#003 | Stocks Demystified
An essential breakdown for new investors
Hey friends,
In my last newsletter, we discussed the importance of budgeting and allocating a portion of your income toward investments.
Investing is arguably the most important skill needed to achieve financial freedom, yet many people don’t invest at all.
Many people feel overwhelmed or intimidated by the complexity of financial markets, so they never start. Others have tried investing in the past, but they experienced losses and are afraid to try again.
But don’t worry; winning in the investing game can be easy. There are just a few rules you need to live by.
Rule number one in my book? Only make investments that you understand.
To that point, today’s article will break down everything you need to know about common stocks, which are one of the most accessible investment choices available to the general public.
By the end of this post, you will have an understanding of:
What stocks are
Why they are inherently valuable
The difference between a stock’s price and its value
The potential risks of owning stocks
Stocks represent ownership stakes in businesses
A share of a company’s stock is a certificate representing a fractional piece of ownership in a business.
Shares of stock used to be represented by physical pieces of paper. Nowadays, these certificates are digitally maintained by the company you invest with.
Let’s assume that a new company was created, and the founders split its ownership into 100 shares of common stock. If you owned 10 of the 100 shares, you would own 10% of the company and be entitled to 10% of its profits and assets.
Owning a company doesn’t mean you need to work at it though. Business owners can hire employees and managers to run their businesses.
This makes common stocks one of the best vehicles for cultivating passive income.
“When you buy a stock, you become an owner of the company. Its managers, all the way up to the CEO, work for you. Its board of directors must answer to you. Its cash belongs to you. Its businesses are your property”
- Jason Zweig, The Intelligent Investor
The stock market is where millions of shares change hands daily
Shares of companies are either privately owned or publicly traded, which means they are available for purchase by the general population.
If a market is where buyers and sellers exchange goods and services, then the stock market is simply where buyers and sellers exchange shares of publicly traded companies.
The stock market functions like a giant auction house, where the prices of stocks are determined by supply and demand. Buyers make bids and sellers make asks on stock prices. When a buyer and seller agree on a price, a trade executes and the shares are transferred from seller to buyer.
Stocks compensate you through price appreciation and dividend income
When a company generates profits, its owners can do two things:
Reinvest cash back into the business, or
Distribute the cash to shareholders
Their decision influences how your stocks compensate you.
Reinvested profits can lead to price appreciation
When companies reinvest profits back into the business, they hope to generate larger profits down the road.
As a company’s profitability grows, it is expected to become more valuable and favorable to investors. This translates to higher demand for a company’s stock, which will cause its price to rise.
One of the benefits of stocks is that they have an unlimited return potential, meaning there is no limit on how high a stock’s price can go.
When you sell stocks at a higher price than you paid for them, this is called capital appreciation.
The tradeoff to selling stocks is you own a smaller percentage of the company than you did before. As a result, you now participate less in a company’s unlimited upside potential.
Stocks can provide an additional income source
A dividend payment occurs when a company distributes profits back to its shareholders.
This allows you to earn a return on your investment without selling your shares.
It is like the company saying “thank you” for owning their stock, and they give you a paycheck.
The tradeoff is that companies paying dividends will have less cash to invest back into the business. As a result, it is expected that their stock price will grow at a slower rate than companies that reinvest profits.
The most important concept in stocks - price does not equal value
Stock prices can significantly deviate from what a company is actually worth.
A stock’s price is simply an objective measure of what the last person paid for a share.
Estimating a price worth paying for a company’s shares is determined by your valuation. You may have heard this fancy word on Shark Tank before, but it’s the process of identifying a company’s subjective worth.
Bubbles form when stock prices become completely detached from any realistic sense of value.
It’s easy to understand why bubbles happen - stock prices are driven by an auction system. That auction is filled with humans. When it comes to money, we have a strong tendency to make irrational and emotionally charged decisions.
Once the price of a stock gets to a level that is no longer sustainable… *pop*.
It will quickly collapse, causing stockholders to experience significant losses. In extreme cases, years’ worth of gains can be totally wiped out.
“Price is what you pay, value is what you get”
- Warren Buffett
Can you explain NFTs to your Grandma?
If you can’t articulate why an investment is inherently valuable, don’t buy it.
Can you explain your investment thesis to your friends? To your parents? To your grandparents?
If you own stocks that pay dividends, it is easy to understand their inherent value. You own a piece of a company that generates enough profits to give “paychecks” to its shareholders.
But what if the company doesn’t pay a dividend? Can you still explain why it’s inherently valuable?
A stock may not currently pay a dividend because the underlying company is focused on reinvesting profits.
Stocks that don’t pay dividends are still inherently valuable because of the expectation that they will pay a dividend in the future.
What if a stock is never expected to pay a dividend?
Warren Buffett’s holding company, Berkshire Hathaway, became publicly traded in 1965. It has never paid a dividend, and there is no sign that it will start paying them anytime soon.
Stocks like this still have inherent value because someone else may pay a higher price for them in the future.
Yes, I know. This sounds like a giant scam. But stick with me here.
Large investors can acquire companies, meaning they buy out a company’s current stockholders and become the 100% owner. When this happens, the company may be taken private and delisted from the stock market.
A recent example was the acquisition of Twitter (now X).
The company was publicly traded until Elon Musk bought it and took it private. He paid ~$44 billion, a valuation that translated to $54.20 per share.
If you had bought Twitter when it was publicly traded at $33 per share, close to the lowest price it hit during 2022, you would have earned a ~64% return on your investment. And you would have earned that in less than a year!
There’s no free lunch in the stock market
While all the advantages of buying stocks can paint a rosy picture, owning them comes with very real risks.
If you invest in the wrong company, or even the right company at the wrong time, you risk losing some or all of the money you invested.
While risks are always inherent in investing, you can mitigate your exposure to risk through diversification.
To diversify your portfolio, spread your money across different companies, industries, asset classes, investment instruments, and countries. This ensures you don’t “put all your eggs in one basket”.
Don’t treat the stock market like a casino. Use it to build your empire
Just because you bought a stock doesn’t mean you made an investment.
The stock market rewards patient, long-term investors who employ a disciplined and analytical approach.
Speculators, on the other hand, are people who treat the stock market like a casino.
Trying to make “quick flips” in the market is no different than playing blackjack at the Cosmo in Vegas… except the odds are even less in your favor. It is estimated that 80-99% of day traders fail to make any money.
Conclusion
Stocks represent real businesses - they are much more than symbols, tickers, and line charts on a screen.
Building a portfolio of stocks can be a pivotal step towards financial freedom, as they allow your money to “work for you” and grow passively over time through capital appreciation and dividends.
That’s all for today - thank you for taking the time to read!
Subscribe to "The Asset Column" to have future publications delivered straight to your email inbox.
Follow us on Twitter/X, where we post daily content about personal finance, investing, and entrepreneurship.
Refer to the disclaimer on our “About” page.