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If you’re looking to spend some time assessing your overall long-term financial plan, then it is imperative that you have a firm grasp of what stocks are and how they work. This will enable you to incorporate a much broader portfolio of investments, subsequently diversifying risk levels.
While the stock market will always go through ups and downs, historically, those holding onto their investments long-term have typically been rewarded.
For example, the S&P 500 – a stock market index that contains 500 of the largest US companies, has averaged annual returns of 10% since it was launched in 1926. As such, and albeit somewhat of an extreme example, a $1,000 investment in the US stock markets back in 1926 would now be worth surplus of $7 million.
So what exactly is a stock? Well, you’ve certainly come to the right place, as I’m going to explain everything you need to know.
This will include an explanation of what stocks are and how they work, some of the reasons why you might decide to buy stocks, what risks need to be considered, and finally, how you can go-about adding stocks to your overall financial plan.
Let’s get started by exploring what a stock is:
What is a Stock?
When companies begin to grow in size, they often decide that they want to be publically listed on a stock market. In doing so, they raise money from investors, who in return, receive equity in the company that is proportionate to their investment.
For example, let’s say that a company initially raises $500 million in its respective fundraising campaign (known as an ‘Initial Public Offering’ or IPO). If an investor purchased $5 million worth of stock in the company, then they would effectively own 1% in equity.
As the stocks that you now hold are traded on a public market like the New York Stock Exchange (NYSE) or NASDAQ, the value of them will rise and fall depending on market forces. During standard trading hours, this gives you the option of selling the stocks at any given time.
By holding stocks in a publicly-traded company, this also gives you a number of other perks. For example, if the company in question decides to distribute some of its profits to stockholders in the form of dividends, you stand the chance of earning passive income.
Moreover, some stock arrangements give you voting rights, although this will sometimes depend on the size of your holding.
Ultimately, by holding a stock, this means that you have legal ownership in a publicly listed company, proportionate to the amount that you invested.
You might sometimes hear ‘stocks’ being described as ‘shares’, or even ‘stocks and shares’. These terms and used interchangeably in the markets, and essentially refer to the same thing.
The key difference is that ‘stocks’ refer to an overall investment in a particular company, while ‘shares’ refer to the specific fractional ownership of each investment.
It’s probably wise for me to give you a quick example so that you fully grasp the difference between stocks and shares.
Let’s say that Company ABC offers $10 million worth of stock, at a value of $100 per share. This would mean that in total, the company has 100,000 individual ‘shares’ outstanding.
If the price of the shares increased to $110 in the markets, there would still be 100,000 individual shares outstanding, albeit at a different price to what they were originally worth.
The key point here is that shares effectively refer to the specific fractional distribution of company stock.
So, if you invested $1,000 in the above company, you could equally say that you have $1,000 worth of ‘stock’, or $1,000 worth of ‘shares’. Alternatively, you could also say that you held 10 shares in the company, albeit, this would still be worth $1,000 ($100 per share x 10 shares)!
Different Types of Stocks
It is also important for you to understand that there are two different types of stocks that you can own – common and preferred.
As the name suggests, common stock is the most common type held by everyday investors like you and me. Essentially, common stocks represent ownership into the company in question, and as such, gives you a right to receive a proportion of the profits in the form of dividends (don’t forget, not all companies pay dividends).
Moreover, you also get voting rights, which amounts to one vote for each share held. The biggest drawback to common stocks is with respect to bankruptcies. If the company runs into financial difficulties, you would not receive any money back until creditors, bondholders and then preferred stockholders were paid.
This could leave you with nothing, or a significantly small percentage of what your common stocks were worth.
Preferred stocks are somewhat different from common stocks. First and foremost, those holding preferred stocks have no voting rights. On the other hand, preferred stocks are attributable to a fixed dividend payment for an indefinite period of time.
Preferred stockholders get priority over common stockholders in the event of financial liquidation, although they still sit behind creditors.
Ultimately, if you are an everyday investor, then it is all-but-certain that you will hold common stocks, as preferred stocks are typically held by institutional investors.
Why Buy Stocks?
So now that you have a firm understanding of what stocks and shares are, as well as the two different types of stocks issued by companies, I am now going to explain some of the main reasons why you should consider making a long-term investment.
You might remember how I mentioned earlier that the S&P 500 has made average annual returns of 10% since it was launched in 1926. The reason that the value of the top 500 US stocks has continued to rise is that this falls in-line with the performance of the companies themselves.
Companies are in business to make money, and when they do, the value of their underlying stocks should in theory rise. When stock prices do rise, your overall investment will also increase.
For example, if you bought stocks at a share price of $100, and in 5 years time the same stocks were worth $150 per share, this would mean that your original investment would have increased by 50%.
On top of this, you would also stand the chance of making additional profits via company dividends. Not all companies issue dividends, however, when they do, this usually sits within the 3%-5% range.
As stocks are traded by investors of all sizes, you always have the option of selling them on the open marketplace. This gives you full control of your money, insofar that you can enter or exit the market at any given time (during market hours).
One of the overarching benefits of investing in stocks is that you can earn substantially more than you would by letting it sit in your bank account. With interest rates at all-time lows, stocks allow you to grow your money much faster. Stocks also allow you to beat the rate of inflation, subsequently protecting your wealth over time.
However, it is important to note that there is never any guarantee that you will make money in the stock markets. I’ll discuss the risks of owning stocks in the next section.
