The Covid-19 pandemic was a strange time for the stock market. You probably heard about it. Maybe you even bought a few stocks yourself. The years since lockdowns sequestered billions of people in their homes with little else to do has seen a massive boom in interest in passive income and investing strategy. “Meme stocks” and the online forums that fed interest in them made headline news. Companies like AMC and GameStop became international best sellers, often for baffling reasons. Well, if you don’t know what all the fuss is about, but are too afraid to ask, let this post be your resource for learning about the world of stock investing. We’ll cover some basic questions about the stock market, from what a stock is, to how to choose the right stocks for you. So sit down, strap in, and step carefully: this is Why Invest in Stocks.
What Even Is a Stock?
Virtually every daily news report on TV, radio, or via MorningBrew email has a blurb on “stocks and bonds.” And they usually go something like this:
“Stocks took a tumble today, with the NASDAQ closing down 50 points, the DOW down 5, as investors feared a rise in interest rates. S&P weathered the storm, dropping just 3. Bonds rallied in anticipation of the FED announcing a 100 basis point rise in rates.”
Does that sound like little more than complicated airflow? That’s alright. You aren’t alone. Despite the fact that public education rarely covers finance in any kind of depth, we’re expected to learn and understand what stocks are in order to navigate the world. Our failure to know and understand these terms can, and indeed does, lead to us missing out on many of the potential opportunities that stock investing can offer us.
So let’s break it down:
“Stocks took a tumble today” : Stock prices fell. Stocks are shares in a publicly traded company, such as Apple, Spotify, or General Motors. These public companies trade their stocks in one or several stock exchanges: places where stocks can be traded. Stocks are a share in the ownership of a company. But they can also infer certain rights: particularly the right to vote in shareholder elections, which choose the board of directors for a company. Shareholders also have the right to receive specific performance reports from the company board. And to receive dividends, or shares of the profits of a company. Ultimately, even the CEO of a public company is answerable to shareholders.
“NASDAQ” : The NASDAQ, standing for National Association of Securities Dealers Automated Quotations, is one “market” among the many similar “markets”. They together make up the stock market generally. Others include the NYSE (New York Securities Exchange), the LSE (London stock exchange), and the Nikkei, a major Japanese stock market.
Centuries ago, up until about the 1970s, these “markets,” were literal places where stock brokers (the people who buy and sell stocks on behalf of the customers) would actually go and look for someone to buy their clients’ stock, or to sell stock on behalf of clients. One of the first such markets was started in a coffee house in London, called Lloyd’s. Lloyd’s of London traded mainly in shares of shipping contracts, and it was here that investors from London were able to invest in or buy insurance for expeditions to places like India and North America. Today stock markets are highly automated data centers where trading computers interface with banks and stock brokerages, and millions of trades pass through these systems every minute.
“Down 50 points” : the average of all the prices on the exchange has dropped by $50. If you owned one of every stock listed on this exchange, you would have lost $50 in value on that day.
“The DOW Down 5” : The DOW is not a stock market. It stands for the “Dow Jones Industrial Average.” It’s a group of 30 highly traded stocks which are meant to be representative of the overall market. By looking at this curated list of stocks, investors are supposed to be able to see how the market is doing as a whole. The problem of looking at the average of ALL stocks on the exchange is obvious if you think about it. One stock crashing in price can cause the whole market to appear to be going down. If all stocks but one stay at the same level, and one stock drops 100 points, then the market can be said to be “down 100.” But in actuality, this drop only affected one company. Therefore investors use these averages as a way to represent the most commonly owned stocks that are more likely to behave the way that the whole market behaves over time.
“S&P weathered the storm” : S&P, or Standard and Poor’s, is a stock index. It is a list of 500 publicly traded companies which are curated to provide investors with a safe, stable mix of investments. Importantly, indexes like S&P are used by investment funds to make investing decisions. In order to get into the list, companies must achieve a certain level of performance, and fulfill a number of criteria in regard to how they are managed. If a company fails to live up to its expectations, it may be removed from the index, causing mutual funds and individual investors to sell the stock. On the other hand, being included in the list gives companies access to a huge pool of investors.
“Bonds rallied” : Bonds, often seen as the “other half” of the financial market, are different from stocks in key ways. For one thing, a bond is not a share of ownership in a company. Instead, a bond is most simply understood as a debt instrument, which a company (or government) can issue for sale. If you buy this instrument, you are lending your money to the company that issued the bond (or buying the debt from someone else), and are agreeing to take the risk that you may lose this money if the company defaults, or fails to pay. However, in exchange for this risk, you receive a payment expressed by the “bond yield,” the percentage of the principal amount the bond pays to the holder until it is “due,” or has to be repaid in full. When bond prices change, this reflects the investor sentiment as to how likely it is for the company or government to pay back these bonds.
