Investing Basics: What Are Common Stocks?
I have talked about how to get rich in other posts. One of the ways to get rich is to start a business and sell a good or service that people are willing to pay for. However, many people think they are not suited for operating their own business. I disagree but that is another post. A way to have an interest in a business without actually operating a business yourself is to invest in a business through the purchase of common stock.
What Are Commmon Stocks?
What are common stocks? Investopedia defines a common stock as, “A security that represents ownership in a corporation. Holders of common stock exercise control by electing a board of directors and voting on corporate policy.” So basically a share of stock is a percentage ownership of a business. For example, if a company has 1000 shares and you own 100 of the shares then you own 10% of the company.
Typically companies have millions if not billions of shares of common stock outstanding. Nevertheless, ownership of common stock in a company represents fractional ownership in all of the assets and the potential earnings of the company. In addition, ownership of shares entitles holders to a portion of the company’s earnings, assuming the company makes money, and the board of directors elects to pay a dividend.
Most public corporations will have an operating management team that runs the day to day business of the corporation. The company also will have a board of directors that meets several times a year and has fiduciary oversight of the corporation and the management team. Sometimes members of the management team will serve as directors on the board. Shareholders have the opportunity each year to vote on who serves on the board of directors.
So if we understand that shares of common stock represent a percentage share of a business then it stands to reason that if we are going to invest in common stocks we must approach the analysis of each company we invest in from a business perspective.
Most Investors Are Gamblers Not Investors
If someone is just putting money into common stocks with no full understanding of the underlying business or the targeted company’s financial condition than this is not investing this is speculating (gambling). Unforntuanely this is what most individual investors do and it is one of the reasons that most individual investors returns are terrible.
Investing in a stock requires a couple of actions on the part of the investor. An understanding of the company they are investing in along with an ability to understand basic financial metrics. This is necessary in order to determine whether or not the company being considered will have the ability to compound earnings and cashflow over time. This is the key to investing; consistent growth in earnings and cashflow over a long period of time.
Many people will not invest in common stocks because of what has happened to them in the past i.e. losing their ass in the 2008 financial crisis. However this is shortsighted and stupid long term. Common stocks have historically been one of the best asset classes for building wealth over a long period of time.
The key is to treat these common stock investments as the businesses that they are and to understand that you are attempting to buy a portion of a business’s future earnings stream. If you were investing in a business of your own you would not do it with the intent to sell it in a week, a month, or even a year.
Wall Street, which is not interested in you making money, has made it so easy for people to set up brokerage accounts online and to trade via computer, and now their smartphones, that many people have forgotten this principal and reduced stock investing into a roulette game of chance. That is gambling and a game you cannot and will not win.
The people on Wall Street are most interested in fostering an environment where you over trade. Every time you place a buy or sell order for a stock they make a commission. The same holds true for the so called financial media like Bloomberg and CNBC. If you are listening to Jim Cramer or the people on “Fast Money” than I can pretty much guarantee that you will have subpar returns.
In order to successfully invest in common stocks as an individual investor requires a tremendous amount of work and devotion to developing your craft. Investing is similar to any other craft. It takes time to master and most people will not be good at it unless they have a passion for learning and are willing to devote thousands of hours to study. That is why the top investors make so much money.
Best Way To Invest In Common Stocks
Most individual investors, as has been shown, will never even beat the market averages on their own. The best bet for most individual investors is to dollar cost average into a low cost index fund like those offered by Vanguard. The trick is to start when you are young and then put the same amount of money into the fund every month.
Ignore the market’s ups and downs and let your money compound over time. If you follow this advice you will have a huge pile of money in twenty to thirty years. You can estimate your returns and see the effects of compounding by using a compounding calculator. These are available online just google it.
The problem is that most people will not take this advice. They will read this and think they are a great surgeon, mechanic, piano turner, or whatever. I can do this they think. But the odds and history say you can’t because you do not understand the craft of investing. You do not have control of your emotions and you will not put the time into understanding the techniques that are necessary to be successful investing in common stocks.
As Dirty Harry said, “a man has got to know his limitations”.