Introduction to the Stock Market

Introduction to the Stock Market

July 30, 2018

Ahhh the Stock Market. The Magical place where money is created out of thin air, crooks run amok, and geniuses day trade to make millions. Right?

Not quite. The Stock Market is really best described as any other marketplace. Picture a farmer's market but for businesses. Stock (or equity) is just a fancy name for "piece of ownership in a business". So when you buy one share of stock, you are now a shareholder! You own a piece of that business. If you don't own anything yet, or you want to sell what you do own, you have to go to the market.

At the market you walk up to a booth where participants are trading in Amazon stock. There is a booth for every stock, but you notice Amazon IS HOT! You own one share that you bought last year for $500, and now it is trading at over $1,000! Everyone is buying now and it seems like everyone in the world is in this booth with you. The next guy is so excited to buy he is willing to pay a higher price than the guy before him, and the woman after him is more excited and she bids the price up even more! The price keeps on going up, but the underlying business may not have changed all that much. How would we know?

Well, that is when a wonderful organization called the SEC or "Securities and Exchange Commission" comes in. They are like the police officers at the farmer's market. They make sure no funny business goes down. Every three months, the business owners have to tell the whoooooole market how their company did over the preceeding quarter. They are mandated to tell us important things like:

Revenue - How many sales did the business make?

Cost of Sales - How much did it cost to do business?

Net Income - How much money did the business have left over for itself?

Assets - What does the business own? How much does it own? Assets are funded by either DEBT or EQUITY.

Liabilites - What debt does the business owe to others? How much? When is it due?

Equity - How much of the business is owned outright, meaning there is no debt on it. This portion is free and clear for the shareholders.

With all of this great information, we can now look at the business (the stock) and make an educated decision on whether or not we want to hold the business, buy a larger stake of ownership, or sell the ownership that we have to someone else.

In the Amazon example, we already OWN the equity. We must have made that decision to buy it based on some fundamental set of reasons. It was growing revenues faster than costs, its net income was consistently increasing, and it had very little debt owed to others. This is the case with Amazon! It is a fast growing, high flying business that EVERYONE knows and hears about on a daily basis. It is a monolith in both the e-commerce space AND in the cloud business, two areas that seemed very hard to crack by traditional retailers like Walmart and large tech companies like Microsoft.

So if Amazon shares with us (through their quarterly reporting mandated by the SEC) that the revenues are still growing, the expenses are staying constant, the net income to shareholders is increasing, and they did not issue any more debt, then our thesis when we bought the business is still intact and we can make the educated decision to hold our shares or purchase a larger ownership (more shares) if we have the funds.

What if the stock goes down? What if tomorrow Amazon stock falls by 10%. Our $1,000 shares are now only worth $900. There was no news, there wasn't any reporting mandated by the SEC, there was nothing. The NEXT DAY the stock falls by another 10%!! So our original investment of $500 is now worth $810. Should we get out while we still have a profit? Or should we wait for it to bounce back? Should we buy more? Or should we hold on?

This decision making process is at the heart of what keeps the stock market alive. One woman's profit taking could be another man's bargain buying. At the market, we buy and sell from eachother. One person's loss does NOT HAVE TO BE another person's gain. This is not a zero sum game. Trades at the market CAN BE and many times ARE mutually beneficial to both the buyer and the seller.

By understanding the basic concepts that govern the marketplace, like the necessary reporting, the price fluctuations, and the psychological aspect, you can make decisions that will benefit you consistently. What if Amazon stock goes down to $400, but during the reporting process you uncover that the metrics we follow are still in our favor? Then it would be a great decision to purchase more ownership in the business at a cheaper price per share!

NOW, the valuation of these businesses are not solely based on the price per share. As mentioned before, you want to use metrics based on the company's earnings, assets, and debt to make sure that the business is still healthy. Purchasing just because the "price looks cheap" is NOT a viable long-term strategy without the fundamental understanding of how the business is doing. Without understanding that, it is like you are flying blind.

