What is Investing

Being an analytical person, I always struggle with needing to understand the fundamentals of what I’m doing or learning.  I’ve found that understanding the fundamentals makes it so much easier to expand on them for more complex applications.  For example, I keep blowing the fuse for the blinkers in my car (that’s the turn signal for the people that don’t live in Wisconsin). I know nothing about electricity and, as a result, am hopeless at diagnosing this problem.  I also remember studying for a Probability Theory exam in college and questioning the very existence of numbers.  How am I supposed to solve hypergeometric probability distributions if I’m not even sure numbers are real? As it turns out, numbers are real and there is proof! This is one of my favorite things about mathematics and why I minored in actuarial mathematics in college. I ended up not pursuing that career path, mostly because the proofs started to get a little ridiculous and beyond my grasp. They looked a little something like this:

 

 

 

 

 

 

 

 

 

 

 

 

This is a real picture from my notebook, something I actually understood at one point. Now, I couldn’t tell you if I even completed copying this proof from the textbook.

Working in personal finance now, I don’t need to know Tchebyshev’s Theorem or how electricity works, but it does help to know how investing works.  You’ve no doubt heard from financial gurus online or on the radio telling you that you need to start investing. But what even is investing? What’s the difference between a stock and a bond? What are the risks? How do I do it? When should I start? I can’t have all the answers in a single blog post, but I can help to lay the foundation, so you can make better sense of what all this means.

What is a stock?

A security is a financial instrument that has some type of monetary value. A stock is a type of security that represents a share in the ownership of a company. For a publicly traded company, this stock can be traded on an exchange for a defined price, set by the market. Ownership of this security comes with certain rights. For the common investor, the main rights include voting rights, ownership of the company, the right to sell your share of the company, and a claim to some of the company’s profits.

Voting rights are often not a concern of most individual investors but it is their right, nonetheless.  For individuals owning a fraction of a percentage of the entire company and likely owning multiple different companies, perhaps even hundreds of companies, staying up to date on the ins and outs of the proceedings of the annual shareholder meetings and knowing enough about the issue to have an informed decision is unlikely. Look at the percentage of Americans who vote for government elections. Now imagine you have to vote for 100 different governments each year.  Hard to keep track of. This could change however if you happen to own a significant percentage of a company where your opinion could hold some weight.

Growth or Income… or Both?

In my eyes, there are two main reasons to invest: producing income or growth. The next two shareholder rights detail these two options.

Growth is likely what people think of when deciding whether to invest. I’m sure you’ve heard of concepts like compound interest, time value of money, etc.  You buy a stock, the price goes up, you sell it. Buy low, sell high. Sounds pretty easy. Well, the reality is that the majority of people do the exact opposite because we are irrational creatures that have many biases and emotions, especially tied to our money. 

Taking a step back, why/how could the stock price go up? There is an enormous number of factors but to sum them all up, the company does well.  Going back to Economics 101, this would increase demand for this company as more people want to buy shares of the successful company.  This increased demand would increase the share price, assuming a fixed supply (the company didn’t issue more shares).  This supply and demand rebalancing act occurs continuously with millions of investors trading all the time which makes the market fairly efficient.

One question I asked myself when I first learned about this was why does the company care if the stock price goes up? They already sold their shares and raised all the capital at the initial public offering (IPO) and now these shares are being traded in the secondary market among individual investors.  The company doesn’t directly benefit from this trading.  The answer is that a company wouldn’t issue all of its shares in the IPO.  These unissued shares can be issued later to raise more capital if necessary. If the price goes up, the company could raise more capital than if the price stayed flat.  Many companies also give employees, especially executives, stock options as part of their compensation package. This way the employees are invested in the company’s growth and success.

If the stock price falls, then the company faces many risks including being bought out by another company, lending drying up, not being able to raise as much capital through issuing new shares, poor publicity which could harm revenue, etc.

Income is the lesser known reason for owning stocks. Some companies are called “blue-chip” companies, meaning they are very well established in the market, industry leaders, earning steady profits.  Once a company becomes well established, it might want to return some of its profits to its shareholders. They are the people who helped get them there after all.  Here is a screenshot from some notes I took on my tablet a while back detailing what a company can do with their free cash flow (FCF).

FCF’s two main functions align with the investors two main objectives: Growth or income. The growth-oriented company allocates most, or all, of the FCF to acquiring other business or reinvesting in itself to spur further growth.  A “blue-chip” company competes on a slightly different plane. Perhaps an established company with consistent earnings doesn’t need to reinvest in itself like it did while it was still a growing company. Another way to foster growth is through dividends, which is a slightly different value add to investors than capital appreciation. Paying a dividend consistently shows the strength of the company. The investor claims this cash dividend as ordinary income. After all, this is technically earnings from a company they own.  When these dividends in your portfolio become large enough to live off, perhaps you could even quit working 40+ hours/week. I call this “retirement”.

What about the risks?

None of this comes without risks.  It’s important to understand your risk tolerance and investment time horizon to come up with the right allocation of your funds. If you’re 25 and want to retire at 65, you’ve got 40 years to invest and can afford to take more risk. However, if the stock market scares you and you pull your money out every time the stock price falls, you’re doing the exact opposite of the golden rule of investing: buy low, sell high. Perhaps you should be investing in something more conservative that will ease your stress and allow you to stick with your investment plan. This is a list of many of the risks associated with investing to help define what risks you are facing.

  • Market Risk – The risk of your investment declining in value
  • Liquidity Risk – The risk of not being able to readily sell your investment for its fair market value. This is not a risk for most publicly traded companies thanks to our nations efficient stock exchanges.
  • Specific Risk – The risk of having all your eggs in one basket. Diversification is an investment buzz word that can help mitigate this risk.
  • Inflation Risk – The risk that your investment will not keep up with inflation. The whole purpose of investing is to grow your money to outpace inflation. I view this more as a risk of not investing or investing with the wrong allocation (if your objective is growth).
  • Behavior Risk – The risk that your emotions get the best of you and buy or sell at the wrong time.
  • Horizon Risk – The risk that an unforeseen event will cause you to need to sell an investment prematurely, at an inopportune time. 
  • Legislative Risk – The risk that a government will change policy that can negatively affect a certain business model.

It is important to consider the risks and rewards of any investment and the purpose it has in an overall financial strategy to achieve the things that are truly important to you.  A larger balance in your investment account doesn’t mean anything for you at the end of the day. It’s all about what that balance does for you. One exercise I do with my clients, and one that I would challenge you to do yourself, is to clearly define what those things are and why.  Don’t chase other people’s goals or the goals you think you’re supposed to have. Use your investments as a tool to achieve what you want to accomplish with the brief time you have here on this planet.


 

 

This material is provided for education purposes only and should not be construed as investment advice or an offer to sell or the solicitation of offers to buy any security. It is not intended to recommend any securities or retirement accounts. Opinions expressed herein are current opinions as of the date appearing in this material only.

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