Mon. Oct 26th, 2020

How Does Stock Investing Work?

If you had caught Microsoft at twenty bucks a share just a year after the 2008 financial crisis and had the distinct foresight to ride the longest bull market till date, you would’ve made a decent killing. Well, it’s a hypothetical scenario and should no way be the compelling reason for you to trade or invest in stocks. But situations like that do happen and those who have the fortitude to take on the risk at that point in the market’s cycle reap the reward.

However, to someone starting out, the whole Microsoft example may seem completely baffling which is understandable for stocks can be a tricky topic to discuss. This article will answer the question: how does stock investing work? The other topics include the types of stock, brokers, types of analysis for stock trading and an overview of strategies.

The evolution stocks


It’s funny how the stock market had evolved with such formality even though unceremonious profit sharing from ship voyages centuries ago described its very roots. It’s unfathomable how it transitioned to a very restrictive, organized, and technologically interwoven exchange when it used to be just some deal-making done beneath a buttonwood tree.

Stocks today are relentlessly studied, countless research is conducted, businesses are scrutinized, market sentiment is carefully analyzed, and price movements and its patterns are followed. For you to keep track of stocks unprofessionally can be an arduous task, but some concepts can be simplified.

Trading and Investing


Start by understanding the difference between investing and trading. When talking about investing, refer to the word long-term and by long-term, think years.

The best friend of investing (in a good stock) is time which, coincidentally, is also its archenemy (in a bad stock). Time allows your investment to grow or your stock to appreciate in value because the company you’ve invested in also requires time to improve its business. If you were misfortunate enough to have put money with an unprofitable and inherently lousy corporation, time would make things worse.

On the other end, in trading, it’s about timing — catching the right move, or entering and exiting at the right price.

What are stocks?


So, if you’re hanging in there, the next topic is what stocks are all about.

The crudest way to define stocks is it’s a way for acquiring the rights to the profits of a company. A business needs to make profits, right? So, if you bought Apple Inc.’s stock, for example, you basically purchased a claim to their income after discounting all the expenses. And, who has the rights to the profits of Apple? The owners. So, what does that make you? Yes, a part owner of Apple.

Nevertheless, you can’t barge in one of Apple’s stores and start claiming to have dibs on all the iPhones and iPads. Like what’s mentioned earlier, it’s a formal process. You get your piece of the pie once the board of directors (the people that ensure the firm’s management acts in the best interest of the shareholders) decide to issue dividends (a portion of the company’s earnings).

Why do companies want to share their profits?


If you can have all the money that your business earns, why share it right? For charity? No. Companies sometimes require more capital to expand, finance projects, a different method for compensating employees, or some other reason.

This new capital will either come in the form of liability or equity (stocks). If a company chooses to finance with equity, the current shareholders will have to dilute their ownership; a percentage of the company will be “floated” in the markets and will be available to retail investors. The process of offering company shares to outside parties is called “going public.”

Here’s a rudimental explanation of how it works: If owners control 100% of the company initially, but they went public by floating 25% of their shares, then that means they now have a 75% claim on the company. The benefit of this is the stocks they sold brought in the cash they needed, and their remaining shares have the potential to increase in value which they can sell later on.

Common and Preferred Shares


Now, a stock mainly has two types: common and preferred. The difference between the two is voting rights and preference for dividends. Voting powers tilt to the favor of common stocks while dividends to the preferred.

When it comes to risk, the common stock carries a buttload of it, but that’s redressed with voting privileges which can be used to elect members of the board or for voting on certain company decisions.

On the other hand, preferred shares are similar to liabilities (like a bank loan that you have to pay interest regularly) of the company because come dividend payment time they are ahead of the common shares. Moreover, the company’s income distribution to preferred stockholders continues in perpetuity with a claim on unpaid dividends if the preferred stocks are cumulative.

On the flip side, common shares don’t have the same command for demanding dividends like the preferred.

The function of a stockbroker


A stockbroker functions like a facilitator — the connector of one person’s trade to another. Assume that you want to be an Apple Inc. stockholder. So, for you to be one, you need someone willing to part ways with his/her Apple stock so that you can buy it. Your broker’s job is to connect you to that seller.

If you still picture the scene from The Wolf of Wall Street movie where a broker calls you to purchase a stock is pretty much passé. That type of broker still exists though, but what’s predominant now are online brokerages or simply trading or investing done through an online trading application.

Some accounts can be activated with relative ease, but do exercise caution when dealing with anything you find online because, as you know, the internet is not exclusively run by honest people.

How to earn money from investing in stocks?


Go back to the scenario where you have bought stocks of Apple from a seller through your broker.

The first way for you to earn money from investing in stocks is through capital gains:

If you bought 1000 shares at $190 a share, for example, and, over time, because the business did well, it reached a $220 a share price tag. Once you’re convinced that selling your shares back to the market (buyer hunting) is the optimum way to go, then you could clean up a profit of $30,000 (15.8% gain), before taxes and other fees.

The second way is through dividends:

Companies that do well and make profits consistently can pay their investors a dividend. They can declare a specific amount that each share will receive — recently, it’s $0.73. Therefore, if you have a thousand shares, you’d get $730.

Do note that you can’t control the dividends you’ll receive because, again, that’s decided by the board. Also, some companies choose not to issue dividends but instead they reinvest corporate profits back to the company. Nonetheless, dividends provide an excellent way for you to earn something on the side. Also, dividends can take in the shape of new shares, not just cash.

What’s the strategy?


There are two schools of thought that you can weigh up to pick out a great stock to buy: technical analysis or fundamental analysis.

Technical Analysis is concerned with the price action of stocks, so technical analysts keep track of it by plotting them on charts. Conversely, the fundamental analysts make use of annual reports and other pertinent data concerning the performance of a company to figure out if the prospective stock is a worthwhile investment.

Both methods have their own merits and demerits and certainly works just as well as the other. It just depends on the investor to select a suitable one.


Summary

Investing in stocks grants you the opportunity to become a part-owner of a company.

Companies offer shares to the investing public because they require an injection of new capital to finance various purposes.

Stocks generally have two types: common and preferred.

Brokers serve as your link to the stock market for finding either buyers or sellers.

You can start investing in the companies you know through opening an online trading account.

There are two ways for you to earn money from stocks: capital gains and dividends.

There are also two types of analysis: fundamental and technical analysis.


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