Risk of Owning
While the likes of Amazon, Apple, and Microsft (to name a few) are all huge success stories, others aren’t. For example, the likes of Blockbusters, Lehman Brothers, Pets.com, Geocities, and Enron are no longer here to tell their story. Had you invested in any of the above companies, you would have likely lost your entire investment.
The best-case scenario might have seen you sell your shares in the final days of the company’s respective downfall, albeit, for a fraction of what you originally invested.
In other cases, while the company in question might not have gone through bankruptcy, share prices might never get anywhere close to previous highs. One only needs to look at the likes of Kodak and Western Union to see that the risks of the stock markets are ever-present.
The key point here is that your investment is only as good as the company you own the stock in. If the company is poorly managed or operates in a declining industry, then this will be reflected in the value of your stocks.
On top of the risks of a falling share price, you also need to make some considerations regarding dilution. In a nutshell, if a company needs to raise more money, and it decides to do so via the issuance of new shares, then the value of the shares you hold will be diluted. This is because the company will need to share its profits across more shareholders.
How to Reduce the Risks of Owning Them
In order to counter the risks I outlined in the above section, there are a number of things that you can do. The most important thing is to ensure that you diversify as much as possible. This means that you should consider owning stocks in a number of different companies, across a number of different industries.
This way, should a particular stock that you hold go down in value, or worse, go bankrupt, then the effects on your overall finances wouldn’t be anywhere as severe.
Once again, I need to point back to the S&P 500.
You see, as the S&P 500 contains 500 different companies, all of which operate in different sectors and industries, you are completely diversifying your risk. Sure, some companies within the S&P 500 might run into financial difficulties, but, the chances of them all going under are super unlikely.
Now, I should also mention that from time-to-time, the wider stock markets will go through something called a ‘bear market’. This means that the stock markets in their entity lose value over a specific period of time. This is usually in response to wider economic issues, such as a recession. However, and as history suggests, the stock markets have always recovered.
Nevertheless, when it comes to diversifying your risk, you don’t need to invest in the S&P 500 or other stock market indices like the Dow Jones or FTSE 100. On the contrary, you can build your own portfolio of stocks, as long as you diversify into multiple companies across multiple sectors!
As a final tip, you can also reduce your risks by buying stocks on a regular basis. For example, by investing a bit of money at the end of each month, you can reduce the risks associated with timing the market incorrectly.
How Can I Buy Them?
So now that you have a good understanding of what stocks are, how they work, and the underlying risks, I am now going to explain how you can actually buy them.
Regardless of how much you intend on buying, you will need to use a stockbroker. The role of the stockbroker is to match buyers and sellers. So, when you choose a particular stock that you want to buy, the broker will buy them from a seller on your behalf in return for a small fee.
The good news for you is that there are now heaps of regulated online brokers that will allow you to do this at the click of a button. Once you open an account and deposit funds, you can choose which stocks you want to buy. When you decide that you want to sell them, you also do this via your online brokerage account.
While there are tonnes of brokers to choose from, we’ve listed my favourite two below to help you along the way.
The reason that we like eToro is that the platform is super easy to use, which makes it perfect if you’re a stock market newbie. The platform lists thousands of different stocks, across multiple different stock exchanges. This includes popular stock exchanges like the NYSE and NASDAQ, as well as smaller markets based in Spain, Sweden, and France.
It only takes 5 minutes to open an account, and you can verify your identity by uploading a copy of your government-issued ID. Deposits are free, and you get to choose from a full range of payment methods. This includes traditional debit/credit cards, e-wallets such as PayPal and Skrill, and a bank transfer.
In terms of fees, while eToro does not charge traditional commission fees, you do need to make considerations regarding the spread. This is the difference between the ‘bid’ price and the ‘ask’ price.
eToro holds a number of regulatory licenses too, issued by leading financial bodies such as the UK’s Financial Conduct Authority.
2. Ally Invest
Ally Invest is a super popular online broker based in the US. As the name suggests, the broker is backed by leading US financial institution Ally Bank. The platform operates in a highly stringent regulatory environment, and thus, is regulated by the Securities and Exchange Commission, and the Financial Industry Regulatory Authority.
One of the best plus-points to using Ally Invest to buy stocks is that the platform is really well-priced. In fact, it costs just $4.95 to buy and sell a stock via the platform, and you are not required to hold a minimum account balance to get this price.
Although Ally Invest offers a significant number of US companies to invest in, the platform doesn’t offer the same level of exposure to foreign markets like eToro does. Nevertheless, if you’re looking to primarily focus on the US stock markets, this shouldn’t be an issue.
Much like in the case of eToro, you will need to verify your identity before getting started, and you can deposit funds using a debit/credit card or bank account, although e-wallets are not yet supported.
If you’ve read my guide all of the way through, then we hope you’ve now got a firm grasp of what a stock is, the different types of stocks that you can own, the pros and cons of investing in stocks, and finally, how you can make your first ever investment.
The key takeaway is that on the one hand, owning stocks can make you significantly more money than you would earn by simply leaving it in a bank account. Traditionally speaking, the overall stock markets have performed incredibly well over the past century, which is why so many people invest in it.
However, you should also remember that returns are never guaranteed. While it is true that the cases of Enron, Lehman Brothers, and Blockbusters, these were rare and isolated outcomes, they still happened. As such, if you are going to invest in stocks, you should always make sure that you are fully diversified to reduce your risks of losing money.
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Founder of The Modest Wallet, Ricardo is an entrepreneur and investor who enjoys working out, spending time with his family and friends, travelling and creating great content. He’s passionate about helping others achieve their financial goals.