Investing Basics

While the stock market can be vast and intimidating, there are basic concepts that everyone can use to build individual and generational wealth. Quite often, it can feel like you're trying to read a language you've never seen before. While fortunes can be made, it can easily turn into another form of gambling. Don't worry, though; there's a method to the madness that can help secure your financial future. In this article, we'll discuss exactly what the stock market is, how you can use it to make money, and ways you can protect yourself from risk.

What is the stock market?

Think of the stock market as a dynamic store that sells pieces of a company to the general public, known as "shares." The value of the share changes every day, depending on micro and macro-economic trends. These shares represent ownership in a company. And if you own enough of these shares, you are able to help make key decisions regarding that company.

The stock market is comprised of several different groups, including investors, facilitators, and regulators. Investors can either be institutional or retail, meaning they can be part of an organization that buys/sells stocks for a group of people, such as hedge funds, pension funds, or even insurance companies. These institutions manage large pools of money and invest on behalf of their clients to grow their investments. Individual investors, or retail investors, are people like you and me who are not associated with another organization, and any stock purchases or sales are made for those individuals only. The regulators are the organizations that oversee the stock market as a whole, such as the SEC (Securities and Exchange Commission). Their focus is to enforce regulations to ensure that everyone is playing by the rules. By enforcing regulations, they protect investors and maintain the integrity of the stock market. The SEC has the power and obligation to pursue legal proceedings against individuals or even companies that violate federal securities law.

How does the stock market work for individual investors?

As a broad overview, when companies offer shares to the public, they make them available through the stock exchanges (New York Stock Exchange, NASDAQ, etc.). Each exchange has its own requirements for a company to have its shares available on the exchange. Once the stock is available on the exchange, it is accessible for all investors to see, listing its current value. Once the order to buy a stock is submitted, it is sent to a broker, who will then find someone on the opposite end who is selling that same stock, at a price that is less than or equal to the purchase order. The process for hedge funds or investing firms is slightly different from the process for retail investors.

How does a stock relate to company ownership?

As we described before, a stock, or "share," represents ownership of a small percentage of that company. If there are 1 million shares in existence (outstanding shares) of a company, and you own 1 thousand shares, you own 0.001% of that company. To have any considerable influence on the company, 10% ownership or more is usually required. Regardless, any amount of stock in a company gives you part ownership of that company.

Not all stocks are created the same. Stocks are divided into two groups: Common and Preferred. Common stock provides voting rights to the holder, while preferred stocks hold more face value, receiving dividends before common stockholders. Even common stocks can hold different values. For example, the well-known Berkshire Hathaway, led by the famous Warren Buffet, offers two separate common stocks, Class A stock (ticker BRK-A) and Class B stock (ticker BRK-B). One of the key differences, other than the current stock values, $509k and $335, respectively, is that shareholders of BRK-A have more voting rights in the company than shareholders of BRK-B. This is due to the difference in stock value. BRK-A shareholders have a much higher equity in the company than those of BRK-B. It would take BRK-B shareholders over 1500 shares to have the same equity.

When it comes to understanding stock value and assessing potential value, there are certain terms you will want to understand.

Earnings per Share (EPS): The amount of a company's profits that have been allocated to each share of common stock.

P/E Ratio: Compares a company's current valuation to its earnings. A high P/E ratio indicates that a stock is selling at a much higher price, indicating to some that it is "expensive." Conversely, a low P/E ratio may indicate that a stock is selling at a lower price, and may be "selling at a discount."

Market Cap (capitalization): The total value of a company's outstanding shares, calculated by multiplying the current stock price by the amount of outstanding shares. For example, a company selling at $20/share with 20 million shares in existence has a $1 billion market cap. Companies are then divided into Large, Mid, or Small-cap based on how large their market cap is.

Revenue: The total amount the company has earned through services or selling goods.

Debt-to-Equity: Assesses how much the company relies on debt by comparing the company's total debt to the shareholders' equity. Calculated by dividing the company's total debt by the shareholders' equity. The higher the ratio, the more debt a company has.

Return on Assets: A metric that indicates how well a company is utilizing its assets to generate profit. A higher ratio indicates a company uses its assets wisely, which leads to higher revenue.

Return on Investment: A metric that assesses how profitable an investment was by comparing the returns to the cost of the investment.

Return on Equity: A metric that assesses a company's ability to generate profits by dividing the company's net income by its shareholders' equity. 

What are some ways to invest?

When it comes to putting your money in the stock market, it's important to understand the different methods, which comes down to intent. Stock trading, or "speculating," refers to the buying and selling of stocks based on stock price and performance in a short-term (less than one year). Investing, on the other hand, focuses on the company fundamentals over a longer-term period, which could be a few years to a few decades. Here, we will focus on investing. Almost all investing is based on the premise of buying stocks at a low price and selling them at a higher price down the road ("buy low, sell high").

There are many different "strategies" you can use when investing your money. The most common strategy that experts advise is "dollar cost averaging."

Dollar cost averaging is a strategy used to reduce the risk that comes from trying to "time" the market, where people wait to invest their money until they see a sizeable drop in the overall market. The term dollar cost averaging refers to the strategy where an individual invests a predetermined amount of money on a regular schedule, regardless of the market value. So that means whether a stock is going up or down, you are still investing.

The idea is that over the long run, the market value will continue to rise, and over that time, an investor will regularly invest a predetermined amount of funds, regardless of the stock market's performance. This helps investors build wealth without needing to dive into market analysis and prevents emotional decisions. The opposite approach is to "time" the market, where an investor waits for the market to crash before they invest. Studies have shown this approach underperforms the dollar cost average approach by a huge margin. One reason is that it is almost impossible to determine when the market will start to rise. So then investors will invest well before or well after, missing potential gains. This is why many wealth managers adopted the phrase "time in the market beats timing the market."

