Business Basics

Part 2- Investment and stocks

We’ve already covered bonds. The other principle form of investment is stock. Stock represents ownership in a company, which is why it’s considered equity financing. There are 2 specific types of stock- common stock and preferred stock.

Let’s start with common stock

The primary feature of a stock is its price. The price of stock is based on demand- the more people want to buy stock at any given time, the higher the price of the stock will be.

Indirectly, the price reflects many things that would cause people to want to buy the company’s stock. Generally, stock prices vary directly with company performance- if the company is doing well, stock prices will rise, since people will tend to want to buy some ownership in a successful company.

Unlike bonds, which may be either traded or just used to gain interest, stocks carry very little investment incentive other than trading value.

The stock market game

There are 3 principle trades I can do with stock:

1. Straight buy: Say I believe that tomorrow, the stock of company A will rise since they’ve just introduced a great new product. I buy 10 shares for $1 each. The next day, the shares rose to $1.5, so I sell the stock, and I’ve just made $5. It’s simple and useful.

2. Margin buy: Say I believe the same thing, but I want to play it more risky. I buy 10 share for $1 each, but now I also borrow $5 from the bank (with some interest) and buy 5 more shares. Tomorrow the price rises to $1.5, so I sell the stock and make $7.5, less the $0.5 interest, which comes down to a better earnings of $7. This has potentially greater return, since I’m making money off the bank’s money, but it’s also riskier, since I’ve borrowed their money and may have to pay it back.

3. Short sell: The most complicated of trades. Say the stock price of company B is $2, but I expect it to go down. I can sell some company B stock without actually buying it, as long as I promise to buy it afterwards. So I sell 10 shares for $2. The next day the stock prices drop to $1.5, so I buy the stock back- I’ve just made $5. This concept is a bit weird, but it’s fair game in the stock market.

All of these have some strict rules. You should consult a financial expert or stockbroker before attempting any transactions yourself.

More points on common stock

Common stock is risky. It’s riskier than bonds, since you’re not guaranteed anything and if the company goes bankrupt you can lose everything. But there’s also potential for greater return- the stock price has no limit, it can rise by a large amount quickly, so you can potentially become really rich overnight.

Also, since stock represents ownership in the company, you are eligible for some benefits:

1. Dividends- if the company did really well last year, they may decide to issue divideds and give a small amount of money per share to shareholders.

2. Voting rights- as an owner, you have the right to attend the annual meeting of the corporation and vote on who should sit in the Board of Directors next year.

Preferred stock- the perfect combo

Preferred stock is a combination between bonds and stock. Companies offer preferred stock as a form of ownership that’s more secure than common stock, so they don’t have to give up as much ownership rights.

Preferred stock are used for trading the same way as regular stock. But unlike common stock, preferred stock comes with a fixed annual divided rate, kind of like the bond’s interest rate. This is good if you’re looking for a bit of steady income.

However, unlike the bond interest, dividend payment isn’t mandatory- it’s not illegal to skip payment this year and pay you double next year instead. You will get paid before common stockholders, but if the company goes bankrupt… there’s nothing anyone can do about it. You also don’t get any of the voting rights common stock has.

Preferred shares have some advantages and some disadvantages, like all forms of investment, but they represent a middle ground between the security of bonds and the potential for great return of common stock.

And this is what stocks are all about.

In part 2D, we’ll discuss the other few forms of investments- options and mutual funds.