Stocks: What you should know before investing in stocks.
Stocks. The word brings to mind images of Wall Street and bankers, wealth and power. But what exactly are stocks? You hear about them in the news or maybe you tune to a channel and see symbols run across the bottom of your screen during a commercial. You ask yourself, what are they talking about?
Most of the time when people hear about the “markets” on the news they are referring to the stock market. The stock market is a group of exchanges that list financial securities. To be accurate, the stock exchanges list other securities besides stocks, such as bonds, units and even derivatives. But before we get into all that lets focus on stocks.
Stocks are Businesses
So, you may be asking yourself, what are stocks? Stocks are financial securities that represent businesses. Every public company has stock listed on the stock exchanges. How do you find a company? If you want to look up a specific company you can just type in the ticker symbol in Google search.
For example, if you wanted to look up the stock price of Microsoft Corp you would type MSFT. Or if you wanted to know the price of Facebook’s stock it would be FB or Apple Inc, AAPL ect.
Stocks represent part ownership in a company. When you are buying stocks you are buying a piece of a business. In fact, stocks are also called shares. If you ever hear someone say they have shares in “xyz” it means they have stock in that company, its one in the same!
Understanding the Basic Layout
The above picture is a snapshot of the stock app in the iphone. At first glance it may seem overwhelming but it is actually quite easy to understand once you learn the basic layout. We will start on the left side.
You will see a bunch of other ticker symbols, the price, and either red or green with a number inside the rectangular colored box. To begin, it shows the Apple Inc ticker symbol, AAPL. Next is Apple’s stock price for that day, $665.18. Last is a negative 8.36, what this means is that Apple Inc stock has gone down $8.36 on that day. Below this is Apple’s stats.
“Open” is what Apple shares started at as soon as the stock exchanges opened for the day. The “high” and “low” show the highest and lowest price of the stock during the trading day or intraday if the exchanges have not closed yet. Below the high and low is “volume” which is the amount of shares that have traded hands from buyers to sellers throughout the day. (To the right is the volume average, the average volume level within the 52 week time frame.) Think of the volume as the amount of activity that a certain stock recieves. A higher trading volume means the stock is more liquid, which is good. Next, is the “P/E ratio”. The P/E stands for “price to earnings”, it is a basic way to measure how expensive or cheap a stock is. It basically says investors are willing to pay some multiple ” x” over the earnings of the business.
For Apple, the P/E ratio is 15.63 so investors are willing to pay about 16 times earnings or $16 for every dollar of Apple’s earnings. Because this is a ratio you can also tell what the earnings are if you reverse the equation. You can take Apple’s $665.18 price and divide it by the 15.63 to arrive at 42.55, it’s earnings per share.
On the right is market cap or market capitalization. This is what the company’s market value is, the share price multipled by all shares outstanding. It is what the markets assessment is of the company at any given time. As mentioned earlier, stock prices fluctuate throughout the day but over the long term it will reflect the true worth of the business. Notice how I said the market cap is not what the company is worth but what the market thinks it is worth. This is because sometimes the market misprices shares of a company, meaning it can trade at a discount or a premium. This is what Warren Buffet calls value investing, he finds companies who’s stock trades at a discount to its true value and buys them up before the market realizes and corrects the imbalance. But over the long term the true value will be reflected in the stock price.
The 52 week “high” and “low” shows the lowest and highest price of the stock during the 52 week time period. The “yield” is the dividend of the stock. A dividend is a payout to the stockholders of a company in the form of cash. Not all companies will have a dividend, but if it does you will have another form of compensation. If you own stocks there are basically two ways to generate money or wealth. One is the price appreciation of the shares and the other is the dividend or yield. Keep in mind that not all companies give a dividend. As a stockholder you may like receiving money for holding on to your shares but there is a drawback. As I said a dividend is a payment to stockholders taken from company profits, but in doing so it means there is less money for the company to use to fund projects, to fund research and development or for expansion which means slower growth. However, if you are looking for income with price appreciation this is an option.
Stocks Power: Compound Interest
As I mentioned, there are two ways to generate money or wealth. Although they sound the same they are different. If you want money, buy dividend paying stocks. A company that issues a dividend will payout to the stockholders so you will receive money in your brokerage account every pay period.
Let’s look at Apple Inc again. Apple has a yield of 1.60% so with a stock price of $665.18 the dividend is $10.64 per year. Keep in mind that the dividend of most companies is paid out every quarter or four times a year. However, some may pay their dividend every 6 months or even monthly, it just depends on management.
However, the real power of stocks comes not from the dividend but from price appreciation. Although income investors may disagree, ideally you want most of your investment gains in the form of price appreciation. This is because over the years compounding takes effect. Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t… pays it.”
I want to help you become the person who understands it. Most people understand that the interest rate is the cost to borrow money but the interest rate can also be thought of as the rate of return on an investment. In today’s market the interest rate on savings accounts are at zero or close to it. In other words cash investments generate 0 or negative returns. Most bonds offer a 3-4% return but with the fed about to raise rates bonds will likely lose value. The best case is for stocks which have generated an average 6-7% over the past 50 years. Think about this that 7% return over 50 years will turn a mere $10,000 investment into almost $295,000! And thats with a one-time investment of $10,000. Imagine when you save and put more into investments! This is due to the effect of compound interest. Compound interest is when money is generated from interest. Instead of earning money off of your principal balance your money will start to earn money off of the new balance.
If you had $10,000 and it earned simple interest, it would only earn money on the principal balance and nothing more. Using the same example the $10,000 with a 7% return would only grow to be worth $45,000 after 50 years. That’s a $250,000 difference with continuous compound interest. That’s the power of stock investing. As long as you leave your investments alone, reinvest your returns and put more savings into investing you can really ramp up your retirement portfolio. This is why I urge everyone my age, millennials and the younger generations to start investing as soon as possible. The earlier you start and the longer you keep at it, the more money that will be earned in the later years of investing. Start now and watch your wealth grow over the years.