Stocks for Newbies aka the Stock Investor Apprentice
What is a stock?
If you do not know the answer to this question, then I encourage you to go to Wikipedia or Investopedia or About.com. These sites are fantastic resources as you learn the basics of investing.
Now, I'm not trying to pass the buck - and I certainly don't want you
all to leave NewInvestorToolKit for other information sources never to come
back! But to be brutally honest, I don't
see much value - either for me or you - simply regurgitating such basic of
basic information that already exists ad
nauseam on the internet. Rather, what I aim to do in this website is provide
you with a comprehensive methodology for investing that will create long-term wealth.
So, with that out of the way and now assuming you know what a stock is, let
me give you my take on stocks.
Stocks are one of the best long-term wealth creating vehicle every
created my man. In fact they may be the
best, with real estate a strong competitor.
But let me put this 'competitor' to rest immediately. Stocks (also referred to as equities - which
literally means ownership) have three huge advantages over real estate:
they are liquid: meaning if you
need to raise cash quickly, you press a button on your internet brokerage
account and you transfer your equity holding into cash. Raising money from a house or apartment/flat
takes much longer, the transaction costs are much higher, and selling a
property is like bringing a bazooka to a fist fight (i.e., what if you need to raise
$5,000 - do you really want to sell a $50,000 apartment?). Assuming you even have a $50,000 apartment,
which leads me to item 2.
small investments possible: equities can be purchased in very small
monetary amounts. Gone are the days you
need to buy in 100 share allotments to minimize brokerage fees. There are great tools like DRIPs (which are
automatic investment vehicles directly with the companies you are interested in
investing - we'll cover these products in later sections) as well as services
like Sharebuilder.com which allow for partial share ownership (you decide how
much money to invest and Sharebuilder buys partial shares).
tax efficient: there are no annual property taxes on stocks, only
capital gains, as with properties, when you sell. You do pay tax on dividend income from
equities but this tax rate is currently less than normal income tax rates which
is how rental income is treated (assuming you do not live in your property but
rent it out instead).
The bottom line is that you have much more control over a stock
investment than you do over a real estate investment. Let me emphasize emphatically, though, that
real estate does have a place to play in one's portfolio. But given the advantages of stock ownership,
I wouldn't bother with properties until you've amassed at least $100,000 in
But back to my views on stocks:
An equity investment in a company grants you part ownership of that
company. Now this doesn't mean you get
discounts on candy at, say, Walmart (this is a favorite position of my kids as
they each own shares in Walmart)! But
what is does mean is that you share in the business outcome - both good and bad
- as a shareholder.
Management of a given company sometimes does not pursue owner-friendly
policies (management, after all, has different interests than owners. A lot of recent investment theory suggests
restricted stock & options align interests between management and owners. As a senior corporate executive, I'm not too
sure this works in practice). So, what
to do? Well, you can target only
investing in companies that pursue shareholder friendly policies; policies that
come in two primary forms:
Dividends: companies that pay a large portion of free
cash flows to its owners instills discipline on management. If they want to divert cash to, say, buy
another business, they may need to adjust the dividend policy or issue more
shares (thus diluting current shareholders).
This complicates things for them (when compared to a company that hoards
all of its cash to pursue 'strategic' acquisitions). And since a 1999 survey by KPMG found that "83% of mergers were unsuccessful in producing any business benefits regarding
shareholder value" (KPMG, 1999)
a McKinsey & Company study found that "61 percent of all acquisition
programs were failures because the acquisition strategies did not earn a
sufficient return on the funds invested", it seems to me that companies with well-established dividend programs are less
likely to pursue these value destroying (and management ego-boosting) moves.
Share repurchase programs: another efficient way to return value to its owners is for a company to use its cash to repurchase outstanding shares from the marketplace. This reduces the number of shares outstanding of the company you have invested in which, in theory, should your share holding by a similar percentage of shares being purchased relative to total share outstanding. Buying back shares is more tax efficient than dividends so such action is good for shareholders.
Now, don't be scared away from bad management - they exist (in far too many cases). Remember Enron? Unfortunately, I do, as I was an Enron employee when they went bankrupt.... One of your jobs is to make sure you avoid such ethically poor managers. My advice? Stick with blue chip stocks that have a history of increasing dividends year-on-year and you should be ok. I discuss proper stock selection in the more advanced sections of this website.
Once you've made an investment - and, in fact, even when you're in due
diligence regarding making an
investment - you should begin feeling like a
part owner. To me this is a very
important philosophical leap that you must
make....for good reason. Just
like if you owned a small, private business, you would keep a close eye on it,
right? You would visit it, sample its
product or service and reflect on whether it still offered a unique value
proposition to justify your (part)ownership.
There is no difference when you own stock in a large publically traded
company. Your opinion matters
because if you're thinking a certain away about the business, many other are
likely to be thinking the same thing (both good & bad). Besides, and perhaps of equal importance, if
you feel ownership of a given business you'll likely become a pretty good
ambassador of said business, which may help its customer base and, perhaps,
even expand its shareholder base. If
only everyone did this....!
Equity ownership in a business gives you limited liability; meaning you
can only lose your investment amount, not more.
This is due to the limited liability nature of corporations that protect
their owners from losing more than the equity capital of a business.
So, stocks are a pretty awesome investment vehicle. But don't just take my word for it. A recent summary by Tom Dyson published in
the Palm Beach Letter of a study conducted by Jeremy Siegel, a professor of
finance at the Wharton School of the University of Pennsylvania, that proves
this very point (Siegel's analysis is found in his book The Future for
returns of several different types of investment products, ranging from stocks
to bonds to gold.... over a 200 year period (!). Don't worry, he did the same analysis over a
shorter period of 50 or so years (heh 15 year olds out there - this is now
until retirement for you....it isn't that
long!). The results prove my premise
that stocks rock over time (note that Siegel did not include real estate so my
above qualifiers are still valid). Check out
his astonishing results:
From 1802 to 2006, $1 invested in:
Gold grew to $32.84
Bonds grew to $18,235
(the wrong kind of Bond....but you get the point)
Stocks grew to $12.7 million
Stocks are the
clear winner; but then you're not surprised now, are you?
analyzed 50 of the largest companies from 1950 to 2003 and found the following
results of a $1,000 investment in various companies over this time period:
$1,000 turned into $2,042,605 in
$1,000 turned into $1,263,065 in
$1,000 turned into $1,211,456 in
Now that's what I call having my money work for me. You should now be thinking the same thing. Huge wealth can come from investing in equities and letting the company work for you over the long haul. I term this 'firing & forgetting' - you'll learn more about it in the more advanced sections of this website.