What is a stock and how can I make money investing in them?
Stocks are the money making machine for accessing the full power of compound interest and watching your nest egg grow. Living in America, we hear about the stock market a lot. But most people aren’t taught about it in school and don’t even know what a stock is. Basically a stock is a small percentage of ownership of a company you buy. This means that you are an owner of whatever company it is, and you get a say in how it’s run and what happens to the profits. It’s a really confusing concept so we are going to start with a little story.
Let's say Tim decides he wants to start a lemonade stand. He has saved up $50 and goes to the store to get lemons, ice, sugar, cups, and whatever else he needs. He sets up shop on his front lawn and is in business. Right now, Tim is the sole owner of the lemonade stand. He gets all the money made and he gets to make decisions about how the company is run. Lets say that business is good and Tim is consistently making money. He gets an idea that if he also sold cookies, he could make more money and make his business grow. He needs $100 to get the cookie selling business up and running and he used all of his money to get the original business started. He goes to his friends and explains that he has a great idea on how his business can make more money by selling cookies! And he tells his friends if they are able to lend him the money then they can become owners of the business. Sally, Jill, Jack, and Joe agree to give Tim $25 each. So Tim has put in $50, and his four friends have put in $25 each. Tim still owns the biggest portion of the lemonade stand, but his friends all own a part too. Now when Tim makes money he will share it with everyone and everyone will get a say in making decisions that impact the company.
This is what you are doing on a much larger scale when investing in stock. You are becoming an owner of a company. Unlike Tim's lemonade stand, there are millions of shares of businesses so owning a share only gives you a tiny percentage of the company.
You make money investing in the stock market in two major ways - if the company becomes more valuable and you then sell the stock, or if the company shares its excess profits with you (dividends). There is a lot to be said about investing in the stock market. There are individuals who will trade (buy/sell) stock daily trying to make profit as quickly as possible. Others will buy stocks and hold them for years betting on the long term value of the company, not just the next few hours. People have very strong opinions on how to invest and the best way to do it. I will write a lot more about this in the future but this is just an intro to stocks. I chose to invest long term in stocks meaning once I buy a stock I plan to hold it for a year, or ten, or the rest of my life. It’s the investing strategy my dad taught me, and is supported by my idol Warren Buffet. Buffet is famous for saying he doesn’t invest in anything unless he is comfortable owning it for at least 10 years.
It takes a lot of research to be knowledgeable about companies. There are long reports with big words and financial terms that most people struggle to understand. The great thing is that there is a way to invest in the stock market without having to know every detail of every company. There are two major vehicles of investing where you are able to invest in a large group of stocks instead of one individual company, mutual funds and exchange traded funds (EFT’s)
Mutual funds are pools of money from many different investors given to an financial professional to manage. The fund manager buys and sells stocks for you, and the fund tracks her progress. ETF’s are a very similar concept, except there is no one actively managing the fund. So instead of having someone buy and sell stocks, ETF’s are more passive and track various indexes. I don’t want to spend too much time on mutual funds verses ETF’s here, we will come back to this later. What I will say is that ETF’s generally offer significantly fewer fees, and better returns than mutual funds. I invest about 65% of my nest egg in stock ETF’s, and don't own any mutual funds.
Click Here to go back to Intro to Asset Allocation