Recently, I was at the doctor’s office for a chest cold which turned out to be bronchitis. After the doctor did his diagnosis, he told me that he was going to prescribe a medication that would solve the problem. He gave the names of the two medications which for this non-medical person sounded like long Latin terms. He described how he decided to go with this one Latin term prescription over the other longer sounding Latin prescription because he thought it would be better for my stomach. Later when I arrived home and told my wife that I was prescribed medication, she asked me which one. I told her that I had no idea but the doctor told me it would do the trick.
As financial planners we use language and terms that while they may not be Latin-based, are still not fully understood by our “patients”. In an attempt to try to add some insight to the tools that we use to help solve our clients’ problems, I will spend the next few blogs highlighting some key financial terms that are not always well understood by the general public.
This blog post will only deal with answering the question – “what is a stock”? And it’s related question – “what is equity”? We hear these terms daily from TV and radio commentators speaking about how the stock market did that particular day in general or how a specific stock either declined or advanced. I believe that the financial world does not appreciate that most people do not understand what the term ‘stock’ means. And while there are textbook answers to this question – concerning the capital structure of the company –I’m going to try to describe in a more understandable way.
First let’s begin by understanding that the term ‘stock’ and ‘equity’ are interchangeable. Stocks represent the fact that you are actually an owner of the company for which you hold one or more shares. So you can purchase a share of Microsoft like you can purchase a bag of chips and the price of the stock is established by the thousands of buyers and sellers who trade their shares daily.
Most people who own only one share of Microsoft are surprised to learn that they are an owner as much as Bill Gates is an owner of Microsoft with the very large difference being that Bill and Melinda own a large number of shares versus the mostly pedestrian number held by most people. [quote]So can you imagine owning a piece of companies like Apple, Disney, Boeing, McDonalds? Well you can.[/quote]
All of the benefits to ownership of companies are derived by the owners regardless of the number of shares held by each. As most people instinctively understand, one would rather own a business whether it is a small local business or a large beverage company such as Coca-Cola versus lending money to each of these institutions. You are afforded a better potential return as owner and participate in any profits of the companies. As an owner, if the companies generate increasing profits, the stock may become more valuable and the company board may even pay out to the owners some profits as dividends. However, as owner you take on added risk because you have the potential that the business can go bankrupt. If it does, then you can possibly lose the amount that you have invested in that company reflected by amount invested in the shares.
Currently, the number of companies that can now be publicly owned by anyone who has the means and desire has grown to over 10,000 different companies in over 45 countries. This has allowed any individual to become an owner of some of the greatest financed, most profitable companies the world has ever seen. And for most long-term (think retirement) portfolios, one should own thousands of these stocks. If history is any guide, then the ownership of these companies will provide the means for most to be able to achieve their goals, as long they are steadfast and continue to own them regardless of the current market conditions. So remember: [highlight]You are not invested in the stock market, but invested in the great companies of the world.[/highlight] Next post in this series will address ‘what is a bond’?