Many people consider stocks to be something virtual, very risky, fearing a decline in their market value, or even the company's bankruptcy. They may have their own (bad) experiences from the past, etc. And those who buy them may be labeled as gamblers by some people. How can perceive stocks?

What is a Stock

At the beginning, just a bit of boring but necessary theory. A stock is a financial security associated with three fundamental rights: (1) the right to participate in the management of the company (participation in the general meeting), (2) the right to share in the profit (payment of dividends), and (3) the right to share in the liquidation balance in the event of the company's dissolution. And now, in human terms.

By buying stocks, you become an owner, more often a co-owner or participant in the company. Even as a small investor, you own at least a small piece of a potentially huge company. Not only is it a good feeling, but it also has its advantages, such as receiving a share of the profit in the form of dividends, which usually lands in your account quarterly (U.S. stocks) or yearly (e.g. European stocks). But nothing is entirely without risk.

Stock Market

Figure 1: Stock Market (source: Craiyon)

For example, by buying 10 shares of Apple, out of the 15,599,434,000 shares outstanding (as of the end of 2023), your share will be a tiny fraction, but you can attend the general meeting and vote on the most important matters of the company, such as the choice of leadership or profit distribution, but most importantly – participate in the profit. True, the voice of one small investor may not be heard, but the opportunity to share in the success of the company remains (increase in stock price – capital gain) and the achieved profit (in the form of dividends – dividend yield).

It's Like Running Businesses in Various Industries

By investing in stocks, or we can say buying a stake in a particular company, you become a "business owner" in that industry, in which this company operates. Are you attracted to businesses in energy, telecommunications, banking, gambling and betting, or maybe social media? You don't have to start your own company. Just buy shares of established companies.

Not everyone has the skills or means to build a company or run a business themselves. Nevertheless, it is possible to indirectly achieve this through stocks. By buying stocks, you can get on board with Apple, Amazon, Coca Cola, McDonald's, or Meta Platforms (formerly Facebook). And as an owner (even if micro), you also have the right to participate in its prosperity – rising stock prices and achieved income – dividend yield.

The return on stocks is higher than, for example, government bonds or savings accounts. Understandably, nothing is free, higher potential returns come with higher potential risk of loss, especially in the short term. The risks can be limited with a suitable investment strategy. The average annual return of the S&P500 index for the years 1871 to 2023 with dividend inclusion was 9.17%.

Besides investing in stocks, it is also possible to consider investing in commodities or commodity stocks, especially in gold or silver (miners or companies) which are often considered a safe haven in turbulent waters, economic and monetary crises and high inflation.

When Things Don't Go Well

It may happen that a company gets into trouble and goes bankrupt, for example, due to a combination of high debt and poor results (on grounds of bad decisions, inaccurate future estimates, etc.). It's possible. However, with large established companies, the probability of bankruptcy is very low. If you own shares in multiple companies, the probability of all companies going bankrupt is negligible. Risk can be reduced (spread) through diversification – as the saying goes, “Don't put all your eggs in one basket.” What remains from the company is the liquidation balance, which is divided among shareholders.

However, Warren Buffett (93) and the late Charlie Munger († 99), renowned for their value investing philosophy, have expressed skepticism about traditional diversification. Dubbing it "deworsefication," they prefer a focused approach, patiently waiting for opportune moments to concentrate heavily on promising investments. Buffett has even referred to those who advocate excessive diversification as "know-nothing investors." While their strategy suits their unique expertise, it's worth noting that diversification can still be a prudent approach for many ordinary investors seeking a balanced and lower-risk portfolio.

Despite Warren Buffett's reservations about traditional diversification, he has advocated for ordinary investors to consider index funds, particularly those tracking the S&P 500. He believes this passive approach allows individuals to benefit from the overall growth of the market, offering a practical alternative for those who may not have the time or expertise for active stock picking.

It is essential to keep in mind that shareholders are owners of the company and are last in line. They must satisfy the claims of others before they themselves come into play. State claims (owed taxes, social security, etc.), employee claims (owed wages), owners of corporate bonds (who are not owners-shareholders of the company, only lent money) have priority, and shareholders come last. It may happen that the debts are so large that nothing is left for shareholders.

About Terminology and Stock Returns

Portfolio is a set of companies whose stocks you own. For example, you own a certain number (pieces) of stocks in Apple, Coca Cola, and McDonald's.

A shareholder can achieve two basic returns from holding stocks: capital gain and dividend yield. Capital gain represents the growth of the stock price (buying with the expectation of selling at a higher price later), but there may also be a decrease in the market price of the stock. Dividend yield consists of dividend payout, i.e., a share of the profit, usually paid out on a quarterly basis or once in a year.

Companies are often referred to as growth or dividend stocks. Growth stocks are usually companies that invest their profits in expansion, expanding their activities. This means that they either pay no dividend or only a small one. Dividend stocks refer to established companies, sometimes in the maturity phase (with lower growth potential), which pay a large or even the entire part of the net income to shareholders in the form of dividends. Growth stocks usually experience more significant fluctuations in stock prices.

You Might Be Also Interested