I think it is fair to say that most of us have a general sense of what a stock is. Although it is often quite easy to forget this as you are bombarded with the latest daily stock market buzz words from the hoards of financial media outlets vying for your attention. Phrases like “Margin Calls” and “Total Return Swaps” don’t mean much to the average investor, and in many cases, they shouldn’t.
In the below article, we look to remove much of the noise that modern media brings to the fore, focusing instead on the fundamental principles of stocks. At first, investing may seem intimidating or complicated. That is why it is vital to learn the basics.
As John Reed writes in his book Succeeding:
When you first start to study a field, it seems like you have to memorize a zillion things. You don’t. What you need is to identify the core principles that govern the field. The million things you thought you had to memorize are simply various combinations of the core principles.
Merely understanding the core principles of investing will allow you to minimize risks and protect your investments into the future.
What is a Stock?
A stock represents partial ownership of a company. When you buy a stock, you are purchasing a piece of that company. Once purchased, you have a claim on that company’s assets and future earnings.
When a company needs to raise money, there are two main ways to do so. They can take out a loan, but this will mean taking on debt. Alternatively, they can issue stocks, allowing the company to raise money without going into debt by selling shares of ownership, providing claim on future earnings for investors.
The purchase of stocks provides returns in two ways.
- Stock Appreciation: In strict theoretical terms, the current price of a stock is the present value of future cash flows, so as a company’s earnings increase, so too should their stock price. In reality, however, there are far more variables at play with company earnings and stock price rarely moving in unison. Multiple market forces result in daily price movements for stocks depending on the supply/demand relationship in the market at any given time. As demand for a given stock increases, so too will the current market price. This increase in stock prices above your original purchase price will provide profits to you as an investor in the form of stock appreciation once sold.
- Dividends: You can think of dividends as profit-sharing. If a company does well, it wants to reward its investors with some of those profits. The company will provide periodic cash distributions directly to investors based on the number of shares held. Bear in mind, not all companies pay dividends, opting instead to re-invest company profits into further growth.
Stocks tend to be more volatile than other traditional asset classes such as bonds and Cash Equivalents but with this higher risk comes higher potential reward for investors.
S&P 500 Historical Annual Returns
Stock can be a lucrative tool to help you achieve financial independence. Since 1900, investors have averaged a 7% return on their stock investments per annum. That’s a lot better than leaving your hard-earned money sit in a savings account that returns less than 0.5% per year. The power of stock investing has been magnified in the last ten years, with the S&P 500 index returning ~14.0% per annum as savings account slip towards negative rates. A $100,000 investment in the S&P 500 in 2010 would be worth over $370,000 today, highlighting the need to have your money working for you instead of gathering dust in your savings account.
Stock exchanges are simply where stocks are bought and sold. These exchanges allow investors to buy and sell shares of a company among each other in a regulated physical or electronic space.
The exchange works like an auction with a buyer and a corresponding seller. Traders who believe a company will do well bid the price up, while those who believe it will do poorly bid it down.
The better known listed stock exchanges in the United States are the New York Stock Exchange (NYSE) and the Nasdaq, but there are numerous stock exchanges worldwide. Across the top 3 American exchanges, over 6,000 different company stocks are listed, and in aggregate, they represent over $30 Trillion’ worth of value.
A market index tracks the performance of a group of stocks, representing the market as a whole or a specific sector of the market, like technology or retail companies. You have likely heard of the S&P 500 or the Nasdaq Composite Index. The S&P 500, for example, is an index showing how 500 of the largest companies in the U.S. have performed over time.
The more popular Indexes are often used as proxies for overall market performance, which is why we hear so much about them in financial media. You can also invest in an entire index such as the S&P 500 through index funds. These Index Funds work by mirroring the holdings of the specific index in question.
Stock Picking vs. The Rest
Stock picking refers to an investment approach whereby an individual selects and invests in specific stocks that they believe will outperform the broader market.
When stock picking, you will typically invest in multiple types of stocks. This approach reduces stock-specific risk, balances out the inevitable losers, and eliminates the risk that one company’s implosion could sink your entire portfolio.
Building a diversified portfolio of individual stocks takes a lot of time, patience, and research. The alternative is a mutual fund, ETF, or an index fund (which I discuss in more detail in last week’s Investing 101 article). These hold a basket of investments, so you’re automatically diversified.
You may be confident enough to pick several companies that you know and love to invest in, or you may feel more comfortable going down the index fund route. Regardless, make sure you pick a strategy that’s not going to keep you up at night or cause you to panic sell at the least opportune time.
Growth vs. Value
Value investing and growth investing refers to the two most well-known investment styles.
Although Wall Street loves to try and push every stock into either the ‘value’ pile or the ‘growth’ pile, the truth is a bit more complex, as many stocks have elements of both value and growth. Putting my grievances aside for a minute, some important distinctions between the two need to be made, and many investors prefer one style of investing over the other.
