Getting Started With Stocks: Part I (from ground zero)
Disclaimer: There are a number of websites and resources dedicated to personal investing strategies. We are not one of them. The information presented here is meant to provide you with a guide to investing in stocks. If you would like to learn more through one of these resources, I suggest trying any of the following:
What is a stock?
Think of a company like a pie. Each slice represents a share of stock. The more times you cut the pie, the smaller each slice or share is worth.
At the root of it, a “stock” (also referred to as a share) of a company is an ownership percentage of the company; so owning stock means you are a partial owner of a company! The actual percentage of the company you own depends on 1) the total number of shares of stock that belong to you; and 2) the total number of shares of stock a company has made available for all people to own.
Does that mean you and I can become an “owner” of any company we want? Unfortunately not. The vast majority of companies around the world are privately held which means mom and pop are still the sole owners. Shares of their company are not for sale to everyday folks like us.
Public companies on the other hand are available and offer a portion (or all) of their shares for sale to the general public. How many shares a company decides to offer up for sale is ultimately a decision of the company (most likely the original owners). While offering more shares can result in greater proceeds; it also means selling a larger portion of the company to the public.
Once you purchase shares of a company through stocks, you are essentially making a bet that the company will perform better than it has been performing to date. Congratulations, you are now a partial owner and have a vested interest in the future of your company.
How do stocks trade?
Like any transaction, there is a Buyer and Seller. These two parties negotiate back and forth before settling on some agreed upon price (which typically falls somewhere between what the two parties each want). The same concept applies when trading stock. On one end you have a Buyer who places a “bid” and the other, a Seller, who places an “ask” price. The thing is most publicly traded stocks are highly liquid, which means you could easily purchase and sell shares of the stock. As a result, there is usually little to no difference between a Buyer’s bid and Seller’s ask price. The reason for this is there is usually another buyer or another seller willing to transact at the current trading price.
However, not all publicly traded companies’ stocks are traded equally. There are smaller companies who are less liquid due to lower daily volume (shares purchased and sold on a daily basis); resulting in a wider spread between a Buyer’s bid price and a Seller’s asking price. Additionally, Over the Counter (“OTC”) stocks (covered below) can be even less liquid than other publicly traded companies. The bottom line is, the more liquid a stock, the higher the chances you will be able to purchase the stock at the current trading price. The less liquid the stock, your chances will decrease.
Where can I buy stocks?
Again, privately held companies do not allow for public investors to come in and purchase shares of their stock.
Publicly traded companies on the other hand can be purchased on two types of platforms: 1) Listed Exchange and 2) Over the Counter.
Common listed exchanges in the U.S.: New York Stock Exchange (NYSE), National Association of Securities Dealers Automated Quotation System (NASDAQ), American Stock Exchange (AMEX), etc.
A listed exchange is a centralized, formal and regulated platform for a company to list its stock on. Listed exchanges provide investors and companies a sense of security because stocks are traded safely, quickly, and with great transparency. You can easily pull up the current trading price of a company’s stock online.
Think of the various listed exchanges as the different platforms you can sell concert tickets on (Stubhub, Ticketmaster, Ebay, etc.). The reason there are different listed exchanges is the same reason why there are so many platforms to sell concert tickets: accessibility, listing fees, reputation, etc. Each exchange offers something the other may not.
On the other hand, Over the Counter is a decentralized network, typically reserved for smaller companies, consisting of dealers who are using computer networks, emails, and phone calls in order to contact one another for a trade. Prices are negotiated and determined by dealers who ultimately buy and sell these stocks. Trades can be made between two parties where the price is unknown until after the trade is completed. Keep in mind requirements (including financial filings) for OTC stocks are less stringent than those for a listed company. This resulting lack of transparency may make it more difficult to find additional information regarding the company. Going back to our concert ticket analogy, buying OTC stocks would be like selling tickets through word of mouth.
