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Basics of Investing: Stocks

Have you ever dreamt of owning a piece of Sim Darby?

With stocks you can. Stocks are basically 'shares' of a company. It is ownership in the most literal sense: You get a piece of every desk, filing cabinet, contract and sale in the company. Better yet, you own a slice of every dollar of profit that comes through the door. The more shares you buy, the bigger your stake in the company.

Stocks are the means by which companies obtain additional financing for their businesses - by selling off parts of their company to investors. The price of a stock can vary tremendously, from a couple of cents a share, to more than a hundred dollars a share! 

How is the price of a stock determined?

It's all about the company's earnings. Suppose you own a company which makes RM10 in profits every year. How much would you be willing to sell the entire company for? Say you ask for RM100. Would anyone buy it?

To a potential buyer, he will assess his situation with this question "How much return can I get if I invested my money somewhere else?"

If he buys your company at RM100, he is essentially investing in a vehicle that can generate 10% returns a year. If he can't find that kind of return somewhere else, he will pay your RM100 asking price. If he can, then he won't. You might have to lower your asking price.

Another factor that enters into the consideration is earnings growth. Your company may be making RM10 today, but it may make RM20 next year. For a 10% return, an investor might be willing to pay you around RM150 for your company. He may only make 6.6% this year, but he makes 13.3% next year, and possibly more the year after.

So his RM150 now can still be considered well-invested, as he would meet his investment objective. You can sell your company for RM50 more. Many people are projecting that their future earnings will be good, so they are willing to invest in these companies now.

What are stock markets? 

Stock markets are places where companies can offer their shares for sale. They do this through an Initial Public Offer or IPO. If a company sells 10 million of its shares at RM1 each, then it is able to raise RM10 million dollars for itself.

Companies raise money for a variety of reasons. Mostly, it is to expand its business, or to pay down debt.

Potential investors who look at a company's IPO will ask the same 2 questions outlined above - What is the company's earnings potential, and whether there are other investments which might give them a better return. If they decide that the company's earnings potential is good, and can offer a better rate of return, they will invest in it.

That is why many companies which offer IPOs usually price their stocks at attractive levels.

After the IPO, the thousands or millions of investors who have bought the stocks can go back to the stock market and sell the stocks to other investors, so 'trading' of the stocks begin. A stock market is simply the clearing house for these 'trades'.

What causes volatility in stock prices?

Factors that affect a stock's price can be separated into 'macro' factors and 'micro' factors.

'Macro' factors are factors that affect the whole economy. Higher interest rates, inflation, national productivity levels, politics and such, can have important effects on a company's earnings potential, and so affect its share price.

'Micro' factors are factors that affect the company itself. Management change, prices and availability of raw materials, productivity of workers and such, affect that individual company's earnings performance.

Fund managers and stock investors have to study both macro and micro reasons to try and ascertain the profitability of a company, and determine the 'fair price' of its shares.

What causes volatility in the prices is that there are often different opinions about where a company's earnings are headed. In a day when more people think that a company's earnings are headed down, there will be more sellers, and prices will head down. Of course, the reverse happens as well.

Dividends

Price increases, or capital appreciation, is not the only way you can make money on stocks. Many companies also pay yearly dividends. These are cash payments that represent a portion of profits. However, it is entirely up to the companies whether to pay out dividends or not. They are not obligated to. Often however, they will often return a portion to reward their investors.

Diversify your risks 

While history shows that the prices of stocks of good companies will rise in the long run, there are no guarantees - especially when it comes to individual stocks. Companies do go bankrupt. When that happens, the share price drops to zero and you lose all your money.

The best way to avoid this heartache is to diversify your investments by owning a variety of stocks. That way, the collapse of a single company wouldn't give you a minor stroke. You can either choose to hold a range of different stocks and monitor each one, or simply buy into a unit trust, which is a diversified collection of stocks, and let a professional fund manager manage your money.

These fund managers spend all their time studying companies and their earnings potentials, and chances are that they will do better at stock picking and make more money for you.

What you can be assured of though, is definitely less stress, as you won't need to watch prices everyday!


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