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Stocks & Bonds – Like Vanilla & Chocolate - Part 2

In part 1, we understood in detail about bonds, their features, various terms and parameters and the types of bonds. In part 2 we shall learn all there is about stocks and why stocks are an essential part of a portfolio if one wishes to become wealthy. 

Let us begin with what a stock or share is. A share of a company is a document representing ownership interest in that company and those who own the shares are called shareholders. While everything is digital now including the document, this is how it looked like when it was an actual paper document:

Forming and starting a company requires money. When a company is formed, shares are created using that money called share capital representing shareholder’s contribution to the business. The number of shares created depends on the share capital and initial value of the shares. The initial value is also called face value or par value. It will be easier to understand the same with an example. Say an individual A starts a company with $10,000. A now has an option to create 100 shares each with face value of $100 or 1,000 shares with $10 or even 10,000 shares with $1 as face value. It is to be noted that fractional face value is not generally implemented due to various issues. Assume A starts a company XYZ with 1,000 shares each with a par value of $10. It can now sell these shares to anyone and those who acquire it shall become co-owners of the company alongside A in the proportion of shares bought. Say B buys 100 shares from A for $1,000. B now becomes an owner of 10% of XYZ and A remains owner of 90% of it. It is to be noted that a company can also create and issue additional shares by bringing in additional share capital.

Now that XYZ has begun running and making profits, there are others who wish to invest and own the company. A and B either have a choice of selling their shares to those investors or have XYZ issue new shares for them. Since the company is making profits, they are not restricted to selling those shares at par value and can in fact demand extra for those shares. This is known as share premium. Most of the shares you see in markets today are all trading at varying premiums based on the quality of their profits or earnings, longevity of business and other factors which shall be discussed in detail in subsequent blogs.

Shares not only signify ownership interest but also allows the shareholder to enjoy the benefits of being an owner including a share in the profits, proceeds from company liquidation after paying debt and voting rights regarding various decisions to be made about the business. Shares are collectively known as stock as well.

Why would a Company issue shares or sell them to public?

A company or an owner can have myriad reasons to sell their shares. Let us explore the major ones:

Raising additional capital

A company may be looking to expand and may need additional money. While internal accruals are often used, they are not always sufficient for the necessary tasks in which case a company may issue additional shares and offer them to the public and utilize the received funds for its expansion

Owners looking to cash out and diversify

Owners of a particular business have set it up and made it profitable. Often they would now look to doing something else and would need some money for the new venture which they will obtain by selling some of their shares. In some cases, they would cash out their entire ownership and simply walk away. For e.g. Myspace founder Tom Anderson sold out his entire stake in the company just before it began its decline. Finally, owners want to make some money and use a rising market to sell out their shares at a high valuation.

Regulatory requirements

Some countries mandate foreign countries to have local ownership and thus force the companies to issue shares to the local public. This might often go against the wishes of the company who does not wish to dilute their ownership and the company may often shut operations in the country itself. For e.g. in the 80s, India forced all multinational companies to issue shares to the public compulsorily at face value. While some like Colgate Palmolive complied, others like Coca Cola simply shut operations and left the country only to come back a couple of decades later once this mandatory regulations were removed.

It is to be noted that a company cannot simply up and offer shares to the public. It has to take regulatory approvals and meet certain profitability and business quality criteria before going public. It needs to do this only once however and once it has gone public, it can then issue additional shares or buy them back with regulatory approvals. The process of issuing shares of a private company to the public is known as an Initial Public Offer (IPO). All companies looking to become public have to announce an IPO for issuing shares. The one of the largest IPOs in recent times was Facebook which was listed in 2012.

The shares once issued need to be available for trading so those who wish to sell or buy can do so. This public trading also helps in price discovery and those wishing to monitor their portfolio will be able to track the performance basis the prices at which the shares are traded. To make the shares available for trading, a common marketplace needs to be provided and in this case, that place is called a stock exchange.