If you want to be a hardcore analyst, you can look up a publicly traded company's financial reports by searching google for "XYZ COMPANY ANNUAL REPORT" or "XYZ COMPANY QUARTERLY REPORT". The annual report has all of the business info for the entire year, and the quarterly report breaks each 3 month period down. If you really want to understand a business, its risks, its strong/weak points, read a full annual report from cover to cover. There is quite a bit of legal jargon in there, but it is a great read for someone who is into that kind of thing. Also, there is usually a recording of the conference call where the CEO and CFO take questions from professional analysts. If you are an aspiring analyst yourself, it is really cool to hear the questions these professionals ask the CEO/CFO. If these guys/gals are asking about it, you can bet your bottom dollar that it is worth paying attention to.

For the more "hands off" type of person, or for someone who just doesn't have the time to pick individual stocks, you can invest in either mutual funds or something called an "ETF". ETF stands for Exchange Traded Fund. This is very similar to a mutual fund, but has distinct differences. They are similar in that both an ETF and a Mutual Fund are portfolios managed by professional investors (or algorithms). They are different in that:

1) ETFs do not have a minimum investment threshold - Most mutual funds have a minimum investment ($1,000-$100,000 minimums are common), but ETFs are priced per share. This is great because you can buy as many or as little shares as you can afford. When it comes to mutual funds, only after you have invested the minimum amount can you add or withdraw as much/little as you like.

2) ETFs are EXCHANGE TRADED - Exchange traded means that they can be bought and sold throughout the trading day on the exchange and through your broker (Like Robinhood). Mutual funds are priced once per day, usually after the closing bell, and are bought directly from the investment manager. This can be at Vanguard, or Fidelity, or whoever is managing the fund.

3) ETFs are usually more "Passive" - Mutual funds (Excluding "Index" Mutual funds) are usually run by a professional, a person, trying to "beat" the stock market over time. People cost money, and it has been shown that it is VERY difficult to outperform the stock market over the long term. Therefore, it is better for most individuals to buy the "Index", an entire collection of stocks, without focusing on picking winners and losers. Most ETFs are Indexed by nature meaning they track a benchmark, such as the S&P500 (ETF TICKER: VOO), or the Energy Sector (ETF TICKER: XLE), etc.. so they can easily be run by computers. Read: ETFs ARE CHEAPER AND USUALLY MORE EFFECTIVE

If you are interested in learning more about the nuanced differences between ETFs and Mutual funds, click here.

Now you understand the type of work it takes to do your own research, like digging through annual reports for data, analyzing the data to understand the valuation of the business, and ultimately comparing companies based on this to try and pick the best ones to invest in. Do not underestimate how much work this is, but if you truly enjoy it (Like me!), it can be very rewarding. If you aren't interested in that sort of thing, you have a little primer on ETFs and Mutual Funds (more to come on those).

There is nothing wrong with investing passively through an ETF or a Mutual Fund. Both my 401k and my Roth IRA are invested in "Index" mutual funds tracking the S&P500 passively. In my taxable brokerage accounts, I invest in specific stocks/ETFs that I research and choose myself. This is a lot of work, but it is also a lot of fun for me. Also, over the long-term, I can calculate my returns and see if I performed better or worse than the stock market. Over many decades it is VERY difficult to outperform. That is the fun part for me, I love the challenge! If after 60 years I realize that I could have gained an extra .0643% per year by investing passively, so be it. I am willing to take that risk because of just how much I love to research and invest. However, there is no shame in having all of your investments passively managed. It is a great way to go for someone who just wants to build wealth without putting in massive amounts of research/effort.

So now you are probably thinking, "Well, how do I get started?". Click Here for the 3 steps you need to take to reach financial independence. That blog post focuses a lot on the passive investing side of things, but the article lists the real actions you need to take before you can start to build long-term wealth. It also clarifies what investment buckets you should prioritize, like choosing between investing in a 401k, IRA, or taxable accounts.

If you are interested in reading books on this topic, HERE is a list of some of my favorites.

I know this was a LOT of info all at one shot. If you have any questions or need clarification on something, don't be afraid to ask! And remember, it is not how much you make that matters. It is how much you save!

MDAS

If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!

P.S. New blog posts coming your way every Monday!

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