Many people think it would be a good idea to invest in the stock market, but they have absolutely no idea how to go about it. So I thought I'd write up this little "beginner's guide". I don't claim to be an expert on the stock market, so if someone more knowledgeable sees errors here, please let me know. But my goal here is to explain the basics. This is an intro level course, not a PhD class!
When someone starts a business, they need at least some money to get it off the ground. If you're opening a store, you need to buy some merchandise to sell. If you're starting a factory, you have to buy some machinery. Etc.
Sometimes the person starting the business has some cash and he can pay for it out of his own pocket. Sometimes he borrows from friends and relatives. Maybe he can get a loan from a bank. But another option is to sell "stock". That is, you get people to give you money, and in exchange they now own a share of the business. If you sell 100 shares of stock, then each share represents 1% of the business. If someone buys 10 shares, then they own 10% of your business. (The person who started the business probably wants to buy some of the stock himself.)
Then when the business makes money (if it ever does!), it pays "dividends". Dividends will be an amount per share. If the dividend is $1 per share, then if you own 10 shares you get $10.
Stock holders do not normally participate in the day to day operation of the business. Rather, the stock holders elect a "board of directors". The board of directors select managers who actually run the business. Each stock holder gets one vote for the board of directors for each share of stock. If you own 51% of the stock, or you can get together a group of stock holders who between them own 51% of the stock, then you can pick the board of directors and run the company. (Side note: In the US, there are laws to prevent a majority of the stock holders from doing something to undermine the interests of a minority. Like, a majority can't decide to give themselves all the profits and give nothing to anyone else.)
A very important thing about stock is that a stock owner's possible loss is limited to the stock he bought. Say you start a business and you fund it with your life savings. You sink, say, $100,000 into the business. But things go very badly, and before you decide to call it quits and give up, the business has debts of $200,000. As the sole owner of the business, you have to pay the $200,000. You could lose your home, your retirement fund, everything.
But with stock, if you buy $100,000 in stock in a company, and the company goes broke, your stock could end up being worth zero. You could lose your entire investment. But that's all you can lose. People that the business owes money to can't come after you for the debt. This is called "limited liability". At worst, your stock could end up being worthless. You throw it away.
In the old days, when you bought stock you got a pretty certificate with the name of the company and the number of shares. These days it's all just recorded on computers. I've never seen a paper stock certificate.
The stock market has distinct advantages as a place to invest your money.
Historically, in the long run, the stock market has consistently gone up. There are years when it has gone down, but in the long run, it has always recovered. On the average, for the last few decades, the stock market has gone up 7% per year. Let me make absolutely clear that that doesn't mean it has gone up 7% every year. But on the average, over the long run, it goes up 7% per year.
It is easy to buy and sell stock. There are some things you can invest in that are easy to buy but hard to sell. Like, a company that sells gold once tried to convince me to move my assets to gold. I asked them, Say I buy gold from you. If I want to sell, will you buy it back? They hemmed and hawed and ultimately their answer was no.
Some people invest in "collectibles", like Beanie Babies or bear cans or designer plates from the Franklin Mint. The gigantic catch to these investments is that the value depends entirely on the whim of buyers. If you buy a designer plate because you think it's pretty and want to set it up on a shelf, well good for you. But if you are buying it because you think the value will go up ... maybe it will and maybe it won't. For the value to go up, other people have to either want very much to get these plates to display on a shelf, or they have to also buy them as investments. The whole thing could come crashing down in a day if people lost interest.
You could invest in real estate, or start a business. But such things require active work on your part. With stock, you buy the stock and then sit back and collect the income. Start a business and you have to work at it every day to keep it going. Maybe if the business does well enough you can afford to hire someone else to run it, but then that eats up a lot of your profits.
And selling real estate or a business is not trivial. When I sell a stock, it takes somewhere between minutes to a day for me to get the cash. When you sell a house, it can takes months to find a buyer. Some houses sit on the market for years. That is, some investments have low "liquidity". It can be hard to sell them when you want or need cash.
So stocks have the advantage of consistent growth and liquidity. Does this mean that stocks are unquestionably the best investment? No. They have distinct advantages. If you are debating where to invest your money, you might want to consider the advantages of other possible investments.
