Johnny has some extra money lying around. He’s been pondering the idea of putting it into the stock market and having his own money work for him, but Johnny’s not sure how to go about doing that.
He’s heard of investing being compared to gambling — is it a good idea? Luckily for Johnny, he’s stumbled across this edition of Business Basics.
What’s a stock and what’s the stock market?
If you could represent a company as a pie, a company’s stock would be slices of that pie. Simply put, stock is a share in the ownership of a public company. The more stock you own, the larger the slice of pie you can claim as your own.
The stock market is the place where shares of public companies can be traded between investors — like trading slices between your siblings so that everyone gets their favourite. The basic mechanics behind the stock market should be quite intuitive to anyone who’s familiar with how supply and demand works: when demand for a certain stock shoots up, so too does its price on the market, and vice versa.
Because the prices of stocks are never static, investors are able to make money by buying low and selling high, capturing the profit in between.
The price of a stock captures the speculative value that investors see in a particular company. If, for example, Microsoft has done particularly well this year in terms of generating profits and growth, then we can expect its stock price to have risen accordingly. Therefore, investing in stocks boils down to picking companies that you think will be successful in the future.
What are the risks associated with buying stocks?
Johnny should only buy stocks if he’s certain that he won’t need any of the money he invests in the short-term. While stocks are liquid — they can be converted to cash relatively quickly — the value of stocks aren’t always stable.
In the stock market, like most things in life, the higher the risk, the greater the potential reward. The chance exists that Johnny may lose his entire investment if all the companies he’s invested in go bankrupt, but this risk can be significantly mitigated by investing in a broad array of companies.
How do I begin investing
Before Johnny can even begin to fantasize about capital gains, he needs to open a brokerage account. This is easily done. Most banks in Canada offer inexpensive brokerage services that allow investors to take control of their own trades, such as TD’s Direct Investing or CIBC’s Investor’s Edge.
Once you have a brokerage account, it’s a simple matter of transferring funds in and then you’ll be ready to trade.
What stocks should I buy?
Johnny sees the thousands of companies listed on the Toronto Stock Exchange (TSX) and feels overwhelmed. What should he pick? Unfortunately, there’s no correct answer — if there were, everyone would be rich.
It all depends on what your appetite for risk is and how long you’re willing to hold on to an investment for. As a general rule, a longer time horizon and higher risk mean higher potential returns. Always do your research before purchasing a stock. Understand how a company makes money and what the key factors behind its growth are. This will help you understand the circumstances required to help your investment grow.
While Johnny can buy the stocks of individual companies, he can also opt to buy shares of an Exchange-Traded Fund (ETF). An ETF is a best explained as a bundle of assets comprised of anything from stocks, bonds, gold, foreign currency, etc., which is then divided up and sold as shares to individual investors. Go back to your pie and imagine that instead of having to cut separate slices of blueberry, cherry and pumpkin, someone blended them all together and you can just cut one piece with all three flavours in it.
The iShares S&P/TSX 60 Index Fund (XIU) is one example of an ETF. It consists of the 60 largest stocks on the TSX, granting investors the opportunity to easily diversify without having to handpick stocks of their own. ETFs are great for investors who like to be hands-off with the market.
What’s the bottom line?
The stock market may seem like a scary place, but a well-informed investor has no reason to be afraid. With proper due diligence and a healthy dose of patience, the stock market can become a place of prosperity and fortune.
Historically, the stock market has always trended upward—since 1928, the S&P-500 — an index measuring the performance of the American stock market ‘ has returned, on average, 10 per cent annually.
So step right up! The odds are already in your favor.
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