Hey there accounting fans!
Following on from our beginner’s overview to investments – let’s take a look at how the stock market works and what sort of options are available for those of us regular-type individuals who want to invest in the stock market.
Now, before we go on any further, I would like to put up a disclaimer that I am not giving any hot stock tips nor am I giving any specific investment advice – I am merely giving you, my dear reader, some general information about investing which I hope will be able to assist you in making wise investment decisions based on your personal financial situation.
With that out of the way, let’s get started!
What are stocks/shares?
Let’s start off with this question.
Ok, so you remember equity right? Equity represents the owner’s investment into the business. In other words, a share represents a partial ownership of the company. In high-highfalutin financial speak, we sometimes call them (financial) assets and/or securities.
So when you buy a ‘share’ in a company, you are effectively buying partial ownership of that company.
So this means if you bought 100 shares of Apple Inc. – you would own 100 shares of Apple out of the gajillion (a valid financial term) shares they have out on the market. Your ownership would be a drop in the ocean so to speak, but you would be a part owner nonetheless!
What is the stock market?
The stock market is a market where stocks in publicly traded companies are listed for sale.
Think of the stock market like any regular market you would go to. Let’s say you jumped on TradeMe/Ebay/Lazada/AliExpress/your favorite online shopping store and are browsing through a selection of goods to purchase. The stock market works the same way.
You can jump online and view the prices of stocks, the description of the company they belong to and their performance (return on investment) over time. If you find a share that you like which is selling at a good price – you can buy it! Hooray!
You can also sell shares on the stock market (which is how some people make money on the stock market) based on its current price.
You see, unlike your favorite online shopping store, prices on the stock market are not determined by the individual sellers – rather they are a representation of the general level of demand associated with any one share. In other words, share prices are priced by the market, not by you as an individual.
Stock markets are also known as stock exchanges and some stock markets around the world include the ASX (Australian Stock Exchange) the NZX (NZ Stock Exchange), KLSE (KL Stock Exchange), NYSE (New York Stock Exchange) etc etc etc.
Why do companies list their shares on the stock market?
That’s a good question!
So let’s imagine for a moment that your little business has grown exponentially and you find yourself with some GRAND plans for capitalistic world domination but you realise that you need some additional funds to make that happen.
You look at your own personal funds and realise that you only have $1 mil to spare (wishful thinking – but we’ll get there one day!). $1 mil isn’t going to cut it for world domination! So you then look for other sources of finance. A company your size has options – but we won’t look at all of them, we’ll just say that you decide on selling shares in the company to raise additional capital (because it’s often the easiest and cheapest option – but that’s a topic for a different day).
And so, your company, You Ltd, issues 10,000,000 shares as part of an Initial Public Offering (IPO) at $1 per share (for example) to the share market in general and a slew of buying and selling happens until the market settles on an appropriate price for You Ltd shares at market closing time.
Either way, you will have successfully raised a cool $10,000,000 (in theory*) from selling shares in your company!
*In reality, IPOs are more complex and some form of underwriting by the investment bank handling the IPO will guarantee some buyback/compensation for non purchased shares. And let’s not even get started on oversubscribed shares. So we’ll leave it at that for the moment.
Cool! How can I invest in the share market?
Glad you asked!
As an individual there are two ways you can invest in the stock market:
- By purchasing individual shares.
As an individual you can invest in the stock market by opening up an account with a broker. This can be a bank, an organisation or a qualified individual in your country. In NZ, we can buy shares through the banks and online platforms (like Sharesies).
Purchasing individual shares is easy. You simply choose a share and purchase it through your broker. Then it gets added to your account. Then you spend the rest of your living days rejoicing as the price goes up and losing sleep when it goes down! Hooray! Also you get to stress out about if you made the right decision in buying the share at the price you did.
You can also sell the shares you bought through your broker, if you feel its price is dropping or if you want to make a capital gain (more on this later).
- By investing in a managed fund
So, most of us don’t have the time/energy to watch individual stocks go up and down every week, so some finance-y types have set up what are known as managed funds. Managed fund managers pool together money from many different individual investors and invest that money in the stock market using awesome financial trading strategies that they’ve learned in their expensive University education.
