A stock, very simply put, is a piece of ownership in the profits or cash assets of a company. Ownership of a stock is represented by a paper or digital certificate. This very definition holds the key to how you should look at investing in stocks. However, we’ll address how to invest in stocks later. For now, let’s just try to understand what stocks are.
Understanding Stocks – A Simple Scenario
Imagine you start a private company, a single-person corporation, by yourself. As the founder of that corporation, you have complete control over which direction the company goes, what business areas the company will focus on, who you hire, and so forth. Many entrepreneurs love that control. Oh yes, and possibly more important, you are entitled to all of the money (profits) the business makes.
In the process of starting any corporation, there are formal documents that you will be given, which will set out the maximum number of shares the corporation can issue to potential “profit partners” in the business. Let’s say that number in 10,000 shares. Each of those shares represents 10,000 individual pieces of the corporation’s cash assets or profits. As the founder of the corporation, you own 10,000 pieces or parts of the business’ assets (anything of value that can be converted into cash).
Now, suppose you have a great idea and want to expand. You are confident that it will make a lot of money, but you have neither the money nor expertise to accomplish your goals. However, you know of a savvy and trustworthy person who has both things you need. You work out an agreement to where this person becomes an “owner” in the profits of the corporation, with each owning 50% of the company’s assets. You give or sell to him half of your shares (technically and legally, it’s the corporation which distributes the shares), half of the rights to the profits, in exchange for his money and expertise. You now own 5,000 shares, and your “partner” owns 5,000 shares of the corporation. Each of you now has rights to 50% of the corporation’s cash assets. If you had kept 8,000 shares and given your new “partner” 2,000 shares, he would have the legal rights to 20% of the cash assets or profits: 500 shares, 5% of the cash assets, and so on. The greater the number of shares you own, the greater the earnings to which you are entitled.
In principle, you’ve sold half of your rights to the profits to expand your operations in hopes of accomplishing the company’s goal of making much more money long-term. However, you may have sacrificed complete control because now someone has equal ownership of the company’s direction. Of course, contracts may define the level of control by the two shareholders (an owner of shares in a company).
Simply put, when you buy stocks, you are purchasing ownership in the profits of a company. You do not own the corporation, and you do not own the non-cash assets (furniture, property, or buildings, etc.). The amount of control you have in the business will depend on how the corporation is structured and what percentage of the overall shares you own.
In the scenario above, we are dealing with two shareholders of one company. In a typical situation, you would be dealing with possibly thousands of shareholders, each with little to no control over the direction of the company. Which leads to our next question, what is the main thing to consider when becoming an owner of shares in a company?
How to Invest in Stocks – The Most Important Consideration
As previously stated, when you purchase a share of stock in a company, you are buying a piece of ownership in the profits or cash assets of a company. While you technically do not own the corporation, you do have a vested interest in its well-being. You want to make sure the people running the corporation know what they are doing, have a proven track record, and understand how to build and manage money. Research the people who make the decisions and ensure that your trust in them is justified. Also, you want to know that leadership is stable since it is always best to think of stock purchases as long-term investments. Frequent turnover in a company’s key players results in instability and uncertainty in the direction of a company. So, choose the people you invest in wisely. If there is a significant change in the leadership of the corporation, reassess your investment in that company.
Always remember that a company typically issue stocks to grow the business, raise money, or undertake new projects. Find out what they are going to do with the money you are giving them. You would never give someone cash without knowing what they are going to do with the money, would you?
Do not leave your financial future to chance or guesswork. Remember, you are not investing in a company or stocks; you are investing in the people who operate that company.