According to Investopedia; a stock is a form of security that indicates the holder has proportionate ownership in the issuing corporation. In simple terms, a stock represent a piece of business.
When you buy a stock, you are buying into a business.
Units of stocks are called shares.
Companies usually sell shares of stocks if they want to raise money to grow or develop their business. Stocks are bought and sold predominantly on stock exchanges and are the foundation of many individual investors’ portfolio.
Investors purchase stocks for numerous reasons which can include;
- Wealth building, which occurs when a stock rises in price
- Dividend payments, which come when the company distributes some of its earnings to stockholders
- Beating inflation
- Ability to vote shares and influence the company
Types of Stocks
There are 2 main types of stocks – common and preferred stocks.
- Common Stock: This can easily be bought on the stock exchange and gives owners the ability to vote at shareholder meetings and receive dividends.
- Preferred Stock: This pays out dividend more quickly (than common stocks) but don’t usually give stockholders voting rights. The special thing about this type of stock is that they have priority over common stock holders if the company goes bankrupt and its assets are liquidated.
As a retail investor, you will most likely be purchasing common stocks in the stock market.
Categories of Stocks
There are multiple ways of categorising stocks, one common way is dependent on how the stock behaves. They include;
- Growth stocks which have earnings growing at a faster rate than the market average. They rarely pay dividends and investors buy them in the hope of capital appreciation. A start-up technology company (e.g Snapchat, Facebook etc) is likely to be a growth stock.
- Income stocks pay dividends consistently. Investors buy them for the income they generate. An established company (e.g Coca Cola, Microsoft) is likely to be an income stock.
- Value stocks have a low price-to-earnings (PE) ratio, meaning they are cheaper to buy than stocks with a higher PE. Value stocks may be growth or income stocks, and their low PE ratio may reflect the fact that they have fallen out of favor with investors for some reason. People buy value stocks in the hope that the market has overreacted and that the stock’s price will rebound.
- Blue-chip stocks are shares in large, well-known companies with a solid history of growth. They generally pay dividends.
Stocks can also be categorised based on the characteristics of a company or industry sector, and include:
- Basic materials: Companies using natural resources
- Conglomerates: Global companies that may cover different industries
- Consumer goods: Companies providing retail goods to the public
- Financial: Banks, insurance providers and real estate companies
- Healthcare: Healthcare providers, health insurance, medical equipment suppliers and companies that sell medicines
- Industrial goods: Companies manufacturing products or goods
- Technology: Companies selling computers, software and telecommunication products
- Utilities: Companies providing electricity, water and gas
Another way to categorize stocks is by the size of the company, as shown in its market capitalization. There are large-cap, mid-cap, and small-cap stocks. Shares in very small companies are sometimes called “microcap” stocks. The very lowest priced stocks are known as “penny stocks.” These companies may have little or no earnings. Penny stocks do not pay dividends and are highly speculative.
Your investing strategy will inform the category of stocks you would choose for your portfolio. Typically, one should have a mixture of the different categories of stocks to stay diversified (reduce risk) and meet projected investing goals.
Example, if you are looking to make extra income, adding a dividend stock to your portfolio might be the right move for you. If you are looking to grow your money in a short period of time (say 2-5 years), growth stocks might be a better add.
How Do Stocks Work?
Companies typically sell their stocks on the stock exchange to generate capital, which they use to grow or develop their business.
Stock prices rise or fall depending on the company’s performance. It is also worth knowing that supply and demand drive the prices of stock; the more people are selling the same types of stock, the lower the price. Similarly, the more people are buying, the higher the price.
This is why it is not advisable to buy stocks based on popular opinion.
Iterating one of Warren Buffet’s favourite quotes on investing;
“Be fearful when others are greedy and be greedy when others are fearful.”
Investors make a profit with stock investing when the stocks grows in price. This usually happens when the company performs well over time. This is why you must do your due diligence and understand the fundamentals of said company before buying the stock.
The risk with stocks come in when the company doesn’t perform well. This can lead to share price dropping and your portfolio losing a lot of value.
At this point, you must not panic and it’s normal for stocks to rise and fall in the short term. You must remind yourself of your investing goals and have a long term horizon.
Another way to make money from stock investing is through dividends. They are usually paid out quarterly on a per share basis from the company’s earnings
What To Consider When Buying Stocks
Before buying a stock, it is important to do your due diligence as you do not want to lose your hard earned. Your goal should be finding businesses with good long term prospects. What do they manufacture? What kind of service do they offer? In what countries do they operate? What is their flagship product and how is it selling? Are they known as the leader in their field?
As I earlier said, buying a stock is simply buying a piece of that business. You should aim to understand the ins and outs of said business, analyse the business fundamentals and check if it fits into your investing strategy. Are you investing for the long term or short term?
Your risk tolerance is another factor to consider. This is the amount of financial exposure you’re willing to take in relation to the expected profit or returns you will make in an investment. The higher the risk, the higher the reward and vice versa.
Here’s a risk calculator tool to help you understand your risk tolerance.
Finally, you need to understand fees and taxes. Most investment platforms will charge a fee for you to use them. I prefer platforms that offer fixed fees like Freetrade and Interactive Investor versus the ones that charge percentage based fees. This is because with fixed fee, you are sure of the amount you’re paying per time. With percentage based fees, as your contributions and returns increase, your fees also increases
On the long term, these fees pile up and can affect how much return you make.
In the UK, investment returns are taxed because they are seen as income. This is why it’s advisable to use an Investment and Savings Account (ISA) to buy stocks, as they are tax free up to 20k.
If you invest in a Lifetime ISA (LISA), the government adds an extra 1k to your 4k.
Should you invest in an ETF instead?
Yes, investing in stocks is a great ways to build wealth but they come with a lot of risk.
According to experts, to be successful in stock investing, you’ll have to be diversified across at least 30 stocks. This is because as a retail investors you do not have the resources, bandwidth and quite frankly the time to deep dive into the millions of businesses out there.
This is where Exchange Traded Funds (ETFs) come in.
They are basically like basket full of different stocks. They are lower risk investments and help reduce your risk exposure because they are diversified across different businesses inside the fund.
If one stock is performing well, another could be performing poorly and therefore balance each other out.
Example, $QQQ is an ETF that trades on the Nasdaq exchange. This ETF offers broad exposure to the tech sector by tracking the Nasdaq 100 Index, which consists of the 100 largest and most actively traded non-financial stocks on the Nasdaq. It contains Apple, Microsoft, Nvidia and 97 other stocks, Instead of just investing in Apple, you are now diversified across 100 other businesses.
I believe that index funds should be the basis of every retail investor’s portfolio. As you make more money and become more knowledgeable, you can now take on more risk by investing in other assets.
If you want to find out more about how you can use ETFs to build wealth and live your best financial life, visit my website.
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