Back to Basics: What Exactly is a Stock?

January 05, 2012

With the start of a new year, it might be a good time to take a step back. As financial planners and educators, we can get so caught up in the complexities of things like employee benefits, various investment strategies, and tax laws that sometimes we forget that sometimes people just really need to understand the basics. I recently asked a group of workshop participants what exactly a stock was and one person said it was just a piece of paper. I thought about it later and realized that his answer reflected many of the misconceptions people have about investing (aside from the fact that we don’t even really use paper stock certificates anymore). In fact, there’s a surprising amount of insight you can gain just from examining some of the basic investment vehicles.

We can start by saying you can basically do one of two things with your savings. You can loan them to someone or you can own something.

With a stock, you become a part-owner owner of a corporation.

After a company pays expenses like wages, rent, and interest, the remaining income is profit. This profit can be paid out to owners of the company as a dividend, it can be invested in expanding the company, or it can be used to buy back shares of its own stock. The first provides immediate income to shareholders while the latter two can increase the value of the stock.

Now, think about the companies you buy from. Wouldn’t you love to get a share of the profits every time you fill your car up with gas, stop at your favorite fast food joint, or buy the latest iPhone? While most of us may not have the capital or the business expertise to start and run one of those companies, we can all become part owners of companies like Exxon Mobile, McDonalds, and Apple simply by buying shares of their stock.

With all the news about the ups and downs of the stock market, it’s easy to forget that shares of stock represent actual companies. We start thinking of them as just pieces of paper or numbers on a computer screen. The problem is that this can cause us to stop treating them like a tangible investment. If you wanted to buy a rental property, would you want to buy it when the price was high or low relative to the rental income? Hopefully, you also have a sense of how much you’d pay for a given property before you even know the price.

The same should be true of investing in the stock market. We want to buy when prices are low relative to earnings. If you’re going to invest in individual stocks, you should also know what you think a share of the company is worth, without knowing the price. If you don’t, you should probably hire someone else to invest in stocks for you.

I’m not talking about a broker who is paid commissions to sell you stocks and other investment products. I’m talking about a registered investment adviser with a fiduciary duty to you. That’s a fancy legal term that basically means they are legally required to manage your money in your best interest.

The problem is that most people don’t have enough assets to qualify for a private investment manager. That’s where mutual funds come in. With a mutual fund, you pool your money with other investors to hire an investment manager to manage the money in the pool.

Of course, none of this is free. The mutual fund fee is called an expense ratio and is charged as a percentage of all the money in the fund. You may also pay load fees for certain funds and transaction fees if you buy your fund through a broker.

Regardless of how you buy stocks, they make you an owner instead of a loaner. You have more risk because interest gets paid before profits, but you also have more potential for return because there’s no limit on how much a company can make. There is one big difference between an owner of a stock versus an owner of real estate though. You can buy insurance to protect the value of your rental property from catastrophic loss, but there’s no equivalent for stocks. If a company goes under, the stock can become worthless and never come back. That’s why it’s so important to diversify with at least 20 different stocks, which happens automatically when you invest through mutual funds.

So how should you decide to invest in stocks vs. bonds? A lot of it depends on your goal. Think of investments as modes of transportation. Cash and bonds are like driving. It’s how you probably get around on a day-to-day basis, but it’s not the most efficient method if you want to travel across the country or to another part of the world, and you may not make it to your destination in time.

On the other hand, investing in stocks is like flying (with volatility and all). Do-it-yourself investing is like flying your own plane, a private money manager is like the pilot of your own personal jet, and a mutual fund is like a commercial airline. It makes a lot of sense for a long trip, but not to pick up something at the grocery store.

When it comes to investing, we think of our destinations in terms of time rather than distance. Stocks are better for long term goals like retirement because they tend to earn more over time, but are too volatile for short term needs like a down payment on a home purchase next year. In summary, the sooner we might need the money, the more we want to be a loaner rather than an owner, and vice versa.