What is a stock?
What is a stock? Why do companies issue shares? How do stocks work? how are stocks taxed? why do stocks go up and down? Where can I buy stocks? How do stock exchanges work? We will answers all these questions in this article.
What is a stock?
A stock is simply a certificate. A stock certificate is a piece of paper which simply states who is the owner of a certain company. Think of it as a receipt you receive at the supermarket, it is proof that you are now the owner of the bananas you just bought. It is the same with stocks, it is a certificate which proves you are owner.
Owning a stock certificate makes you an owner of the company which issued the certificate. So yes, if you buy stocks, you are a business owner, pretty cool huh?
What is the difference between a stock and a share?
Stocks, shares, and equity are terms often used interchangeably but they essentially mean the same thing.
Technically, a share is the smaller unit of both. A share essentially grants you ownership of a part (share) of a business. A stock can be a collection of shares bundled together. Shares have nominal values, which mean that each share of a business is worth the same.
These are subtle differences and bare absolutely no value when it comes to investing in the stock market?
Where can I buy stocks or shares?
For most people, stocks can be bought on a stock exchange. Companies which are trading on a stock exchange are called publicly listed companies (because their shares are available to be bought by the general public).
Companies which are not listed on a stock exchange are called private (because their shares are not available to general public).
Publicly listed companies (such as Amazon, Google, or Facebook) are listed on a stock exchange and can be bought through a brokerage firm that has access to this stock exchange. To find the best brokers in your country, simply search for it on Google.
How do stock exchanges work?
A stock exchange is simply a forum where shares of listed companies can be exchanged if two people agree on a price.
In essence, the stock market functions the same way as Ebay: People simply bid on the share of a companies and the best price wins. The only difference is that there are thousands of shares of the same companies selling at the same time, which means the price is constantly changing throughout the day.
If you want to buy a share you submit a buy order. If you want to sell, you submit a sell order. The averages of the two orders make up the price of the share at this current moment
Here is how it used to work: You call-up your brokers saying you want to buy shares in a certain company. The broker will take then take your information and walk to a specific counter at the stock exchange and submit a buy order on your behalf. The teller at the stock exchange would input this buy order into the order book (which will contain every buy and sell order on this particular company). If the price you proposed matches a price in the order book, the stock exchange will complete the transaction. Your broker will then notify you that the transaction was successful. If you bid a price that was too low (and nobody wanted to sell at this price), your buy order will linger in the order book for a while before expiring at the end of the day.
Today everything is done digitally, which has significantly improved the efficiency of the process and transactions are much lower as a results.
Alert in blue: The quality of your broker has little meaning. Maybe the User Interface looks nicer and the webpage loads faster, but all brokers are regulated and must fulfil the same function: registering shares in your name at the stock exchange. If your broker goes bankrupt, you have nothing to worry about. Your shares will remain in your name at the stock exchange.
Why do stocks go up and down?
Let’s use the Ebay analogy again. Imagine someone is selling their company. People simply bid on the price of the company and the seller will sell his or her company at the best price available. The same thing happens in the stock market, except that there isn’t just one share, there are thousands of shares of the same company selling at the same time.
If a lot of people want to buy the same company at the same price, there will be more buyers than sellers, and buyers will tend to bid the price higher in an effort to acquire shares. Therefore the share price increases.
If the opposite happens, and there are more sellers than buyers, then sellers will bid the price down. Therefore, the share price decreases.
Consider what happened during the covid-19 pandemic. When people started realising this virus is a bigger deal than they thought, and countries were implementing confinement and quarantine everywhere, people started to panic. These people turned pessimist and started selling their stocks. As a lot of people were selling their stocks at the same time, and since they were very few people with the courage to buy stocks at that moment, sellers would keep bidding their prices further down in an effort to sell them at any price. This caused the stock market to crash.
In the short term, the stock market is a popularity machine, the sexy stocks get bought and the boring stocks get forgotten and sold. In the long term however, stock price tend to follow the fundamentals (e.g. earnings) of a company. I.e. if a company is growing and earning a lot of money, people will realise it and will buy its shares, effectively bidding up the share price.