Stocks are routinely bought and sold on a "stock market". In the US, the best known stock market is the New York Stock Exchange. Many other countries have their own stock exchanges. Buying and selling is called "trading". That doesn't mean trading like, I'll give you two of my red ones for one of your green ones, but just, buying and selling.
You have to be a member to trade at a stock exchange. This is because they want to limit the chaos. If just anyone could walk in and buy and sell, there could be tens of thousands of people trying to cram into the stock exchange. Many of them likely having no idea how the system works.
So instead you have to find a "broker" to do your buying and selling for you. In the old days, a broker could charge substantial money to carry out a trade. Way back when my broker charged $60 plus a percentage of the trade. Today there are many "discount brokers" who charge only a few dollars for a trade. Many charge nothing for many trades.
Today most trading is done with computers, but let's describe it the old manual way. The principle is the same. Suppose you tell your broker you want to buy 100 shares of Company X. Your broker goes to the stock exchange and finds the place on the floor (that is, the place in the building) where this particular stock is being traded. He announces that he wants to buy 100 shares for, say, $20 per share. If there is someone willing to sell 100 shares for $20 per share, they make a deal and it's done. But suppose there is someone willing to sell 100 shares but who wants $22 per share. They negotiate, maybe settling on $21 per share.
The stock market is, in one sense, an almost perfect market, with prices set by supply and demand. If more people want to buy a stock than want to sell, the price goes up, until more people decide it's worth selling at that price or more people decide it's not worth buying at that price. If more people want to sell than buy, the reverse happens. Either way, the price settles at a point where the number of shares people want to buy is exactly equal to the number people want to sell.
In another sense, the price of a stock is determined by the company's future earnings potential. If many people think that Company X is poised to make a lot of money, the price will go up. If many people think Company X is about to go broke, the price will go down. Of course these people could be right or they could be wrong.
Big investors, those who are spending millions, actively negotiate stock prices. But for the typical small guy, you just take the "going price" the stock is currently trading at. Your buy and sell decisions affect that price, but only a little bit.
Putting all your money into one stock is risky. Sure, if that company makes a bundle of money, so will you. But if the company goes broke, you could lose your entire investment. So a common strategy is "diversification" -- buy stocks in many different companies. It's unlikely that they'll ALL go broke.
But if you're a small investor, you may not have enough money to buy many different stocks, even if you bought only one share of each.
ALso, if you're a small investor, you probably have a job or family responsibilities. You can't spend full time studying the stock market and deciding which stocks to buy and sell.
This is where mutual funds come in. A mutual fund combines money from many different investors, and invests in many stocks. Each investor in the mutual fund then effectively owns some percentage of the total set of stocks. You get diversification. Also, the fund is managed by a person or people who devote full time to managing the fund, deciding which stocks to buy and sell. So you get the advantage of a professional manager.
Of course you have to pay for this service. Mutual funds typically charge a percentage of the value of your share in the fund, like maybe 1/2 of 1% or so. So if you invest $10,000, you may pay $50 per year to the fund manager. Some charge an annual fee. Some charge when you buy or when you sell.
You buy shares in mutual funds similar to buying individual stocks. You buy a certain number of shares at a certain price, and sometime later you sell those shares and hopefully make a profit.
Companies are often classified by the size of their "market capitalization". This is simply the number of shares of stock they have out there times the current price per share. So if, say, a company has 1 million shares of stock and they are currently selling for $20 per share, then their market capitalization is 1 million x $20 = $20 million.
Market capitalization should not be confused with net assets or net worth. Net assets is the total value of everything the company owns, cash they have in the bank, money that is owed to them, etc, minus any debts. So for example, if a small store has a building worth $200,000 and $100,000 worth of merchandise, and they owe $50,000 on a mortgage on the building and $20,000 in unpaid bills to suppliers, then they're net assets or net worth is $200,000 + $100,000 - $50,000 - $20,000 = $230,000.
This could be very different from their market cap. Imagine a company that provides professional services, like a law firm or a computer consulting company. Suppose they are renting their office space so they don't own a building. They have no factory or industrial equipment. All they own is maybe a few laptops and some office supplies. Their net assets might be $50,000. But their market cap could easily be many millions. If they are offering a service that people are willing to pay for, their potential income could be very large, and thus their stock price could be high.
