A stock is a type of investment. When you purchase stock in a company, that means you are buying a small portion of that company. In other words, you own shares of the company. And as a result, you are considered a shareholder of this company.
Companies will sell shares to raise money to operate their business. This money can be used for a variety of reasons, including funding growth and expansion or paying off debt.
How much of the company you own (also known as “your ownership”) depends on the number of shares you own relative to the total number of shares currently held by all of its shareholders.
Let’s consider an example…
SPUD THE DONUT 🍩 BAKER
Spud is a really good donut baker. His family and friends are always asking him to make his famous donuts for events and parties.
His donuts are so popular, that his family encourages him to open up his own donut shop.
Running his own shop has been a lifelong goal, but it would cost Spud a total of $100,000 to bring that to life - money he didn’t readily have available. As a result, he was reluctant to pursue this dream of his. He was a hesi-tater.
But Spud thinks of a brilliant idea 💡. Spud decides to invest $10,000 of his own money. He then convinces 9 of his friends to invest the remaining $90,000 balance.
Each friend invests $10,000 in exchange for 1 share of his business.
If Spud’s business was illustrated as a pizza, now Spud and his 9 friends each owns 1 slice of the pizza, or 10% each of the business, totaling to 100%.
Why would Spud’s friends buy shares of his donut business?
Either Spud has some reeeeeeeeeeally generous and kind friends… or what’s more likely the case, is that they see that his business has great potential to do well - which, in return, will benefit them as shareholders of the company.
WHY BUY STOCKS?
The primary reason people buy stocks is to earn a return on the investment. For the most part, when the company makes money, you make money.
And this is done in two main ways:
1. If the price of each share goes up (or increases in value). Shareholders can sell their shares for more than they paid for them and make a profit. This profit is commonly known as “capital gains”.
This means that if Spud’s donut shop does well down the line and turns into a profitable business that is worth $500,000 - then each share (which is 10% of the company) will be worth $50,000.
For example, Spud’s friend Avocabro originally paid $10,000 to purchase his share. If he decides to sell his share, he would be making $40,000 in capital gains. Holy guacamole!
2. If the company chooses to issue dividends to shareholders. Dividends are payments that companies can choose to make to shareholders as a way to distribute some of the profits back to the shareholders. Think of this as a token of appreciation for the shareholder’s investment in the company. Keep in mind that not all stocks pay dividends.
If a company issues dividends, they are paid per share of stock. Dividends are typically paid quarterly, but can be monthly and semi-annually as well.
RISKS OF BUYING STOCKS
As with most investments, there is risk that comes with buying shares of a company. Everyone buys stocks with the hope that their values will continue to increase over time, but there is no guarantee that a stock’s price will move up. Sometimes, companies may perform poorly. The value of the share may drop lower than the price it was purchased at. Or even worse, the company can go entirely out of business. This can cause the shareholders to lose some or all of their investment in that company.
This is why it is important for investors to spread their money across multiple companies rather than putting it all in one.
PRIVATE VS PUBLIC STOCKS
Whenever people talk about stocks (i.e. Amazon, Google, etc.), they are referring to the stock of “public companies”. The reason they’re called public companies is that their shares are made available to the public, and their shares are traded on the open market through a stock exchange.
Meanwhile, businesses like Spud’s donut shop are “private companies”, where the shares are not publicly traded on the open market, and are held internally by a few people.
MY THOUGHTS ON STOCKS
Different people have different investment risk appetites and investment goals. The below are just a few of my thoughts when it comes to stocks.
Currently, I do not invest in stocks of individual companies. While investing in strong stocks that perform well can be instantaneously rewarding, it is difficult to know which are the right ones to pick (otherwise we’d all do it and get rich). Personally, I think picking individual stocks limits my diversification (too many eggs in too few baskets), and I don’t have the time to research, read the financials, and stay up-to-date on each company that I invest in.
I invest in index funds. When investors buy an index fund, they are purchasing a broad selection of many stocks in one package, without having to purchase each one individually. There are a variety of index fund options, composed of stocks or even other types of assets (i.e. bonds). Make sure to spud-scribe to hear me 🥔hash🥔 out the wonderful world of index funds.
I treat stocks as long-term investments. I prefer to buy and hold for the long run. In the short term, there is so much volatility, which is always difficult to predict. Stock values rise and fall all the time. I cannot time the market, nor will I try to because it is nearly impossible to do. However, I do know that over the long run, history has shown that the market continues to rise.
I view long-term index fund investing as a long-term stream of passive income. I allocate a portion of my paychecks to my 401K (employer-sponsored retirement account), as well as other retirement accounts. The power of compounding interest helps grow your wealth in the long run, because by reinvesting the earnings ultimately results in (exponentially) increasing your return on your investments. This is truly passive income - making your money work while you sleep.