A few weeks ago I started thinking about how to discuss investing with residents, as I have been half-invited to talk with them about financial topics.
I had planned to talk about investing, but realized there were a number of steps a person should go through first before committing money : first, making sure the investor actually has some money they can invest, and then explaining why risking their money in investments beats hiding cash under their mattress.
I have been putting off the discussion of investing–mostly talking about stocks and bonds–because the more I think about them, the more complicated they feel.
It’s sort of like diabetes. At one level, diabetes is simple: you don’t make enough insulin and your sugar is high.
Then you start thinking about all the complications of diabetes, and screening for them.
Then you get to consider prevention, and various medications. Don’t forget discussing the pros and cons of different goals for glycemic control, blood pressure, and cholesterol.
Once you get to debating the merits of one insulin analog vs. another, you know you are in advanced territory, but where before this step do you stop?
I felt the same way discussing investments. I thought I would start with some basics, and get a little more information in before calling it a day.
When you buy stocks, you are buying a part of a business.
For example, Coca Cola has about 4.3 billion shares outstanding. So if you buy one share, you own a little less than 1/4 of a billionth of the company.
Over the years, investing in stocks has been a wealth building strategy for many people. They can make money when the stock price goes up, if they sell the stock for a profit. And/or, they can make money via dividends.
Stock pricing
In theory, if a company you buy shares in is making money because it is a profitable business, the value of your share will go up.
I say “in theory,” because stock pricing of publicly traded companies is really based on a few factors. If your company is making money hand over first, the value of the company should go up, and thus your share will go up as well.
However, the price also depends on what other people think the company will do. If people think the company will lose money, no one wants to buy it, and the price of its stock will go down. If they think it will make a lot of money in the future, the price of its stock will go up.
Thus you can get some seemingly illogical price moves, such as when a company announces they are making a profit, but the stock price drops. The reason for this is that before the profit announcement, buyers of the stock thought the company would be more profitable than announced; and so they bid the price up in line with their expectations (hopes). Once the company “only” makes a smaller profit, these bidders are disappointed, and don’t like the stock as much.
Over time, if a company is doing well, the share price should go up. If you buy when shares cost less, and sell when the shares cost more, you will make money. These are capital gains.
Dividends
A company may decide to return some of their profits to the owners. This means that as a shareholder, you may get a little money every year, or every quarter; these monies returned to the shareholders are dividends. You can think of them as the rewards of ownership. Companies in good health often increase their dividends over time.
Advantages of Ownership
Owning a company can be very profitable. With plenty of work, someone can open a store/restaurant/factory, buy and sell items/serve meals/make doodads From this business, the owner can earn money, support their staff with salaries, and maybe, eventually, sell all or some of the business to someone else who wants the chance to make money by running the business.
Owning a large company has the same opportunity for the share owner.
Proctor and Gamble makes laundry detergent, Kimberly-Clark makes toilet paper and Kleenex, Nestle makes diabetics. If you own part of these companies, and they keep selling their products at a profit, you get some of that profit, either as dividends or an increase in stock value.
On average, over the years, investing in stocks has brought a return greater than inflation. Which is one of the main reasons to invest.
Risks of Stock Ownership
Companies go bust.
Sometimes they go bust because no one buys their products anymore (think film cameras). Sometimes they just don’t make money (think airlines). Sometimes there is some funny business that isn’t all that amusing (Enron).
If the company isn’t making money, sometimes you can salvage some assets (selling property, or airplanes), but usually the stock becomes worthless, and all the money you spent to buy the stock goes up in smoke.
What now?
Once you consider losing all your money when a company goes bankrupt, I suspect buying stock sounds less appealing.
Any discussion of investing in stocks will have to discuss risk mitigation. No one should recommend putting all your money in just one stock. Yes, it could be rising. Yes, you could make a fortune. But, you could also lose it all.
The usual discussion of risk mitigation involves diversification. There are many ways of diversifying. In this case, I am just talking about diversifying your stock choices.
To reduce your risk, you want to own more than one company. Two is still risky. Somewhere around 10 companies, your risk starts to go down a bit. For a long time, 20-30 was listed as a good number of stocks to reduce your risk through diversification. Of course, it depends on how diversified your stock purchases are.
Buying the stock of 20 companies all centered around automobiles isn’t really that diversified. If the economy goes down the tubes, or cities ban cars in favor of electric bikes and scooters, your tire companies, seat upholstery factories, and windshield manufacturers are all going to do badly.
What you really want to do is invest in a lot of companies, in many different fields. This will minimize the chances that all of your companies will go belly up. It also increases your chances of getting a few companies who make money like nobody’s business.
Unless you have lots of money at your disposal, your best bet is to invest in a product that lets you buy a mini-fraction of lots of companies with each dollar you invest. What you are looking for is a mutual fund or an exchange traded fund (ETF).
Mutual Funds or ETFs
These are rather similar financial products, so I will lump them together.
The funds own stocks of many different companies, and you buy shares of the fund. So 10 shares of a fund might still only get you a tiny fraction of a share in 1 particular company.
However, since you own tiny fractions of many (hundreds, or even thousands) companies, the chances that you will lose all your money if one company goes bankrupt is basically nil.
There are all sort of funds. Some basic choices are funds that invest in small companies, medium companies, large companies, American companies, foreign companies.
There are a few tricks to investing in stocks via mutual funds (or ETFs).
- Pick a fund that is diversified. Please don’t pick just one sector or one type of fund. A fund of solar panel companies might be exciting, but is really very concentrated. It’s not well-diversified at all.
- Be aware that funds run by stock pickers tend to do worse over time than those that just buy an index and stick with it.
- Fund companies have to make money. Those brochures don’t grow on trees, and the company workers need to be paid. Therefore, they will charge fees. These fees are sometimes hidden. Paying less in fees will mean more money for you in the long run, so pay attention to them. They always matter.
At this point I think it’s time to stop. Maybe take some questions from the audience. I haven’t covered everything there is to know about stocks and investing, but people write books about this. I can list favorites for reference.
I hope it goes without saying (but I will say it anyway), that this is for educational purposes only. Please don’t make your investing decisions based solely on my meandering attempts to review the basics on stocks and bonds.
What do you think about this introduction to stocks? Too basic? Too much information? Have you had to teach this information to others before?