As I continue to go through our financial basics NextGen blog, the next question that is important to address is: what is a stock? Often people have common misconceptions about stocks and the stock market. Many believe the stock market is no different than taking your life savings to Vegas and hoping for the best. Some basic education often helps to dispel this myth, but investors still must be educated on the risks that are involved.
A share of stock represents fractional ownership in a company. When an investor purchases a share(s) of a specific stock, the investor is now a partial owner of the company. Each share of stock confers some specific rights to the partial owner. In reality though, an individual can rarely buy enough shares to be able to have a say in how things are run.
So how does a stock get its price? Since each share of stock represents a portion of the company, the stock price is determined by how much someone is willing to pay for a portion of that company. Revenue, profit, current management, growth potential, economic environment, and many other factors go into the decision of what someone is willing to pay for a share of stock. Often as company earnings improve, individuals are willing to pay more for the stock.
So what risk is involved in purchasing a stock? Just like any company that you may purchase as a minority owner, there are many risks involved. The company may go bankrupt, causing the stock to become entirely worthless. The company may undergo a period of poor management that hurts the profitability. The economy may have a long period of poor growth known as a recession or a depression. These are just a few of the risks that must be considered before purchasing a company.
While there are many risks associated with owning equity in a company, there also may be long term benefits. According to Morningstar Direct, from 1926-2013, US large cap stocks returned an average of about 10% per year. While that return can be very attractive to investors, one must also keep in mind the volatility that is often present in short term investing. In 1931, US large caps lost almost 44% and in 2008 US large cap stocks lost about 37%.
In order to help reduce some of the risk, a long term strategy that involves discipline and diversification should be used. Stock investors have employed a variety of strategies through the years. For instance, some people focus on a company’s potential for increased revenues; others focus on valuation and financial metrics.
Our approach is to use mutual funds whose managers are looking for good companies at bargain prices. We want those managers to be patient to hold those companies until they reach fair value.
One potential downfall to the value strategy is that if often takes patience and persistence. I would encourage to you watch the video on our Investment Philosophy for more details about how we view investments.
Thomas Gross, CFP®