Stocks and Bonds
“FED announcing a 100 basis points rise in rates” : Generally bond yield is expressed in “basis points,” with one basis point equal to 1/100th of 1%. Thus, a bond yield of 3.9% can be said to be “100 basis points lower,” than a yield of 4%.
The FED stands for the federal reserve bank, essentially the central bank for the United States. This bank, unlike all others, can effectively create or destroy money, by issuing or repaying bonds. These bonds, when issued, are used by the FED to collect investor money. When the FED wants to increase the supply of money in the banking system, it pays back bonds it has issued at the face value of the bond. When it wants to remove money from the financial system, it issues bonds with a specific yield.
So if the FED is going to do a “100 basis points rise in rates,” this means in effect that the FED will now issue bonds worth 0.1% more in interest than the bonds they currently offer. This will cause investors to be more willing to buy those bonds, thus removing money from the financial system. If however the FED wants to “lower rates,” then it will start buying bonds that are paying out a higher interest rate, and substituting lower interest bonds in their place, causing more investors to get out of FED bonds and back into the public market.
Generally if a bond from a private company is paying a higher interest rate than a FED bond, it will be more attractive to investors. However, a FED bond is guaranteed to always be paid back, unlike a bond from a company. Therefore, bonds must offer a slightly higher interest rate, or must be sold at slightly below the face value of the bond in order to attract buyers. The rate at which bonds are trading and the interest rates they offer is an indicator of the health of the economy. If bonds are trading well below their value, or interest rates have to be high in order to attract investors, this is a sign of lack of confidence from investors.
As we discussed in previous post, the FED can use bond rates to control the supply of money, affecting the banking system generally.
In general, if bond yields are going up, meaning investors can make more money by holding bonds, then the prices of stocks will go down, because stocks must be sold in order to free up money to buy bonds. However, the supply of money has a complicated relationship with the prices of stocks.
Anytime we expect stock prices to react in a specific way, there is always the possibility that this knowledge will end up changing the outcome. If everyone expects stock prices to drop, for example, then more investors may bet against stocks. If more investors bet against stocks, and they don’t drop, then this can actually cause their prices to rise, because of a complicated area of stock investing called derivatives, which we won’t discuss in depth today.
Suffice to say; predicting the stock market is something not even the most advanced supercomputers can do, and this is partly because some of the world’s most advanced supercomputers are already trying to do it. If you’re betting on stocks, you’re also betting against the best minds programming the best computers available. So the best policy is to be conservative; follow the basic tenets of all investing: slow and steady.
Why Invest in Stocks?
Investing in stocks is not just about gambling on a stock’s price. That can be one aspect of stock investing, but it should not be the main focus for most casual investors. Instead, picking a stock is about finding a company you want to be invested in, with a stock that is attractive to you for its price, its potential earnings, and other factors.
Here’s are a few reasons you should invest in a stock you believe in:
1. High potential for returns. While investing in stocks comes with risk, stock performance tends to recover over time and generate significant returns in the long term. Investors that are prepared to be patient and hold on to their stocks for years or even decades tend to reap the highest gains.
2. Diverse range of investment options: The stock market is diverse, with a range of investment options available to investors. Investors can invest in different sectors, industries, or even buy shares in companies in different geographic regions. Investing in a variety of sectors and regions reduces risk compared to other forms of investment, such as real estate.
3. Dividend income: Another advantage of investing in stocks is the potential for dividends. A dividend is a payment made by a company to its shareholders out of its earnings. Companies tend to pay dividends to shareholders as a way to reward them for holding their stock. Consistent dividend payments can provide extra income to investors.
4. Access to preference shares: Preference stocks provide investors with the added bonus of getting paid dividends before common stock shareholders. This arrangement provides additional security as preference shares usually have fixed dividend yields and must be paid before any other stockholders receive payment.
5. Liquidity: One of the most significant advantages of the stock market is liquidity. Companies are subject to listing requirements designed to protect the public interest, ultimately, this translates to stocks being traded easily and frequently on the open market. One of the benefits of this liquidity is ease of access. Investors can buy and sell stocks without significant costs associated with the buying or selling transaction pair. Additionally, liquidity ensures that should an event trigger a change in a stock’s price, it will reflect in real-time market feedback. Therefore changes that occur within a company will reveal themselves in the corresponding stock price instantaneously.
