A crash course on stocks for the clueless

Know nothing about stocks? Brian McCann explains what a stock is, how it can make you money, and how to decide if you should purchase one from a company.

I participate in a variety of forums with other advisors. Occasionally there is a question, “Should I buy the stock of X company?” The usual response from advisors is to forgo individual stock investments and concentrate on building a low cost, diversified portfolio of mutual funds or ETFs. It’s good advice. It’s also advice I give my clients.

But I have an additional thought: You should buy that stock.

The reason is simple. Most investors are participating in the stock market for long-term growth. But very few have a good appreciation for what the stock market is. Owning a stock is a crash course in market fundamentals. Own one and you will get valuable insight into the overall market.

What is a stock?

A stock is an ownership interest in a business. Publicly traded companies raise cash by going to the primary market, where shares are first sold to investors in an “initial public offering,” or IPO. What most of us consider the stock market is actually the secondary market. This is where previously issued shares are traded among market participants. Trading venues include the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations System (NASDAQ) among others. Bidding among buyers and sellers sets prices.

The common stock of a company represents your share of the ownership in that company. Common stock holders are legally the owner of a small portion of the earnings and assets of the company. You also get to cast your votes at annual meetings and are eligible for dividends paid by the company. So if you own a share of Starbucks, you are part-owner of the local shop down the street. Because stock ownership in a corporation is a legal construct, it works best in countries where the rule of law is strong. This is why the U.S. is such a popular place to invest.

Why should you own one?

Most people invest their hard-earned money in the stock market through mutual funds or ETFs. Often this is through a company-sponsored plan such as a 401(k). Watching the daily swings in the value of your holdings can seem quite mysterious. If you own a stock and research what the business does, you will start to understand the relationship between business performance and the value of your stock holding. In the short-term, a variety of crazy factors can push the price of your company’s stock around. But in the long-term, the price of your company (and stock) will be determined by its business performance. And it’s the long term-that matters. As you get to understand how this works for one company, you will begin to get a feel for how the markets behave, although I don’t know that anyone truly understands the gyrations of the stock markets.

The Caveats

If you do invest in the common stock of a company, take some time to understand the business that you are investing in. Here are some general guidelines:

• Read a summary of the company provided by your brokerage. Companies like Standard and Poor’s or Morningstar provide these. They break down financials and provide comparisons to similar companies.
• Go to the company’s Investor Relations website. Read the annual report of the company (the splashy website or brochure that details the company’s performance for the year) and the 10K (the non-splashy report that details the annual numbers). Pay particular attention to the management discussion of the business results.
• Write down why you think this is a good investment. What is the company’s competitive advantage? How will it become more valuable?
• Consider what would make the company fail. What are its weaknesses? What should you watch to determine if it is not performing as expected?
• After at least a year or two, look back at your thesis and see if things have transpired the way you thought. What was unexpected? How did the stock price react?
• If you want to get really advanced, read five to 10 years of 10K reports to see how the company has evolved. Read all the annual reports of competitors and other companies in the industry.

If you are not willing to put in at least this much work, then you shouldn’t invest in a company at all. Then you are doing nothing more than gambling. Of course, you should not be investing any more that you could afford to lose. Aim for a tiny fraction of your liquid net worth, less than 1% of your investable assets, if that.

You may well end up losing your entire investment. But you will learn a lot about your business, the markets and, who knows, maybe even yourself.