Market cap is often grouped into "large cap", "mid cap", and "small cap". These days large cap is maybe $20 billion or more, mid cap is $1 billion to $20 billion, and small cap is less than $1 billion. But that changes over time with inflation.
Note that a high stock price does not mean that the company is valuable. What matters is the market cap, stock price times number of shares. If stock in company A is $100 and company B is $2, that doesn't mean A is bigger or more valuable than B. If A has only 100,000 shares and B has 10,000,000 shares, then B is more valuable.
If a company is doing well, their stock price will go up over time. But companies generally don't like their stock to get too expensive. If a company reaches a point where one share costs $2,000, then some small investors won't be able to afford even one share. Note that if a stock costs $20 and you want $1000 worth, you can buy 50 shares. But if it costs $2,000 and you want $1,000 worth, you are out of luck.
So the company may have a stock split. That is, they reduce the value of each share, and then give everyone enough new shares so that their total investment is the same. Like say the stock is at $1,000 and you have 20 shares. So your total stake is $20,000. The company announces a 2-for-1 stock split. That is, they will cut the price of the stock in half, and give every shareholder twice as many shares as they now have. So if you had 20 shares, they'll give you another 20, so you now have 40. The price of the stock then falls to $500 (all else being equal), so you still have $20,000.
A split can be 2-for-1, 3-for-1, 4-for-1, etc.
Technically, the company doesn't change the price of the stock, because the company doesn't control the price of the stock. The market does. The company just gives out the extra shares, and then the market adjusts the price of the stock.
Some companies manage to do okay through good times and bad. Like a company that sells groceries: people still need to eat in hard times, they'll still buy food. In the best of times people may buy more expensive food and the grocery store does better. Like they buy more steak and less hamburger. So their income won't be the same no matter what. But it will tend to be stable. Other companies can do very well in good times but totally crash in bad times. Like a company that sells video games can do very well when times are good and people have lots of space money in their pockets, but when times are bad, something like video games is going to be the first thing people cut from their budgets.
So some stocks are labeled "aggressive", meaning they do well in good times and poorly in bad times, while others are called "conservative", meaning they tend to muddle along in good or bad times.
In real life, companies that do very well in good times tend to do very poorly in bad times, while companies that do okay in bad times tend to do just okay in good times. It would be great if you could find a stock that goes up 30% in good times and only loses 1 or 2% in bad times. But sadly, such stocks are hard to find. More often, a company will go up 30% in good times and down 25% in bad times, or up 5% in good times and down 2% in bad times.
There are (basically) two ways you can make money on the stock market: dividends, and increases in the value of your stock. Dividends are when the company gives money to share holders. Stock price change is when the price of a stock goes up or down with the market.
For example, suppose you buy a stock for $10 per share, and then later sell it for $12. You will make a profit of $2 per share.
On the other hand, suppose you buy a stock for $10 per share. Then the company declares a dividend of $1 per share. For every share you own, you get $1.
Price changes can be "realized" or "unrealized". If you buy a stock for $10 per share and the price goes up to $12, but you don't sell, you have an "unrealized gain" of $2 per share. Your stocks are worth more, but you don't have any cash in your pocket. If you sell, then you turn that in to a "realized gain". Now you actually have money in your pocket.
An unrealized gain may evaporate on you. Like, you could buy a stock for $10. The price goes up to $12. But you don't sell, perhaps hoping the price will go up even more. Then the price falls to $9. So for a time you had an unrealized gain of $2, but now you have an unrealized loss of $1.
(I once bought stock in a company that was in danger of bankruptcy. I only bought $500 worth of stock, so it wasn't any big investment, even for a small fry like me. The company then looked like they would pull through and not go bankrupt, and the value of my stock went up to $10,000. I decided to hold on and see if it would go up yet further. Then their plans fell through, the company went broke, and my stock was worth zero. In a sense, I lost $10,000. In another sense, I only lost $500.)
By the way: someone once said that the stock market is a tool for transferring money from the impatient to the patient. This is true. When COVID hit, the stock market went down. I was chatting with my broker and he said that many of his clients told him they wanted to sell everything and get out of the market. He said that he told them this was a bad idea: the market was low now and if they sold they would lost a bunch of money. But if they just held on it would go back up. They could just ride it out and they wouldn't lose anything. But most of them said no, they wanted out. He said he had to do what the client wanted so he sold their stocks and they lost a bunch of money. I rode it out and never lost anything: my stocks now are worth more than they've ever been.
