The road to riches or dangerous game of chance?

Business - April 16th, 2004

by Jim Dougherty

Over the last few decades, interest in the stock mar­ket has grown exponen­tially. What was once an elite game for the rich is now a popu­lar vehicle for the average person to grow their wealth.

Advances in trading technol­ogy have opened up the markets so that today nearly anyone can own stocks. Despite their popu­larity, stocks are not fully under­stood by most people.

Much is learned from con­versations with other people who don’t know what they’re talking about. Many people think buying and selling stocks is a no-risk method to make instant wealth. Stocks can create massive amounts of wealth, but not with­out risks. The only real solution to this enigma is education.

Stock means ownership. As an owner, you have claim to the assets and earnings of a company, as well as voting rights. Stock is equity, and bonds are debt. Bondholders are guaranteed a return on their investment and have a higher claim than share­holders. This is generally why stocks are considered riskier investments and require a higher rate of return.

You can lose all of your investment with stocks. The flip side is that you can make a lot of money — if you invest in the right company.

Stock markets are places where buyers and sellers of stock meet to trade. Stock prices change according to supply and demand. There are many factors influencing prices, the most important being earnings.

There is no consensus as to why stock prices move the way they do. To buy stocks you can either use brokerage or a divi­dend reinvestment plan (DRIP). To set up a DRIP, contact the Investor Relations Office of your target company.

There are two main types of stocks: common stock and pre­ferred stock.

Common stock: When peo­ple talk about stocks, they are most likely referring to common shares. Common shares repre­sent ownership in a company and claim (dividends) to a portion of profits. Investors get one vote per share to elect the board members who oversee the major decisions made by management.

Over the long term, com­mon stock, by means of capital growth, yields higher returns than almost every other invest­ment. This higher return comes at a cost since common stocks entail the most risk.

If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bond­holders and preferred sharehold­ers are paid.

Preferred stock: With pre­ferred shares, investors are usual­ly guaranteed fixed dividends. This is different than common stock which has variable divi­dends that are never guaranteed. Another advantage is that, in the event of liquidation, preferred shareholders are paid off before the common shareholder.

Preferred stock may also be callable, meaning the company has the option to purchase the shares from shareholders at any time for any reason (usually for a premium price).

Price movement: The price movement of a stock indicates what investors feel a company is worth. Don’t equate a company’s value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding.

The most common method to buy stocks is to use brokerage. There are two basic types of bro­kerage. Full-service brokerages offer you (theoretically) expert advice and can manage your account but also charge big com­missions. Discount brokerages offer little in the way of personal attention but are much less expensive.

Key points to remember:

  1. Brokers make money when you buy and sell stocks (commis­sions). Keep this in mind when a broker suggests you buy a stock; the broker always makes money on the transaction with no risk. You take all the risk but don’t always make money.
  2. Until you actually sell your stocks, your profit or loss is only a numerical figure listed on a brokerage statement (“paper profit” or “paper loss”). Most people tend to hold stock for the long term, but pay attention to the brokers and dealers. They buy and sell as the market yields prof­its and quickly escape from stocks dropping in value.
  3. You can also sell stocks instead of just buying them. This is called “selling short.” In essence, you sell the stock up front in expectation the price will drop. It sounds complicated and it is, but most professionals make millions using this tactic to grab profits when a market is dropping.
  4. At the most fundamental level, supply and demand in the market determine stock price.
  5. Price times the number of shares outstanding (market capi­talization) is the value of a com­pany. Comparing just the share price of two companies is mean­ingless.
  6. Theoretically, earnings are what affect investors’ valuation of a company, but there are other indicators investors use to pre­dict stock price. Actually, it is investors’ sentiments, attitudes and expectations that ultimately affect stock prices.
  7. There are many theories that try to explain the way stock prices move the way they do. Unfortunately, there is no one theory that can explain every­thing.

There are several different prices:

Opening price is the first price paid after trading starts, usually when the stock exchange “opens its trading doors” in the morning.

Closing price is the price of a stock when the market closes — the price “at the close.”

Ask price is the price you will pay for a stock (and is slightly more than the trading price because it includes a dealer com­mission).

Bid price is what the broker or agent will buy your stock for (and is slightly less than the trad­ing price because it includes a dealer commission).

Spread is the difference between the bid price and the ask price.

IPO (initial public offering) is the first sale of a stock which is issued by the private company itself. It is important you under­stand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaran­teed the return of your money (the principal) along with prom­ised interest payments. This is not the case with an equity investment.

Cardinal rule: “Bulls” (buyers of stocks) make money and “bears” (sellers of stocks) make money, but pigs get slaughtered!