This is going to be kind of a long tip. This week I’m going to explain what a stock is and what buying a stock means. This is such a basic concept that I’ve frankly overlooked doing a tip about it. But in conversations with clients and others recently, I’ve been told that buying a stock is gambling, or that a stock is just a ‘piece of paper’ and that there is no logic behind what a stock sells for. I want to put some of these misconceptions to rest.
Let’s say there is a guy down the street who owns a convenience store. He wants to expand the store and so he offers to sell you 10% of the business for $20,000 to raise some cash. You agree and you are now a part owner in his business. You’ll participate in profits (i.e. dividends) and if the business has done well, you can probably sell your 10% of the store for a nice gain some years down the road.
That idea doesn’t seem much like a stock does it? Well now let’s add a new element. You’ve got this crazy neighbor next door, who wants to buy your piece of the business. So he knocks on your door every day and offers you a different price for your 10% share. Today it’s $18,000, tomorrow it’s $20,500, the next day, $22,000. The price jumps all around because you never know what your neighbor is going to offer you for it.
Now we have a closer analogy for stocks and the stock market. We own part of a business, and the prices are jumping all over the place. But notice something. It’s not the ownership of the business that makes it seem random, it’s the crazy neighbor! Remove him, and it’s just the ownership of a business.
So we take it a step further. Instead of a convenience store, it’s a chain of stores. The owner sells millions of tiny pieces of this business at $20 apiece. And instead of one crazy neighbor coming over once a day, you now have essentially thousands of crazy neighbors knocking on your door constantly offering to buy your piece of the business at different prices (i.e. you have bids for your shares of stock).
Let’s look at some of those claims now. A stock is a piece of paper? Since when is owning part of a profitable business just a piece of paper? Gambling? Gambling is a game of chance. Owning a business has risks, certainly. But it’s hardly a game. No logic for what a stock sells for? Ah, there is some truth to that, in the short run. Your ‘crazy neighbors’ could offer you just about anything. But in the long run, the price of a profitable business must rise. Imagine if it didn’t. Imagine if someone were able to buy up all of Microsoft’s stock and own the whole company for $1 billion. If the price hadn’t run up 300 times it’s original price, that’s what would be true today. In the short run, the ‘crazy neighbors’ are just noise. In the long run, for a good business those bids will go up and up and up.
Stocks aren’t for everyone, and just like with any business enterprise, there are serious risks involved. Not all business are good businesses. If that convenience store is located in the middle of nowhere, it might not do very well. But what stocks aren’t is some random casino masquerading as a legitimate investment. Stocks are what have made the US the most powerful economic force in the world (so far). If that’s just gambling, or ‘pieces of paper’, then I’ll be like Oliver Twist and ask “Please Sir, I want some more”.