So why would a company not want to be on a secure listed exchange? Well, with any centralized and regulated platform, there are more stringent requirements and higher fees associated; often forcing smaller companies out who can not meet these requirements or pay the fees.
So how does this impact you? As if investing was not risky enough, If you’re just starting off, I would not recommend OTC (unlisted) stocks primarily due to the lack of transparency and regulation. In addition, because OTC companies are smaller in size, there are naturally less buyers and sellers. This results in less liquidity, making it difficult to not only purchase and sell a stock but also for you to see the stock’s current trading price in real time.
What do I need to buy stocks?
Now that you know where companies list their stocks for purchase, how does an individual access and purchase from these listings? The answer is a brokerage account. Just as a checking account serves a different purpose than a savings account, a brokerage account is a special account dedicated for investing. There are a number of different brokerage firms out there and the one you decide on ultimately depends on personal preferences. Firms vary by minimum deposits, transaction fees, customer service/support, online/mobile functionality, credibility, etc. If you are just starting off I suggest you look for a reputable firm with no minimum deposit, low transaction fees, and good online/mobile accessibility. NerdWallet provides a nice breakdown and ranking of brokerage accounts here.
Why do stock prices fluctuate?
As mentioned previously, there is always two sides to any transaction. A Buyer who is trying to buy the stock for the lowest price possible and a Seller who is looking to sell at the highest price. The price that you see on Google, Yahoo, CNBC, etc. represents the current trading price (Note: there is a minor time lag between what is shown on these sites and the true trading price). The current trading price is the equilibrium, where buyers are willing to buy and sellers are willing to sell; all based on the information we know today. It represents how much investors are valuing a single share of the company’s stock, today.
A stock’s price is ultimately driven by the buyer and seller relationship, or in other words, supply and demand. If you have more supply than demand (i.e., more sellers than buyers), the stock’s price will move lower as seller’s are now selling at a discount in order to make a sale. Alternatively if there is more demand than supply, buyers will have to pay a premium for that same stock. Now what drives this supply and demand relationship? It comes down to the public’s perception of a company. If there is a change of sentiment around the company, the supply and demand relationship will fluctuate accordingly resulting in a change in the stock’s price. Upwards for good news (e.g., new announcement, product launch, superb earnings, etc.) and downwards for bad news (e.g., disappointing earnings/sales, lawsuit, etc.)
How do I make money?
Let’s be honest, you were asking this
Let’s say you purchased a single share of Apple stock exactly two months ago at $100. You notice that it is trading at $110 today and think to yourself, “Great! I just made $10 (or 10%) in just two months, right?” Yes, but only on paper. This $10 represents your unrealized gain and will fluctuate up or down until you realize (or exit) your position. In order to physically receive the profit to where it matters most (your bank account), you have to sell out of your stock position in order to realize any type of gain (or loss).
OK, so you sell out of the position and now you say to yourself, “$10 is a healthy return!”. While true, this 10% only represents the individual stock’s return, or gross return. The actual return to you as the investor, or also known as net return is much lower. Why? First there are fees charged by your brokerage account (this is why it is important to find a credible brokerage account with low fees). In addition any profits will be taxed either at your personal applicable tax rate for any short-term capital gain (investments held under a year), or at a reduced tax rate for any long-term capital gain (investments held over a year). In this example, the $10 will be considered a short term capital gain since the stock was held for less than a year (i.e., two months). The $10 gross profit gets quickly reduced. If your brokerage account charges $4/per trade, it will cost you $4 to buy and $4 to sell, totaling $8. Reduce your profit by $8 and you are left with only $2. Then apply a short-term capital gain tax of up to 39% (this will vary by what your applicable income tax rate is for the year) on the remaining $2 and you are left with less than $1.50 as your net gain to you as the investor!
So what now?
As you can see it’s not so easy to make money from the stock market! We will go over a few investing strategies in the next article including what to look for when selecting a company, when you should start investing and ultimately how you can make more than $1.50 with the same $100!