Understanding Stocks & Shares

What are stocks & shares?

Well first, you are probably wondering what the difference between a stock and a share is as you have probably heard it being used interchangeably. In short, they are actually the same thing but the way the terms are used differs. You tend to ‘buy shares’ and ‘own stock’. But what does this even mean? When you buy shares in a company, you are purchasing legal ownership in that business. You may often hear it referred to as owning equity in a company. In fact, Equity is the main term given to the asset class. When companies want to raise money, they tend to use two strategies, they can borrow money (Bonds), or they can offer up a piece of their company in exchange for some funding. Ever seen dragons den? Well it is a bit like that, but rather than pitching to a group of very rich individuals, with the stock market the company has access to everyone and anyone who wants to invest and can afford to; including retail investors (you and I) as well as institutional companies such as large insurance companies and pension funds. But before companies can have this access, they have to go through a process called IPO (initial public offering).

There are mainly two types of stocks, one is called common stock (in the UK we tend to call it Ordinary shares) and the other is preferred stock (preference shares). For the purpose of this article, we are focusing on common stock also known as Ordinary shares and is the one most people speak off when they mention investments in stocks & shares.

How do people make money in the stock market?

There are namely two main ways to make money in any investment. You either receive an income or gain some capital appreciation. When you buy stocks in a company, you pay the current stock price. That stock price can increase as well as decrease over time; this is the capital appreciation element and you only make money in this way when you sell the stock for the higher price. If you sit on it, you have a 'winning position' but the profits have not yet been made a reality, in other words they have not been “realized”. Some stocks, especially those that are mature and large enough also pay dividends. This is a way for the company to reward their shareholders by distributing some of its profits to the shareholder, usually in the form of cash and sometimes as extra shares in the company. For this reason, it is important to decide your objective before buying a stock.

Are you investing in a stock for its capital appreciation, for its income generation or a combination of both? This is where you decide whether you are a value investor, growth investor or income investor. Value investors are more concerned with capital appreciation, income investors more interested in a and reliable dividend yield where as growth investors want a bit of both but rather than a high dividend yield, they want dividend growth.

What is a Stock Index?

An index is a collective of various different stocks, classified by some sort of similarity. By similarity, what I mean is that it can be classified by things such as industry, sector, region and a combination of others too. For example, the FTSE 100 is an index comprising of the largest 100 stocks (companies) in the UK that trades on an exchange. You may have heard of the S&P 500, which are the largest 500 stocks in the US. Others include Dow jones, China’s Hang Seng, Germany’s DAX, French CAC and many more. You can even have a world index. You can have industry specific ones too, for example an Energy index, Real estate index, and many more. A way to invest in and a whole load of stocks by making one investment is to buy an Index fund, ETF or mutual fund. This gives you what we call instant diversification, to some extent anyway.

What causes a stock price to change?

There are many different reasons why a stock’s price may go up or down but ultimately it comes down to demand and supply, in other words, it is market forces that determine stock prices. Remember that a stock’s price does not necessarily always represent a true reflection of a companies profitability or current state. The stock market is quite similar to an auction, so prices tend to represents what people are willing to pay for ownership in the various companies. Therefore, when there are more buyers than sellers of a stock, then the stock’s price will go up and vice versa when there are more sellers than buyers then a stock’s price will go down. For this reason, what you really want to know is what causes there to be more buyers than the sellers of a stock.

Well firstly there are stuff that will affect stocks price that are relative to just that company alone, and then there are other stuff that will affect various companies as a whole, as a sector or as a region. For technicalities, these are where we talk about things such as idiosyncratic risk vs market risk and Beta vs Alpha. For the purpose of this post, we will not go into detail about these.

Generally speaking in reality it’s about what investors think of the company and their sentiment towards it that they express through demand and supply for the particular company to determine its worth. Some of the most important facts that tends to affect a stock’s price is its earnings and profits. Public companies are required to report their earnings quarterly, i.e. 4 times a year. On this day, you will see and hear that stocks have swung. Earning projection takes place here too. If a company earns better than expected then the stocks price shoots up, and if it does worse it drops down. In addition if companies issue things like 'profit warnings', you can see stock prices shoot down. The main reason behind this is because analysts base their future value of a company of their earnings projection.

How do I buy Stocks?

First and foremost you need to really consider what type of investor you want to be by considering you overall objective, time horizon (e.g. 3 years, 5 years, 10 years, 20+ years) ability with willingness to take risk (e.g. low risk, balanced, high) understanding that the higher the risk the higher the potential reward. Decide on how much involvement you want in investing in stock picking, do you want to be passive or active. Finally consider the type of account to open (e.g. Stocks & shares ISA, SIPP) and what broker or investment platform you want to choose and buy. If you want to actively invest in individual stocks, you also want to decide whether you are a value, growth or income investor or a combination. Do your research, due diligence and once you are ready, invest a lump sum and/or monthly deposits and watch your investments do its thing.

Golden Nugget:

The stock market is an amazing place to build, grow and maintain wealth. If you want to gain the most from the stock market, invest wisely, educate yourself and make sure you have the right temperament if you decide to go for individual stocks.