the average annualised return for investing in the UK and US stock markets. These returns were between 8 and 10% per year over periods of 10 to 20 years.
Now there are exceptions to this trend, not every stock market has outperformed every real estate market in the past four decades. Investing in the Egyptian stock market instead of buying a property in London or Toronto in the 80s and 90s would be considered a terrible investment decision. This is why we need to make a distinction between comparing specific markets for an asset class and the average return of the asset class across all markets. That is why finance professionals and academics consider the average return of all stock markets when assessing the performance of stocks as an asset class. It is unfair to compare the worst-performing market for an asset class with the best-performing market for another.
Liquidity
Another reason why stocks are extremely popular is because of the liquid nature of the stock markets. Stocks are generally liquid, with the exception of some very small companies that trade on unregulated or loosely regulated markets (more on this soon, subscribe to our newsletter for post updates). Otherwise, liquidating assets in the stock market is much faster than liquidating property, for instance. However, liquidity is a double-edged sword because with liquidity comes volatility. Because of how easy it is to buy and sell stocks and shares on the open market, their prices can change significantly in a single day. Therefore, volatility can be defined as variations in the asset price relative to the average.
Dividends
Not all stocks pay out dividends. But the fact that many companies do pay out dividends renders stocks as yet another cash generating asset. Of course these cash flows are not necessarily as consistent as coupon payments for bonds or rental income from real estate. But they can be higher.
What About The Risks?
Of course, there are risks associated with investing in stocks, and it is key to understand these risks in order to manage them properly. For clarity and simplicity, we list the risks below:
- Total Loss: This is the risk of losing all your invested capital. It may happen if you invest all your money in a single company that goes bankrupt. In such case, the company is insolvent and the share price goes to zero.
- Volatility: This is the risk associated with the variability in stock returns. Everyone knows that stock prices move around a lot. This can definitely be a risk for money required in the short term
- Inflation: People tend to forget that inflation is probably the biggest risk to their wealth. In the long term, inflation is guaranteed to erode the value of your cash so getting inflation-beating returns is a must.
Each of these risks can be mitigated, if not eliminated, by understanding the following concepts:
Diversification
Diversification eliminates the risk of total loss and is self-explanatory, but how much diversification is enough? This is much debated but the consensus is this: you cannot lose by owning the market. This means owning a slice of each company in the stock market. This is cheaply and effectively achieved using funds. More on funds below.
Time Horizon
Understanding the importance of time horizon on stock market returns is paramount. Investing a sum that you will need in the short term is unwise. To manage the volatility of the market, the investment time horizon needs to be no shorter than 5 years, ideally 10 years or more.
Discipline
Discipline in investing is a critical success factor. You need to be consistent and you need to tune-out your emotions. It is difficult to watch your money free-fall in real-time during market crashes. But I assure you, selling during these times is the worst thing you can do. In the words of the great Warren Buffet, be greedy when others are fearful and fearful when others are greedy.
How Do I Get Started?
To get started you need an account with a broker. Brokers are market makers, they are critical to the market as they connect buyers and sellers. They also provide liquidity at times, by buying or selling the stocks themselves. Brokers charge different fees, which you need to be aware of. In fact, we will cover everything you need to know about brokers in a separate article. Make sure you subscribe to our newsletter below to get updates on the latest articles.
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In Conclusion
We covered stocks and answered the ‘what is a stock’ question. They are an established asset class with a track record of high returns over the long term. We also covered the key risks and how to mitigate them. Of course, we only scratched the surface of this exciting asset class, so there will be more on the topic in the future.