Growth stocks are considered stocks that have the potential to outperform the overall market over time because of their future potential. These stocks often demand a high price relative to current earnings due to the anticipated future growth rate. Much of the tech names that dominate the current market were once fledgling growth companies, with many still displaying significant growth characteristics despite their mammoth growth over the years.
- More “expensive:” Their stock prices are high relative to their sales or profits. This is due to the expectation of future profits.
- Riskier: They tend to be less established companies, adding to the uncertainty of future returns. They are expensive now because investors expect a significant upside. However, if growth plans don’t materialize, the price could plummet.
Value stocks are not simply ‘cheap stocks.’ They are classified as stocks that are currently trading below their intrinsic value (what they are really worth) and will, therefore, provide a superior return over time
- Less “expensive:“ Their stock prices are low relative to their fundamentals
- Less risky: They are typically more well-established businesses with a proven ability to generate profits based on a proven business model. That being said, investors must be careful not to fall into the ‘Value trap’ and keep in mind that these stocks may be cheap for a reason.
So, which is better?
Historically speaking, value has outperformed growth over extended periods. Based on a study from Bank of America/Merrill Lynch over a 90-year period, growth stocks returned an average of 12.6% annually since 1926 with value stocks generated an average return of 17% per year over the same timeframe.
Since 2009, the tides have changed somewhat with value investing underperforming its growth counterpart. With the spread in valuations now at their widest point in at least 25 years, the value bulls have re-emerged, adamant that value outperformance is immanent.
Value vs. Growth Performance 1995–2020
There is no doubt that the valuation gap between growth and value does represent food for thought with more and more investor wondering when this dynamic might change but basing your investment approach solely on the idea that value stocks have recently underperformed and therefore, should outperform in the near future is a shallow investment thesis.
While there is no way of knowing if and when the much anticipate reversion to the mean will take place for value stocks, history has shown us some distinct performance patterns.
- Growth stocks, in general, have the potential to perform better when interest rates are falling, allowing for cheaper financing of their growth. However, they may also be the first to be punished when the economy is cooling
- Value stocks, often stocks of cyclical industries, may do well early in an economic recovery but are typically more likely to lag in a sustained bull market
Regardless of which type of investor you are, there may be a place for both growth and value stocks in your portfolio. At the end of the day, we are all seeking quality companies at a reasonable price, so try not to get too caught up in the weeds on this one.
Small-Cap vs Large Cap stocks
‘Small-Cap’ and ‘Large-Cap’ settles nicely into the realm of unnecessary business jargon. These terms simply refer to smaller and larger companies. The “cap” refers to market capitalization or the company’s total market value (price per share X total shares outstanding).
- Small-cap: Companies valued between $250 million and $2 billion
- Mid-cap: Companies valued between $2–10 billion
- Large-cap: Companies valued over $10 billion
- Younger companies and, therefore, theoretically more volatile
- Tend towards a more aggressive growth strategy
- Tighter business focus with less diversification
- Tend to be established, well-known companies
- Stocks are less volatile
- Growth tends to be slower overall
- More likely to pay dividends than small-cap stocks
So, which is better?
The ‘small company effect’ describes smaller companies’ tendency to outperform larger ones over longer time periods. This was first discovered by a researched by the name of Rolf Banz in 1981.
Historical Performance: Small Cap vs. Large Cap Stocks
Lately, however, the return of small-cap stocks is nowhere to be seen. Over the past five years, the S&P small-cap index has returned a cumulative 40% while its large company sibling has returned over 90%. Some believe that the small company effect has broken down due to the emergence of mega-cap tech companies with huge market share and deeper capital resources allowing them to use their economies of scale to force a competitive advantage.
The question is, will this trend continue forever or will conditions revert to the way they were. Any attempt to answer that question would have to look into the future scope of innovation and even anti-trust laws. The historical tendency for mean reversion would suggest that small-cap stocks now look cheap relative to the more expensive large-cap alternatives that have been on a recent run. Still, it’s anyone’s guess as to when this reversion will take place. For now, maintaining some exposure to the growth prospects of small-caps while holding the core of your portfolio in more stable large-cap stocks will offer stability, growth exposure, and some downside protection through diversification as gains in one area may help offset losses in another.
The Bottom Line
It’s pretty much impossible to predict the exact moves of the stock market, but amidst the unpredictability, the benefits of investing in stocks remain unchanged. What needs to change is investors’ perception of the stock market and its associated risks. Focusing on the day-to-day volatile can result in complete inaction, choosing instead to ‘play it safe’ with your savings account’s negative real returns, better the devil you know and all that. In reality, rescripting the narrative to focus solely on your long-term investing goals will allow you to participate in the rising tides of markets over time without being all-consumed by any short-term market uncertainty.
There are several ways to construct your equity portfolio to allow for more stable returns, ensuring you persist in the market despite your misgivings you may have towards the short term volatility. By spreading out your investments across various investment styles and company sizes, you balance high-risk equity investments with more steady and predictable returns. Further diversification across different investment types, such as bonds and alternative investments, will mitigate your investment risk further while still offering the potential for significant returns in the long run.