The theory goes that since they are the experts – you give them your money and trust them to do the investing for you. And they get a cut of whatever gains you make on the share market.
Managed funds have become more sophisticated over the years and these days you’ll find that they come in one of two flavors:
- Actively managed funds
- Passively managed funds
Actively managed funds – as the name implies are ‘actively’ managed by a finance manager with an expensive University education (and an equally expensive student loan) who will ‘actively’ select the best trades for the money you have given them.
Passively managed funds are managed by Artificial Intelligence (AI) that makes trades based on the movements of the particular index (an aggregate of shares from certain companies/markets) or exchange (the entire stock market of a country/region).
Either way – both options have been proven to give you, the investor the same amount of returns over a ten-year period. Generally speaking passively managed funds are cheaper than actively managed funds – simply because AI’s don’t have student loans to pay off (and various other expenses that humans can’t live without).
How do I make money off the stock market?
Err… It depends on who you’re asking. There are hundreds of ‘stock market’ gurus out there and many of them will have different ideas on how to do this. But if you’re boring like me – I like chucking money into a passive Index Fund or Exchange Fund (ETF) and wait the 10 to 20 years it takes for my money to grow. I won’t write too much about this as smarter and more well-educated individuals have written about this subject matter extensively. (just search ‘passive ETF *your country name*’ online and you’ll see what I mean).
You can also purchase individual shares and you can then make money via:
- Dividends (bear in mind that not ALL companies pay dividends) – which is a form of profit sharing.
- Capital gains – buying selling off your shares at a higher price than what you bought them.
There are merits to both investing in funds and purchasing individual shares. Generally speaking, if you don’t have much time and/or the financial acumen to analyse shares – managed funds are better for you. If you have the time and the energy to learn how to analyse shares and spot good deals – then buying individual shares are better for you.
And that being said, there’s nothing wrong with doing both! It really depends on what your individual financial situation is and your risk appetite :D.
How do I get started?
The easiest way to get started is to contact your broker or sign up with an online trading service (Google ‘online share trading service *your country*) if you want to purchase individual shares.
If you are looking to invest in managed active funds, google ‘Mutual investment funds *your country*’.
If you are looking for passively managed funds, google ‘ETFs *your country*’
If you are NZ based – I personally use Smartshares/Superlife for my ETF needs as they are owned by the NZ stock exchange, which grants them a bit more stability and reliability in my opinion. Simplicity is also another good passively managed fund which has the lowest management fees of all funds in NZ.
We’re in the middle of a global recession – is it a good time to buy stocks?
That’s a hard one!
In my opinion, the global economy is set for a massive slowdown, yet stock prices globally are skyrocketing. Any financial expert worth their salt will tell you that shares right now, are overpriced – which is to say, they are being sold for far more than what they are actually worth, based on their business’ performance.
When shares are overpriced, it tells us that eventually these prices will come crashing down in the not-too-far-future. Unless you know the specific share that you want to buy and have been monitoring their performance and have done the numbers to know it’s not overpriced, it’s probably not a good time to buy individual shares. As the experts will say – it’s a good time to wait and see. Choose companies that you are interested in buying and watch until their price drops to a level which you think is worth it.
That being said, you can still put money into a managed fund and let them make all the hard investment decisions for you, which reduces your risk exposure somewhat. Plus, over the long run, managed funds (passive or active) will generally make you your money back, and then some more.
In Conclusion!
The share market is a tricky place to put your money, but fortunately, there is a lot of expert advice and trusted financial institutions you can make use of to better educate yourself about the stock market.
Please don’t start investing straight away after reading this article. Do a little bit of your own research into investing in the stock market, be it through managed funds or through individual stock purchases.
As a side note: Be very, VERY careful about accepting hot stock tips from any source (even Jerry – your super slick investor brother-in-law). Do your own research, make your own analysis and listen to a wide variety of opinions. And most importantly:
Never invest in anything you don’t understand.
Quite possibly Warren Buffet
Stay smart dear reader, and always,
Stay positive!