Platforms like Robinhood have made individual stock trading wildly popular in the last couple of years. Yet I still find many people have questions about some of the basics. I also am consistently asked questions that demonstrate stocks or wildly misunderstood. With that in mind, let’s set the foundational understanding!
We begin all the way at the beginning with what a stock is and why it has any value. A share of stock, part of the “equities” asset class, represents ownership (or “equity”) in the company that issues said stock. If I go buy a share of Apple stock, I now own 1/13trilliionth (exaggeration… probably not even a real fraction?) of Apple. I own a spec of dust on a table somewhere in Cupertino. That share of stock represents my tangible equity in the company. If Apple invents new products, continues their sales growth trajectory, keeps their expenses low, etc their total market value will increase. Therefore my equity will increase. The same is true for the reverse if their market value decreases.
I also like to separate the market value of a stock from actual tangible dollars. People assume $x in a bank account is identical to $x in stock market value. It’s different though. If I have $100k in a bank account, It would be alarming for that $100k to go down in value. The bank is a fixed account, they are paying 0%, maybe 0.10% if it’s a savings account. It’s FDIC insured. I shouldn’t lose money in that account. A brokerage account holds cash as well, but we use that cash to purchase other assets, like stocks. If I purchase a share of stock, I now have tangible equity in a company represented by that stock. I no longer hold this value in dollar bills. We simply value it based on how many dollars investors are willing to pay for my asset. My stock is only worth what an investor is willing to pay me for it. Some days that value may increase, and other days it may decrease. No different than the value of a small business somebody owns or the value of the house they live in. Once we sell the stock, we have now traded that stock for tangible dollars again.
Next let’s talk about risk and reward. The amazing benefit of owning stock is the upside potential is unlimited! There’s no limit to what a company can be worth! Some stocks also pay dividends which are cash payments to shareholders and can create passive income or be reinvested and help increase and compound returns over time. I don’t know of a better long term wealth generator in human history than equities. For all these amazing benefits, stock has risk associated with it as well. The maximum potential for loss is 100%, because companies can and do fail altogether. If the company becomes worthless and goes away, the value of our stock does as well. For this reason, stocks, especially trading individual stocks, are deemed on the higher end of the risk spectrum.
Lastly, we will touch on reducing risk. When it comes to stocks, risk is always going to be present. There are some things we can do to reduce the amount of risk though. You’ve probably heard the term “diversification”. This boils down to buying more than one company’s stock. If I put all my money into one stock, the value of my investment is highly subject to that single company’s performance. If I buy the stock of 25 companies, I’ve now reduced some risk that all 25 will simultaneously have a negative impact on my investment value. We can also take this to a new level by investing in Exchange Traded Funds (ETFs) or Mutual Funds where we are buying into a pool of stocks. Now we can scale up to where we can invest in hundreds or thousands of companies in a manageable way. There are also other factors we can diversify such as the sectors a company operates in, the geographic location they operate in, the sizes of the companies, etc.
Hopefully this article helped bring clarity to what a stock actually is. Now I’d love to hear from YOU! Were there things in this article that gave you an “ah ha” moment? Are you already investing in stocks and see them differently now? If you want to talk more, you can find our contact info or set a meeting directly on our calendar here: https://ifcins.com/contact-us/