Whether you’re an active or passive investor, you need to understand the premise of the stock market. That is, allowing the average person to buy and own stakes in corporate America. In the market, there are winners and losers, and those who understand the market can and ought to stake a claim for themselves.
Let’s take a look at a simple example.
Jimmy is a financially inclined seven year-old. He buys gumballs for 20 cents at the grocery store and sells them for 25 cents to his classmates. Every day, his main priority is to sell gumballs (not grades or girls). He sells 25 gumballs a day and makes (25 x 0.05 =) $1.25 per day. Not bad for a seven year-old. Let’s assume he sells 50 gumballs every day, rain or shine. When the weekend rolls by or school is on vacation, he can be found at the local park slanging gumballs. Over a year he makes $456.25.
Money makes him smarter, so he decides to get a gumball machine. His uncle happens to have one and rather than let it rust in the attic, he decides to make a deal with Jimmy. Jimmy pays him $10 per month and he lets Jimmy borrow it. Great uncle huh? Either way, Jimmy decides he’d be making more money with it than without, so he takes the deal.
Jimmy goes back to school and unbeknownst to his principal and teachers, there is mysterious gumball machine behind the back portables. While the machine costs him $10 per month, it sells 50 gumballs a day. And since it takes no breaks, it earns him money during and after school hours. For sake of simplicity we’ll assume the machine sells the same amount during weekends and holidays. Over a month it makes Jimmy ($75 – 10 =) $65 which equates to $780 a year.
Jimmy’s net income is now ($456.25 + 780 =) $1236.25. Since the government doesn’t require seven year-olds to file tax returns, he doesn’t. At a young age Jimmy falls in love with Apple (like many do) and wants to buy a MacBook, iPhone and iPad. In order to satisfy his needs he will need $3000 to purchase the must haves.
For $3000 he’ll make you a 50/50 partner in “Jimmy’s Gumballs”, do you take the deal? Half the ownership of the company means you get half the profits. That’s a return of ($618.13 / 3000 =) 21%. Better than investing in CD’s or Treasuries by far. Note: $1000 compounded at 21% grows to $304,481 in 30 years. Incidentally, Berkshire’s annual return since inception is pretty close to that, 20.3%.
The Stock Market
The interesting part of the story is every day you are presented with opportunities like Jimmy’s Gumballs in the stock market. While there are certainly great companies – Coke, General Electric, and Apple to name a few – they might not be at reasonable prices. What if Jimmy asked for $20,000 for the 50% stake in the company? A 3.09% return might not be so appealing and you might tell Jimmy, I love your business but your price is ridiculous. And the crazy thing, plenty people buy stocks at those ridiculous prices.
The good news is you have 7000 – 8000 stocks to choose from on the New York Stock Exchange (NYSE), NASDAQ and American Stock Exchange (AMEX). You don’t have to buy unless you feel like the price is right. When you buy a stock, you’re not just buying some paper or receiving electronic confirmations. You are buying pieces of a company that give you rights to profits, dividends, price appreciation and votes (albeit limited at times).
Investing in stocks takes time and at least average intelligence. These days, much of the research required is available online. You can find industry research, financials and reports on the stocks listed on the exchange and do your own analysis of whether or not a stock is a good buy.
More on this to come.