Thursday, May 26, 2011

Why Stocks?

The stock market is a pretty popular place to put your money.  If you have ever seen the news, a section is usually dedicated to how the stock markets moved that day and many people have investments in various companies.  But first of all, why does the stock market exist?

Companies usually get listed on the stock exchange as a way to raise money.  Individual investors have the opportunity to give companies money in the hopes that the company is able to use that money in a solid business plan to make more money.  However, this is only in the case of an IPO (initial public offering) where a company first sells shares to investors.  During the normal day-to-day trading on the stock exchange, however, people buy or sell shares of stock to one another.  There are instances where the company may initiate a stock repurchase to buy back its shares when they think their shares are undervalued, or priced too low, but for the most part the counter-party to a trade is another investor (or fund manager, etc.).

So why would you buy shares of stock in the first place?  There is almost no value in saying that you own part of the company is there?  The only real value you can get is from receiving money back somehow from owning the stock.  The two ways to get this is when companies pay out dividends and if the value of the shares you hold have appreciated (increased in price) before you sell them.  Almost all the value of a stock can be focused onto the dividends, however.  Because companies can provide an infinite stream of cash flow, the value of a stock can be theoretically calculated by taking into account the value of all the future dividends a company will pay out.  Of course, we won't be able to hold onto a stock for infinite, sadly, but the remaining value of those future dividends will be captured in the price we sell our stock at.  This gives value to stocks that don't currently pay a dividend, since there is some value future investors will pay when the company does eventually pay out a dividend.

And finally, why would you invest in stocks rather than in other forms of securities like bonds?  Over the long-run, stocks are shown to outperform any other security.  I've taken a chart of real returns for stocks, bonds, bills, gold, and cash since 1800 from Jeremy Siegel's book, Stocks for the Long Run, and you can see that stocks way outperform any other asset class by more than a hundredfold (click on the picture to magnify it).

Over the long-run, the performance of stocks looks almost like a straight line.  And although this graph only goes up to the early 2000s, even including the recent financial crisis does not seem to change the performance of stocks significantly.  Of course, this means that stocks are something that you would have to invest in over long periods of time if you hope to see certain gains and in the short-run, stocks can be quite volatile.  It is also important to diversify your risk when looking at stocks to mitigate the chance of suffering a severe loss.

Especially for college-students, now is the perfect time to start saving money and putting a little bit into stocks each month since we have plenty of time in our lives to let our investments grow.  Because of our longer time horizon, it would be most efficient to take advantage of these assets with larger returns.  In the next few posts, I will talk more about what features to look for when picking stocks, how to order stocks, and how to maintain your portfolio.

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