One common misperception among newer investors is that stocks are simply pieces of paper to be bought, sold, and traded. This is just not the case.
Let’s start with the basics of what a share of stock is and why companies issue them out. A stock is simply partial ownership of a company. And a company issues stock to raise money.
Here’s a typical scenario: A business is started by a person or small group of people who use their money to start and grow the business. At this point, the business or company is considered private and each of the person(s) who started the business are all part owners of the business. Over a couple of years the business has become successful and has become a decent sized company. Now the owners want to raise money for expansion, future product development, buying out a competitor, or whatever else to hopefully continue grow the business. One of the ways a company can raise money is by “going public” and selling shares of company ownership to the investing public. This is how stocks are created. A share of stock is partial ownership of a company.
Essentially when you buy a stock, you become a business owner. Now as a part owner, you will typically share in some of the profits the company makes. The specific ways investors share in these profits can vary from company to company. There are typically just two ways a stockholder will benefit from buying and holding a stock. The first is dividends. A dividend is typically a cash payment to all shareholders from a portion of the company’s earnings. The second way you can make money with stocks is with the value of the stock increasing. If the price of the stock goes up above the price you bought it for, then you can sell it for a profit and make some money.
Although, the price of a stock is practically impossible to predict and changes every day. Over the long term, the price of a stock rises and falls according to the success of the business. The better the business does, the more valuable it will be, driving the price of the stock up. But there are a lot of factors that can impact stock price that don’t always make a lot of sense.
Stock prices are usually driven by investor speculation rather than the actual current grow and profits of the company. For example, if a company releases an earnings statement showing they are growing fast and making record profits, it would seem logical to think that this would make the price of the stock go up. But that is not always the case. If several stock market financial analysts are expecting high growth and earnings numbers and the numbers the company reports don’t meet the analysts’ expectations, then the stock price can and very likely will go down….even when the company is doing great and making records profits! This has happened with many companies, even Apple. Or just the opposite could be true. There are companies that are new and not yet making a profit and some even have millions of dollars in debt. And yet the stock price of these companies can continue to go up because of how great and successful investors think the company will be in the future. Tesla is a good example of this.
Why You Need to Know This
Stocks are but one of many possible ways to invest your hard-earned money. If you own a stock when dividends are issued (usually every three months) or sell the stock at a higher price it is basically free money. You didn’t have to put any effort in other than maybe some initial research on what stock you wanted to buy. So why choose stocks instead of other options, such as bonds, rare coins, or antique sports cars? Quite simply, the reason that many investors put their money in stocks is that they provide among the highest potential returns. And over the long term, no other type of investment tends to perform better.
On the downside, stocks tend to be one of the most volatile investments. After purchasing share(s) of stock, the value goes up and down on a daily basis and even throughout the day. Profits are not guaranteed and predicting returns is difficult. Because of this volatility, if a company is doing poorly the value of its stock can always drop and even go all the way down to zero leaving you with absolutely nothing.
The bottom line is you should be investing if you want to have any real chance at meeting your long term financial goals. To help show you the power of investing in stocks check out the chart below comparing stocks to other investing options.
As you can see on the chart not investing at all and just holding cash will actually give you less spending power due to inflation. While investing will have it ups and downs from day to day and even year to year, clearly investing in stocks can deliver great returns over the long term.
Do you have any stocks that have performed well? Or that you have lost a ton of money on? How do you choose what stocks to invest in?