So okay, now you know a little about how the market works. How do you actually buy and sell stock?
The easiest way today is on the Internet. You get on the Internet and you search for "stock brokers" or "investment companies". I'm not going to make any recommendations here, because I don't have enough experience with different brokers to say. Brokers out there include Charles Schwab, Wells Fargo, T Rowe Price, Fidelity Investments, and Tastytrade. There are many others, some big, some small.
You pick a broker and you create an account. You can often do this on-line without ever talking to a human being. Then you have to put some cash in the account so you have money to buy stocks with. There are several ways to do this.
The easiest way is to do this on-line. You find a place in the menus where it talks about "connecting a bank account" or "depositing money" or "transferring money". You give them the account number of a bank account. Then you say to "add money" or "transfer in", select the bank account (if you've given more than one), and the amount to transfer in. Normally this is done with ACH, or Automated Clearing House, a system for moving money between financial institutions in the US. There is normally no fee for this.
You can send money by a wire transfer from your bank. There will be a fee for this. The fee varies depending on the bank and the amount sent. I once sent I think it was $15,000 and the fee was $60. I've received wire transfers a few times and had to pay $15 to $20. (I consider those fees large, so I don't do wire transfers if I have any other choices.)
You can mail them a check. This is slow. The only advantage I see is that then you don't have to authorize electronic withdrawals. Some people are very nervous about giving out such authorization.
Once you get some cash in the brokerage account, you can buy stock. Find a menu pick for "buy" -- sometimes you will have to pick "trade" and then "buy". Then enter the ticker symbol for the stock, the number of shares to buy, and a limit price.
A "ticker symbol" is an abbreviation of the company name. Like Amazon is "AMZN", General Motors is "GM", etc. Some are efforts to be cute, like Molson Coors, the beer company, is "TAP". Etc. Most brokerage companies have a screen where you can search for a company by name and they'll tell you the ticker symbol. But note that sometimes this can be tricky when there are companies with similar names, or when the company's real name isn't the same as the brand name that you're familiar with.
A "limit price" is the most you are willing to pay. Your broker will try to get you the best price he can. But if he can't get the stock for the limit price or less, he will cancel the order. If you try to buy at a ridiculous price, like if a stock is going for $200 per share and you give a limit price of $3, your order is just going to get cancelled.
Selling is similar. You select some stock that you own and declare that you want to sell it. You specify the number of shares -- from 1 to all -- and a limit price. In the case of selling, the limit price is the least you will accept, rather than the most you will pay. The broker then sells your stock and adds the cash to your account. You may then use that cash to buy other stock, or have it transferred out to your bank account.
If you don't want to do your investing over the Internet, call an investment company and you can do it over the phone or in person. Some investment companies prefer that you do all your transactions over the phone. I'm not sure why, this seems cumbersome and inefficient. Maybe just to justify some of their employee's jobs! Doing it over the phone can be simpler because then you don't have to figure out the company's web site. But it also creates the nuisance that there may be confusion. Like you may say over the phone that you want to buy ABC and the broker thought you said ABE.
So lets suppose you invest money for retirement. How much can you withdraw each year when you've retired? If you withdraw too fast, you can run down your account and run out of money. This is called "outliving your investments".
Many retirees plan on only withdrawing the profits from their investments, and leaving the principle intact. That way they can live on this money forever and have something to leave to their children. Even at that, though, you really want to let the principle grow with inflation. If you withdraw ALL the profits, your balance will stay constant, but this will be worth less and less every year because of inflation.
A rule of thumb encouraged by many financial advisors is to withdraw 4% per year. I mentioned above that the stock market grows an average of 7% per year. Inflation runs about 2% per year. So if you want your principle to grow with inflation, you have to leave 2% behind. 7% - 2% = 5%. You generally want a consistent income. You're not going to change the amount you withdraw every month depending on what the profits were that month. But the stock market doesn't grow at a consistent rate. Some years it grows a lot, some years it only grows a little, some years it goes down. So you should leave a little pad to allow for inconsistencies. So instead of withdrawing 5% every year, withdraw 4%. If the market does well and the value of your stocks goes up, you can incrase the amount you withdraw.