A stock exchange provides a marketplace environment for freely trading shares as well as allowing for efficient price discovery. They are strictly regulated to ensure complete safety of its customers and their funds while transacting. Some of the popular and well known exchanges include the New York Stock Exchange (NYSE) and NASDAQ.

To participate in the stock market and to buy, sell and hold stocks, one needs an intermediary called as the broker who will do all the transactions on your behalf. One cannot trade stocks without a broker. Some of the legacy brokers include Charles Schwab, TD Ameritrade and Fidelity Investments etc. along with new online brokers offering powerful analytical tools and rapid execution like Ally Invest, Robinhood etc. Well, what are you waiting for? Open an account with Ally Invest or Robinhood and begin right away. We will be here for you when you come back.

Advantages and disadvantages of Stocks

Equity has been a powerful wealth creator. The S&P 500 has generated a 5.9% return per annum net of inflation over the last 20 years. A $10,000 investment in 2000 would have been worth $31,200 in 2020. That is a very powerful growth and one that has not been replicated by any asset class. The legendary investor Mr. Warren Buffett made his billions by investing in stocks and he began pretty early. You too can do the same and I suggest you include equity as a part of your portfolio no matter your age.

The only disadvantage of equities is given a wrong selection of stocks, they are known to be wealth destructors as well. Investors in companies that could not keep up with times like Blockbuster or Fraudulent companies like Enron have seen their investments go to zero. However as the saying goes, do not put all your eggs in one basket. The simple solution to this disadvantage is diversification and asset allocation. While we shall speak about diversification and asset allocation in detail in later posts, it is sufficient to understand to spread our investments across various asset classes and within them, various instruments. For e.g. as we had discussed in our previous blogs about constructing a portfolio around equity, debt, gold and real estate. In equities, one can spread investments across various sectors and industries, each complementing the other. For e.g. one can invest in Airlines, pharmaceuticals and IT. So in case a pandemic situation hit, airline stocks will go down, but pharmaceuticals and IT stocks will go up. This will eliminate your risk of losing money from a bad stock.

That is it. That is the only risk in stocks. Losing money. While it cannot be completely eliminated: something big as a financial crisis or a pandemic will bring the whole markets down and thus your portfolio, patience and continued faith in the US economy will help. In the long run, the markets have always, and I stress the word “always” because the markets have always gone up. The US economy is resilient, robust and has withstood the test of time. So there will be occurrences when equities are in red and you are sitting on paper losses (paper loss because until you sell, you won’t book that loss), these will be opportunities, where one can buy more and invest more so that when the markets eventually move up, which they will, one has a stronger and better investment.

Asset allocation with stocks and bonds

While both stocks and bonds have their unique advantages, it is not advisable to hold only one asset class. A stock only portfolio will provide wealth appreciation but subject it to violent movements. A bond only portfolio will provide stability but no wealth appreciation. A mixture however will provide both.

To better understand asset allocation let us consider an equity only portfolio worth $100 and a 50-50 equity bond portfolio of same $100 ($50 in stocks and $50 in bonds). Let us consider portfolio movement over 5 days with respect to equity movement only. For this exercise we shall assume bonds to be firm and stable over 5 days.

Day Equity Market Movement Equity Combined

As one can see, at the end of 5 days, both portfolios end at the same number but the equity portfolio has moved around violently thrashing around like a raging bull whereas a combined portfolio has had a stable, quiet journey like an amazing car on a smooth, albeit slightly bumpy road. Do not assume that one can predict the market and sell it on Day 3. It does not work that way and no one has been able to predict market with consistent accuracy. One often finds themselves exhausted mentally when dealing with such violent price movements and more often than not capitulate and quit equities altogether.

A combined portfolio protects one from such violence and enables one to stay invested for the long term and as we have seen in the previous posts, money is not made by entering and exiting, but by staying invested.

Join us for the next post where we venture deeper into equity derivatives, trading and its types and various other topics about capital markets and personal finance.