In the previous post I explained what investing is and isn’t. Make sure to start there if you’re new to investing. To refresh our memory: investing is allocating resources into something and expecting some form of returns in the future.
There are plenty of things we can invest in, and not all of them are financial instruments. For example: we can invest in our knowledge, relationships, or well-being, but also in real estate, gold, or your business. However, when the term is used, it’s usually associated to allocating money in tradable financial assets (called securities), and in this post we will cover the most common ones: stocks and bonds.
What Are Stocks?
A stock is a type of security that represents ownership in a corporation. The amount of the ownership is relative to the total number of shares of that corporation, called the outstanding shares.
The terms stocks and shares are often used interchangeably, but there is a slight terminology difference between the two: “stocks” is more general, while “shares” is more specific.
For example, if an investor says that he owns stocks, he would refer to having ownership in multiple companies, while if he says that he owns shares, he would refer to an ownership in a specific company and would add the word “in” after the claim: “I own shares in Tesla“. The word equity is also a synonym, but I prefer to use the other two because equity has other meanings outside the scope of investing.
So, let’t say that you decided to buy shares from a specific company at a specific time and, of course, at a specific price. If the company performs well in the following year, its stock will go up and your portfolio will increase in value. However, the value of the shares can also go down and, theoretically, you can lose everything. Basically, your investment grows or shrinks with the value of the company.
Some companies pay dividends to the shareholders. A dividend is a distribution of the company’s earnings and it’s paid per share. The ratio between the dividend per share and the price of a share is called dividend yield. For example, if a company has a share price of 100$ and pays 10$ per share in dividend annually, that means that the company’s dividend yield is 10%.
Some companies don’t distribute dividends, but reinvest the profits in the company itself (which has an effect in the value of the shares).
But, why would companies decide to sell ownership? The reason for issuing shares in the first place is to raise capital. That means that the first investors who buy shares help the company raise money and believe in its growth potential. Buying shares from the company when they are first issued is called buying shares in the primary market.
These investors, of course, are entitled to the adequate portion of the profits and the earnings in the future and have the right to sell their shares at any time. As described above, the same is true for any investor, even if he buys the shares later – in the secondary market.
Lastly, a company can be private or public. Private means that the company’s shares are not offered to the general public, while public means that the company’s shares can be traded on public exchanges by anyone (which would be us).
Another way for companies to raise money is through borrowing, which leads us to the next section.
What are Bonds?
Bonds are securities issued by corporate or government entities to raise capital by loaning money from investors. The investors are called creditors and are entitled to a fixed or variable interest, paid annually or semi-annually. They’re also entitled to repayment of the loaned funds at a specific date in the future, after which they stop receiving interest.
When you purchase bonds you become a lender to the bonds’ issuer.
To get you up to speed with the terminology, the interest rate paid on bonds is called a coupon, the value owed by the issuer is called principal, and the date on which the bond contract expires is called the maturity date.
For example, let’s say you buy a bond for 100$. If this bond pays 10% in interest annually and has a maturity of 10 years, that means that you will receive 10$ every year and at the end you will get your 100$ back. Please have in mind that I’m using multiples of 10 for the examples, but 10% is uncommon for both interest rates and dividend yields.
The interest rate mainly depends on the credit quality of the bond’s issuer and the bond’s time to maturity.
The credit qualities are calculated and issued by credit rating agencies, such as Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings, and they represent the creditworthiness of the borrower. In other words: the ability of the bond issuer to pay back the debt and its likelihood to default. This is more than enough detail for the purposes of this post. Calculating interest rates is a complex process which has no place in a post called “Introduction to Stocks and Bonds”.
But in summary, a one year bond from an AAA company (highest credit score) will pay less interest than a 30 year bond from a B or CCC rated company. Some bonds don’t pay interest (called zero-coupon bonds), but are sold at a discount and repaid in full at maturity.
Bonds are considered safer (less risky) securities than stocks, because in case of bankruptcy, the company has a legal obligation to repay the creditors with high priority, while the shareholders are at risk of losing everything. However, the bond owners receive the interest payments as agreed when purchasing the bond, and even if the company increases in value, their returns remain the same.
So basically, with stocks you can limit your loss (to 100% :)) but have an unlimited earning potential, and with bonds you limit your earning potential as agreed upon, but there is no risk of losing everything.
Older investors and people who want to have less risk exposure, usually allocate a larger portion of their money in bonds.
Things to consider before investing
OK, you understand what stocks and bonds are. So, what’s next?