Personally, I'm retired and I'm withdrawing 3% per year, to give a little extra pad. Combined with my social security this gives me enough to live on, and it means my balance may grow a little faster. It went up enough in the 3 years since I retired that this year I increased the amount I withdraw slightly -- by $100 per month, not a huge amount.
In the United States, you can have a retirement account, or an ordinary personal account. Or more specifically, you can have a "traditional retirement account", a "Roth retirement account", or an ordinary account. A retirement account may be an IRA, a 401k, or other less common types. Whether it's an IRA or a 401k or whatever doesn't matter for this discussion.
Under US tax law, you can have a traditional retirement account where you put money in "pre-tax". That is, you don't pay income tax on the money the year that you put it in. But then you have to pay taxes the year that you take it out.
With a Roth account, you put money in that you have left after paying income taxes. That is, you pay taxes on the money the year that you put it in. Then when you withdraw it, you pay no taxes.
With an ordinary account, you put money in that you have left after paying taxes, like a Roth. When you withdraw money, you pay taxes on any profit you made, that is, on the difference between what you got when you sold the stock and what you paid to buy it. This is called "capital gains tax". The rate is lower than ordinary income tax.
Perhaps an example will help make this clear. Suppose that you have $1000 to invest. Suppose that your income tax rate, both when you put money in and when you take it out, is 20%, and your capital gains rate is 15%. And suppose that the value of the stock doubles between when you buy and when you sell. (We'll get back to the reasonableness of these assumptions in a moment.)
(Technically, when I say you "don't pay taxes" on the money you invest, in practice this means that you deduct the amount invested from your income when you file your income taxes.)
With an orindary account, again you have to pay taxes on the $1000. You pay 20% of $1000 or $200, leaving you $800 to invest. This doubles to $1600. You then have to pay capital gains tax on the increase. The increase was $800, 15% of $800 is $120, so you are left with $1600 - $120 = $1480.
With a traditional retirement account, you have $1000. You pay no taxes on that so you deposit the full $1000. By the time you withdraw the money doubles to $2000. So you pay 20% tax on $2000, or $400, leaving you with $1600.
With a Roth account, you have to pay taxes on the $1000 before you can invest what's left. So out of the $1000 you pay 20% or $200 in taxes, leaving you $800 to invest. This doubles to $1600. You pay no taxes when you withdraw so you get the full $1600.
A quick point of clarification: I've seen some discussions of the different types of account that say that with a Roth or ordinary account, you can pay the $200 taxes with other money. Well, I suppose so. But then you're saying you started out with $1200, the $1000 that you will invest plus another $200 to pay the taxes. So to make a fair comparison you would have to add $200 to the amount invested for a traditional retirement account.
Also note that an ordinary account is similar to a Roth account, except that with the ordniary account you pay capital gains taxes and with the Roth you do not.
So now let's look at the assumptions. I assumed you had $1000 to invest. This is, of course, a number I just made up for an example. But if you do the algebra, it makes no difference to a comparison between the three types of account. Whether you invest $10 or $1 million, the RELATIVE amount of money you have at the end will be the same.
I assumed your money doubled. Again, this is just a made up number for the example. But again, how much it grows doesn't affect a comparison of the three types of account. As all three types of account are normally invested in the same stocks or funds, they would get the same returns.
But the assumption that your tax rate is the same when you put money in as it is when you take it out is NOT always true and makes a difference. You may have noticed that in my example, you end up with the same amount of money from a traditional retirement account as from a Roth account. If the tax rate is the same at both times, this will always be true -- you can prove it with some algebra. But for most people, the tax rate is not the same at both times. Most people have higher income when they are working and putting money in to a retirement fund than they have when they are retired and taking money out, and so their income tax rate is higher when they put in then when they take out. In this case, a traditional retirement fund is better.
A young person with his first job usually has low income and a low tax rate. A person at that point in his life is probably better off to invest in a Roth plan, and then switch to a traditional retirement fund when his tax rate passes what he will pay in retirement. The trick, of course, is knowing just how much that is.
I once discussed this with a man who said that people should be saving enough when they're working that their income will be higher when they retire than it is when they're working, and so Roth is better. If you're really saving that much, good for you, and yes, in that case Roth would be better. But very few people manage to do that.
© 2024 by Jay Johansen
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