Since the inception of the S&P 500, it has averaged a 10% annual rate of return. But this is no guarantee. As we've seen after the 2008 Housing Crisis, and briefly during the COVID pandemic, the stock market is prone to dips and "crashes."

Another strategy is to follow what's called "value investing." Pioneered by Benjamin "Ben" Graham, and made famous by his student, Warren Buffett, this is an advanced strategy as it requires knowledge of the business, business industry, market trends, and business valuation methods. The strategy focuses on finding companies that are being sold for much less than what it is believed they are worth. These are companies that have good business practices, good cash flows, and are otherwise "healthy," but for whatever reason, the stock price is low, or "at a discount." 

Can I invest in something besides stocks?

Although stocks are the investment of choice for most individuals, there are many more investing options in the market. One popular choice is real estate investing. Others include Bonds, commodities, currencies, and so on. In this article, we will focus on stock-based investment vehicles.

Bonds are one type of investment that many people are at least aware of. For many people, they are gifts we receive from friends/relatives when we are children in the form of a $25, $50, or $75 savings bond. These bonds are issued by the government, which usually take 20-30 years to mature into their full value. Although companies are also able to issue their own bonds, which often have a higher interest rate than treasury bonds. A bond is actually a debt instrument, in that you are providing an entity with a set dollar amount and then repay that amount in x-years. As an incentive, for every year that money is borrowed, they will give you a small percent of that bond value, which you can collect every year or lump sum once the bond has matured.

Another common investment, particularly among hedge funds and investing firms, is commodity trading. A commodity is a tangible asset, such as Gold, Corn, Wheat, Crude Oil, Wood, etc. Despite what it may sound like, investing in commodities doesn't require the physical purchase of the underlying asset. Instead, the investor purchases a contract, and instead of physical goods, contracts are completed with a cash settlement. This investment vehicle is called Futures Contracts, or "futures."

 For example, if you purchase $500 in wheat, and the price rises to $600, you can settle the contract by taking $600 in cash, rather than having $600 worth of wheat delivered to your door. This is another advanced strategy, as it requires knowledge in various markets and an understanding of economics.

How much risk is involved in investing?

The amount of risk present will always depend on the investment itself, but risk will always be present in some form. 

For example, a company stock is riskier than a U.S. Treasury bond because stock prices are volatile, but the government is considered a "guarantee". Stock prices can be affected by seasonal market trends, bad press, poor business performances, and so on. The value of a bond will hold even if market trends go up or down. The downside is that, in most cases, the lower the risk, lower the reward.

To reduce risk, most investment professionals advise their clients to diversify their investment portfolio. To diversify means to spread investments across financial instruments, stock market industries, or other investible assets. If all of your money is invested in Travel Services stocks, like Royal Caribbean Cruises, an advisor might suggest that you also invest in other sectors, such as Energy, Utility, or even Basic Material stocks. By spreading your capital, you ensure that you won't lose all your money if vacation cruises become less popular or are unable to attract as many customers, as we saw during the COVID pandemic. 

The idea is that what affects the Travel Services industry is unlikely to affect the Basic Materials industry. Unless we see variables that affect the entire market or globe, such as the previously mentioned pandemic.

How can I start investing?

When you decide you are ready to invest, there are a few decisions you need to make for yourself, such as:

• • How much time do you have to invest (time horizon)

• • What is your investment goal (How much do you want to have when you're done investing)

• • How much are you able to invest, both today and on a regular schedule

• • What type of strategy best suits your personality

• • Do you have access to affordable, professional advice

Time Horizon

The more time you have, the better. By investing more money sooner in life, the easier it is to save for retirement. On average, to have $1 million saved for retirement, a 20-year old would need to save around $61/mo, and while someone just starting to save at 40-years old would need to save around $625/mo. This is because you have less time to let the interest compound. So the sooner the better.

Investment goal

If your investment goal is retirement, you need to know how much you need each year to maintain your lifestyle. This will directly determine how much you will need to save/invest, unless you are willing to make changes to your lifestyle. If you want to maintain a $100k/yr income after retirement, you'll need to have somewhere close to $2.5 million set aside. If you only need $50k/yr, you'll need around $1.25 million. Your investing goal will determine how much you need to start setting aside each month/year.

Investible capital

Despite knowing how much you will need to save for retirement, it won't help if you don't have the money to invest. Taking a close look at your monthly finances will help you determine if you are able to meet your monthly/annual investment goals or if you need to find additional income.

Investment strategy

In addition to the investment strategies we discussed earlier, it's imperative that you choose a strategy that you're comfortable with. If you're someone who is risk-averse (avoids risk), choosing a risky strategy can lead to poor decisions based on feelings, rather than strict guidelines. For the layman who invests in their 401(k), many financial advisors recommend using an index fund, which can provide reduced risk through diversification.

Have a financial advisor

It's important that, prior to making any major investment decisions, you consult with a licensed financial advisor. Even the information you read here is only meant for general education purposes. Many companies provide access to knowledgeable advisors for free, or a small fee. Even banking services are beginning to offer these services. Financial Advisors have the knowledge and tools to help you determine how much you should be investing, how risky an investment is, and if an investment is generally a good idea.

The stock market is an accessible way to build wealth, and can be volatile or steady. It's made up of different groups that provide value to investors, with regulators that are supposed to ensure everyone follows the rules. While stocks are the primary investment tool for many, the stock market provides other, more complicated vehicles, such as options, futures, and forex. Each investment asset and strategy carries its level of risk, but sitting down with a knowledgeable financial planner or financial advisor can help reduce your risk and meet your goals.