Before going there, I’d like to add a disclaimer. And not about you being responsible for your own actions and decisions – that’s assumed and known a-priori, but about the fact that we covered stocks and bonds on a basic level. The information provided might be overwhelming for a beginner, but there is much more to be covered before one can claim that he understands these instruments. A good and free resource is Investopedia and I’d highly recommend browsing it to expand your knowledge on stocks and bonds, but also in financial markets in general.
So, how do you decide which companies to invest in?
There are various ways to answer this question and lots of parameters to consider. For example, it’s really important to understand the business model of a company (i.e. how a company makes money) in order to consider investing in it.
Another thing to consider are market and legal factors outside the company that may boost the company’s profitability (a recent example: the legalization of cannabis in Canada). Having vision for your investments is really important. Otherwise, it’s just gambling – which is not inherently bad, but way more riskier.
And beware, if stocks become overpriced (pumped by investors who don’t understand how the business works), this may lead to a devastating crash and leave you with less than half of your investments. This is called a bubble and it forms when something is valued more than it actually is. I’ll cover bubbles and market crashes later in this series, but you can read about “the dotcom bubble” until then.
Let’s be specific
Okay, I’ll have to tell you at least something practical… You can believe in the growth of the industry in which the company is a leader, you can understand and support the vision or the business model, you can trust the CEO’s capabilities, etc. However, unless you’re an early investor, which you probably aren’t, I’d recommend looking at the numbers…
The numbers chico, they never lie!
How to pick stocks?
There are a few proportions that should be low in order to indicate that a company is not overvalued. When I say low I mean relative to the market’s or the industry’s average and not necessarily all of them. The next paragraph may be overwhelming for beginners, so just read it and don’t try to remember everything, but use it to get an idea of the type of information you can have at disposal.
So, some of the values you may be interested in are: the P/E Ratio (price to earning ratio) – the ratio between the company’s share price and its per-share earnings (the company’s profits divided by the common outstanding shares), the D/E Ratio (debt to equity ratio) – the ratio between the company’s liabilities and the shareholders’ equity, the P/B Ratio (price to book ratio) – the ratio between the price of the share and the “book value” (the company’s assets minus its liabilities, divided by the outstanding shares), and the PEG Ratio (price to earnings to growth ratio) – the ratio between the P/E ratio and the growth of the company’s earnings over a period.
Still here? 🙂 Good! Although I wouldn’t advise you to remember everything in one go, I would encourage you to take your time and go through these proportions slowly one more time. But this time, instead of just reading, try to understand why lower value for each proportion is good for a company. The previous paragraph won’t hold your hand in doing so, but holds just enough information to make it clear.
That being said, I hope you understand that this is just scratching the surface. I don’t think someone could read stocks effectively after going through one paragraph, but I do think that it gives the new investor a good starting point to research on his own.
If you want to see these values in practice, click here to see the statistics for Apple by going in the “Statistics” tab. As you see, there are more values than the above-mentioned ones to consider.
And I have a confession to make… Although we could go into more detail about various parameters, I decided to cover the fundamentals and stop. Wonder why? Here it comes…
I think that stock picking is risky, maintaining a portfolio of tens of companies is hard and time consuming, and timing the market is almost impossible.
So, how to invest in the stock market?
Yes, I never picked stocks. Even if you go for a large cap company that had a steady growth increase in the past years, there is a lot to go wrong. Google “facebook stock” and see what happened with it in the past 6 months.
If you read this from the future: it fell more than 40% from the end of July 2018 (today is 23 November). Have in mind that this might not be the best example, as it can recover over time, but proves the point that even large cap companies can be volatile.
Oh, and large cap means a company that has value of more than $10 billion. This value is called market capitalization (market cap) and is calculated by multiplying the number of outstanding shares with the price of a share.
Back to the topic – so, what to do? Why did I waste your time explaining something I don’t even believe in?
On the contrary, I believe in investing the stock market. But only through a diversified portfolio.
There are currently more than 3000 public companies only in the US, and even if you only invested in the large cap companies, you wouldn’t even feel a single company’s 20% drop in price, because of how diversified you are. And if you invest in all these companies, you’re actually investing in the market itself.
But I said that maintaining a portfolio of tens of stocks is hard and time consuming, and I’m talking in the hundreds and thousands now! The best part is that you can own stock in all the companies in a much simpler way than buying shares in each one of them, rebalancing all the time, and maintaining them separately.
But this post is getting too long now…
Become an Investor (Part 3) is the place you’ll learn how the top investors utilize the market in their portfolios. Not by beating the market, not by timing the market, but by matching the market! And that’s the only path towards long-term results.
Subscribe in the sidebar and don’t miss the next post in the Become an Investor series to learn how to easily invest in the stock market. I can’t wait to write about it and I think you’re also eager to learn! But please, hold your money for a little while, now…
See you in Part 3!
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