Is investing in stocks risky?
It depends on what you buy.
If you buy a loss-making business with lots of debt in a failing industry, then yes, there’s a fair chance you might lose all your money.
On the other hand, if you do your research, pick stocks wisely and are able to control your emotions, there is very little risk.
If you want to minimise risk as much as possible, buy shares in index funds. This will allow you to hold hundreds of stocks at once and, given you’ll be very well diversified, there is no risk of losing all your money (unless every single company goes bankrupt, but then we’ll have bigger problems!)
You can read more on index funds here.
How much can I make in stocks?
The sky is the limit. If you bought Amazon stocks 10 years ago and held them to this day, you would have multiplied your initial investment by 58. That’s right, if you invested 1000€ in Amazon in 2010, you would have 58,000€ today. Of course Amazon is the exception.
While Amazon would have brought you an average annual return of 500% over the last 10 years, the stock market has averaged an annual return of 9 to 10% over the last 100 years.
There is an important caveat to remember: few investors hold on to stocks for that long. People have a stubborn tendency to try to time the market. As such they trade in and out of stocks, missing out on the occasional stock market upward jumps, and paying excessive trading fees in the process.
As such, the average investor has averaged an annual return of 4.8% over the long term.
Of course the opposite can happen. Mistakes happen and you could invest in a failing company, thus resulting in negative results. To avoid losing all your money in stocks, and ensure your fair share of market return (9-10% annually) read our piece on index funds here.
Is it a good idea to own shares?
Absolutely. The stock market has been the best performing investment over the last century, beating real estate, bonds, and gold.
Owning shares makes you a shareholder. You are now a business owner. If you own shares in a great business, then you are likely to profit. If you own shares in a declining business, you are likely to lose money.
While picking individual shares is dangerous, people like to diversify across many stocks to ensure that they will never be wiped out. The best way to diversify is simply to buy an index fund.
FAQ
I know what you’re thinking, should I really invest now that the market is at an all time high? Shouldn’t I invest when the market is down?
The truth is it does not matter if the market is up or down. Look at any stock market graph over the long term and you will realise that the stock market is always going up.
Even if the stock market is 10% overvalued, you cannot possibly know if the market will drop by 10% or if it will keep going up.
But what you do know is that the market will definitely be higher in 10-20 years than it is today.
Stocks represent ownership in a company but it does not come free. When a company issues new shares, it is raising equity (funding). For example, if a business issues new shares and an investor buys 100 shares valued at 10€ each, the investor is essentially investing 1000€ into the business. This will give the company an extra 1000€ to develop new activities (or pay their debt).
In addition, not only can businesses get additional cash from issuing shares, but since it is not a loan or a bond, businesses do not need to pay it back or pay interests. In uncertain times, issuing shares can be safer than taking on more debt.
Companies need cash to operate. They can get cash in 4 ways:
- Through the revenue they generate (sell their products or services);
- By selling the company’s assets (e.g. equipment, real estate, patent, or copyrights);
- By taking on debt (either from the bank (loans) or from the market (bonds);
- By raising new equity (issuing new shares).
In general, it is easier and cheaper for businesses to take on debt than to issue new stocks. However in certain circumstances, banks may not want to lend any more cash. If businesses really want cash, they can search for new investors and issue new shares. Prospective shareholders are then enticed by the growth potential of the stocks.
This depends on your country of residence but in general you could expect a capital gain tax of about 30%. This means that if you made 100€ buying and selling stocks in the market, you will have to pay about 30€ in taxes at the end of the year.
Alternatively, some countries allow you to register stock market gains as income and pay income tax instead. This could be advantageous depending on your income. For example if you retired early and have no income, you could use that as a an opportunity to sell stocks now and be taxed on income instead. In most countries there is a minimum threshold. For example in the UK the first 12, 500£ is tax-free while France is at 10,000€ and Germany is at 9,000€.
Of course, you are only taxed on the gains realised. This means that as long as you do not sell your stocks, you aren’t taxed.
Lastly taxes on stocks will depend on the net return of your entire portfolio. This means that you can offset losses from one trade with gains from another trade.