Chapter 2 – What are Stocks?

Plain and simple, a stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing.

Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim (albeit usually very small) to everything the company owns. Yes, this means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings as well as any voting rights attached to the stock.

A stock is represented by a stock certificate. This is a fancy piece of paper that is proof of your ownership. In today's computer age, you won't actually get to see this document because your brokerage keeps these records electronically, which is also known as holding shares "in street name". This is done to make the shares easier to trade. In the past, when a person wanted to sell his or her shares, that person physically took the certificates down to the brokerage. Now, trading with a click of the mouse or a phone call makes life easier for everybody.

Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run. In the same line of thinking, being a shareholder of Anheuser Busch doesn't mean you can walk into the factory and grab a free case of Bud Light!

The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed, at least in theory. In reality, individual investors like you and I don't own enough shares to have a material influence on the company. It's really the big boys like large institutional investors or billionaire entrepreneurs who make the decisions and even they find it difficult to actually have a say in those decisions due to how the companies have set up rules for their board of directors.

Theoretically if you own enough stock in a company you should be able to place whoever you want onto the board but to counteract this unwanted influence most companies will have simple rules like requiring approval from the current directors before the person you nominated can join the board of directors, thus the companies retain control and preventing you from having a true say in how the company is run.

Another extremely important feature of stock is its limited liability, which means that, as an owner of a stock, you are not personally liable if the company is not able to pay its debts. Other companies such as partnerships are set up so that if the partnership goes bankrupt the creditors can come after the partners (shareholders) personally and sell off their house, car, furniture, etc. Owning stock means that, no matter what, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets.

Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep profits to themselves? The reason is that at some point every company needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the other hand, issuing stock is called equity financing. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering (IPO).

It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful, just as a small business owner isn't guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until the banks and bondholders have been paid out; we call this absolute priority. Shareholders earn a lot if a company is successful, but they also stand to lose their entire investment if the company isn't successful.

It must be emphasized that there are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those firms that have traditionally given them. Without dividends, an investor can make money on a stock only through its appreciation in the open market. On the downside, any stock may go bankrupt, in which case your investment is worth nothing.

Although risk might sound all negative, there is also a bright side. Taking on greater risk demands a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts. Over the long term, an investment in stocks has historically had an average return of around 10-12%.

When reading this book you are going to run into mentions of Modern Portfolio Theory or MPT for short. Modern Portfolio Theory was created in 1952 by Harry Markowitz, who won a Nobel Prize for his creation. The theory is supposed to allow for the creation of a stock portfolio based on how risk-averse the person is and how much that person wants to gain while emphasizing that the higher the reward, the higher the risk. Markowitz was able to mathematically prove that it was possible to create the perfect stock portfolio, one that would never lose any money.

In the world where logic rules MPT would work perfectly but by adding humans into the mix the theory develops some flaws. Over the years, many people have tried fixing the theory to account for human eccentricity or come up with a theory that supersedes MPT but all have failed with Modern Portfolio Theory still being the classical theory used most often for building a portfolio.

The reason why I mentioning MPT is that Robo-Advisors and various other programs use MPT to create a portfolio for their users. Sites like Marketwatch have written articles comparing Robo-Advisors with selected human financial investment advisors(FIA) portfolios. Marketwatch found that in general FIA’s portfolio’s tend to be simpler with 3 to 6 assets and Robo-Advisors portfolios tend to be more complex with up to 17 different assets.

What this actually means in a real-world performance that FIA’s well-made portfolio will normally produce slightly better results than a Robo-Advisor but if the market takes a downturn it will also lose more. Robo-Advisors will not be as affected as FIA’s in the market due to having the risk spread out between different assets but that means growth will be slower, on the flip side that will also mean you won’t lose as much. That is the reason why a do-it-yourself type investor might sneer at the mention of a Robo-Advisor, conveniently forgetting about all the advantages an automated investing tool will give you and how much time, effort and research that DIY investor spends on his portfolio.

With the rise of the automated investment advisors and investment apps a type of pyramid structure for investing has been created:

1)Human – Top of the Pyramid. The traditional financial investment advisor with high fee’s and a high minimal deposits requirement. In general, they are more flexible and can get you higher returns but at the same time more risk. This requires the most knowledge and uses sophisticated techniques to research the market. Fee’s range are around 1.00%-2.00%/yr, you pay full commission on stock purchases and most FIA’s charge around $200/hour.

2)Human Assisted – Middle of Pyramid. It uses the Robo-Advisor base but allows for the flexibility of using an FIA if needed. The fees are a little higher than Robo-Advisors but way less than the Human level. In general, $25,000 and up is a good benchmark for this level.

3)Robo-Advisors – Beginner Option. Makes it easy to invest and you have low fees. More limited selection of stocks than the others. Best to use when just starting out where fees can eat up most of your profits.

As you can see, if you're just starting out and have very little money to invest, Robo-Advisors are the way to go and once you start getting a high portfolio balance you can make a decision about switching to a Human Assisted or if you were really successful, Human Tier.

Most Robo-Advisors and investment apps will be using low-cost exchange-traded funds.(ETF) Exchange-Traded Funds are comprised of stocks, bonds, and commodities. Like stocks, ETFs trade daily on stock exchanges and their price fluctuate daily. They are also becoming an increasingly popular way to invest.

ETFs are created by large money managers like the Vanguard Group, which bundle the underlying instruments of the funds. After a series of regulatory steps, an ETF can be offered for sale to the public and can be purchased through a broker.

There are ETFs available to suit any taste. Many track an index. This means that their value is tied to a major stock index, like the S&P 500. If the value of the S&P goes up, the value of the ETF goes up as well. Some ETFs track indexes that include commodities, currencies, and bonds. Others invest in precious metals like gold. There are also leveraged ETFs, which, due to their composition, are much riskier than funds that track indexes.

Mutual funds and ETFs are similar in many ways. The main difference is that ETFs are traded actively throughout the day, meaning that the price of a fund will change from the opening bell to the close of trading. The value of a mutual fund is redeemed at the end of each day's trading session, so its value only changes once per day.

ETFs have many advantages that make them desirable for people just starting out and they are low cost, have lower risk than investing in one or two stocks, more tax-efficient and another advantage of ETFs is their connection to indexes. Historically indexes like the Dow Jones Industrial Average and the S&P 500 have gone up consistently over time.