What are shares and stocks? How can a beginner make money by investing in stocks and shares? This article explains the meaning of shares and stocks in simple terms with the aid of an example.
What are shares? Although the words share and stocks are ubiquitous, most beginners do not properly understand the meaning of these words. The total amount of money invested in a company is called the capital stock or more commonly 'stock'. The capital stock of a company is divided into a number of 'shares' that all have an equal value. A person who holds a share in a company is sharing ownership in that company along with the rest of the shareholders.
Stocks and Shares for Beginners
The meaning of shares and stocks is best understood with the help of an example. Let us say that a person wants to start a bakery. He invested $10,000 total for buying the equipment, renting a shop, buying ingredients and all the other expenses related with starting a bakery. He had only $3000 as savings, so he asked his friends and relatives to invest in his venture. In return, he promised a share of his profit.
Let us assume that after one year, his bakery made a profit of $1000. This profit will be shared among the investors proportional to the amount that each invested in the bakery. Of course, the owner of the shop will be entitled to a larger proportion since he also invested 'sweat equity' or his time and expertise into the venture. So if the baker gets $500 as his share of the profit, the rest of the profit will be divided among the other investors in proportionate to the amount that each invested in the company. Someone who invested $1000 will get one-tenth of the profit share, since he contributed one-tenth of the total investment in the company. Of course, if the bakery had not made any profit after one year, no one would have gotten their share of the profit. In the worst scenario, if the business wrapped up after one year all the investors would lose their money.
Investing in a limited company is same as investing in a bakery. Anyone who invests in stocks of a company acquires partial ownership of the company. Profits are shared among the investors and all the investors share the risks associated with running a business. Just as there is the risk the bakery will not be successful, there is the risk that the company may fail and the investor will lose all his money. If a company goes through bankruptcy and liquidation, a shareholder gets his share of what is left after all the creditors have been paid, a major difference between ownership of a share and a bond.
Basics of Investing in Shares
Continuing on our above example, people invested in the bakery because they knew that the person starting the business was an expert in his business. They knew he could make delicious doughnuts and cakes, also he had enough business acumen to make it a success. Likewise, before investing in a company always make sure that the people running the business are experts in their field. Good investors try to learn as much about the company and its objectives before investing in it.
The capital stock of a company is divided into a number of shares that will have a face value. The number of shares that a company has issues multiplied by the face value is the total capital of a company. Although the face value of a company is constant, the value of shares can go up and down. The market value of a company represents the number of shares multiplied by the current value of a share, which can be higher or lower than the total capital of the company.
There are two ways an investor can make money from stock market- Dividends and appreciation of capital. A company that is making profit shares a portion of its profits as dividends to its shareholders. A shareholder can also make money if his stock appreciates in value over time, which is called capital appreciation.
Beginners to investing are better off when do not try to time the markets. According to a study by the University of Michigan, an investor who stayed in the US stock market during the entire 30-year period from 1963 to 1993 would have had an average annual return of 11.83 percent. On the other hand, if he had missed the 90 best days while trying to time the market, the average annual return would have been only 3.28 percent.
There are a lot of advantages of investing in shares. With the introduction of online trading, anyone can invest in stock market and can do so in the comfort of their own home. In the long term, investing in stock market can assure greater returns than any other type of investment. Beginners to investing must seek the help of a good stock broker to pick a portfolio before they start investing in shares.
Want to know when to exit the stock market? Read How to Identify the Stock Market Indicators for a Crash?
1. Stocks Basics, Investopedia article, http://www.investopedia.com/university/stocks/
2. Historical Stocks/Shares Performance Returns, http://www.finfacts.com/Private/curency/historicalstocksreturnsperformance.htm
Image Credit: Katrina.Tuliao http://www.flickr.com/photos/thewalkingirony/3051500551/