Here starts a new part of our 100 steps to financial independence, with this being the first step in a mini-series on investing.
If you are serious about money, it is worth understanding more about the stock market and at least get a basic idea of what it is and how it works, before you decide for yourself whether investing will be something you would like to start doing. Investing is often a long-term decision and depending on the risks you are willing to take, you might or might not feel that investing is the right thing to do for you.
Let’s start with one of the key components of the stock market: shares (also known as stocks) and find out what they are, why they exist and how they make or lose us money.
What is a share
A share is basically a very small part of a company. If you have a share, it means you own a part of that very business and the more shares you have, the bigger the part you own of that company.
Why do shares exist
So why would business sell a part of their company to people like you and me who might know nothing about the enterprise or its industry? They do so because when they sell shares, they are raising money for the company. Sell a share for $50, that’s $50 dollars in the pocket for every share sold. Do this 20,000 times and the company has the $1 million that they wanted to raise, maybe in order to reinvest, start up a new department or launch a new product.
Why not just borrow money from the bank then instead of selling small parts of the company? The biggest advantage this has for a business is that they never need to repay the money they raised, the $1 million they collected is theirs, whereas if they had borrowed it from the bank, they would have had to pay it back to the bank over the next few years and with interest on top.
What do shares give
Now what is in it for you? Why would you voluntarily give money to a company when they sell shares, knowing you’ll not get that money back or in the case of buying them from somebody else who is selling them, why would you want to own a part of a company you know nothing about in the first place. There are generally three advantages of owning shares.
- Voting right – firstly, and probably least interesting for the ordinary person, owning a part of a company gives you the right to vote at the annual meeting and sometimes at extraordinary meetings. This is a right but not an obligation, and not surprisingly the majority of shareholders don’t attend.
- Dividend payments – secondly, the majority of companies pay out dividends on a yearly, bi-yearly or quarterly basis. Dividends are a part of the net profits that is shared amongst the share holders after the company has used some of the gross profits to pay off debts and make new investments. The more shares you have, the bigger the dividend payment you’ll receive. Not all companies pay out divident, and for the ones that do, the amount depends on the profit made minus any necessary loan repayments and investments, so these divident payments can vary substantially from one year to the next and when there are no net profits, there most likely won’t be any divident payments.
- Capital gains – thirdly, the price of shares fluctuates over time, this is the core essence of the stock market. Say you buy a share in a company today for $50, that share in year’s time might be worth as much as $100 or more if the entreprise does very well and when a lot of investors want to buy their shares, driving the price of the shares up. The opposite could also be the case if the company reports a lot of losses, internal strife, an incompetent CEO and / or during a recession, so it could also be that after a year the share you own might be worth nothing more than $15. Once a company has sold their shares the prices these stocks are traded for are determined not by the company but by the market, i.e. what people are willing to pay for these stocks. When people buy stocks they are expecting / hoping that the prices of those shares will go up in the future so they can sell the share at a profit. But if the opposite happens and sell when the prices are below the price they originally purchased the shares at, they unfortunately won’t experience any capital gains, but capital losses.
As you can see, buying shares can be a very lucrative investment but investing is not without risk. There are many reasons why share prices can go up and down and they are not only affected by the company’s performance, profits and the expectations for the future, but also by global economics. Indeed a political event anywhere in the world can have massive effects on stocks all around the world.
Step 47 – Understanding stocks – in detail:
With that very quick introduction to the core basics of stocks, let’s proceed to our action plan for this step. There will be several more steps on investing, so we’re going to keep it simple for now:
- Have a look at some of the financial news and in particular on the stock market. Don’t worry about all the details, but look for some articles on stock prices and how they go up and down.
- The market is extremely volatile, find some articles on how various events in the past year have affected the prices globally positively or negatively.
- Look at some of the prices of shares of some big companies and see how they fluctuate over time. Just type in prices shares + the company in your search engine and you’ll get a nice little graph with the evolution of the prices over time. Again don’t worry about the actual numbers and prices, just to get an idea of how the prices fluctuate.
That’s all for now. The financial market is indeed complex, so we’ll try to get to grips with it one step at the time. For now start familiarizing yourself a little with stocks, prices and ups and downs in the market.
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.