So You Want To Own Stocks? Me Too.
I want to keep this simple because stocks do not have to be complicated, but can get wicked complex fast. For your investing journey, the theme is: start simple, get fancy later.
On that note:
Stock Definition: A security that represents ownership in a corporation.
If we go back to The Awesome Lipstick Company, time has been good to us. Years have passed, and you and I now own the most successful lipstick company in the history of well, lipstick.
Now we have a new problem.
It is the year 2021—we have refinanced our 2020 debt with a new bond issue: The Awesome Lipstick Company 6.7% 07Nov2025, but to expand into Europe, we need to raise $50,000,000.
Our Investment Banker advises us that it would be difficult for us to issue that amount of debt (through a secondary bond issue), and that our best option would be to take our company public.
What does this mean?
It means that you and I will no longer be the only owners of the company. We are going to keep 51% of the company for ourselves (so we will always have voting majority), and we are going to sell 49% of our company to the public for $50,000,000.
How are we going to do this?
If you think of the ownership of a company like a pie, we are going to keep 51% of the pie pieces, and the remaining 49% of the pieces of pie are going to be sliced (very carefully..) into 1,000,000 pieces.
And then we are going to allow investors to purchase each individual pie piece–which are called stocks or shares–for $50 each.
Therefore, if an investory purchased 200 shares at $50 (at a cost of $10,000), she is the the legal owner of .0098% of The Awesome Lipstick Company.
And that is the short version how and why stocks are created.
Why would an investor want to own stocks?
Short answer: Because they rock.
A couple of notes on why:
- Stock markets in the developed world delivered an annualized return of 8.5% over the last 100 years. (historcal rate of returns for bonds are just over 6%)
- Common stocks allow you to potentially receive dividends (a portion of the company’s income distributed in cash). Dividends have accounted for over 40% of stock market returns since 1930.
- While invesitng in shares does not (sadly) allow you to manage the company, holding the common stock of a firm allows you to vote at the company’s annual general meeting. This may not be the primary reason to purchase stockbut you have to admit, it’s still pretty cool.
At the risk of repeating myself, if you have less than $100,000 to invest, please do not invest directly in stocks. Even if the company is the best company in the world, with the greatest prospects for growth (think: The Awesome Lipstick Company), you never want to be exposed to the risk of a single investment. For accounts even up to $1MM, there is absolutely no reason that you can not achieve incredible diversification through ETFs.
And that’s it for today’s lesson!
Watch for Lesson #6, A Primer On Asset Allocation, in your inbox in just three short days!