Note: This article was originally published on Zonotho, a financial education start-up, in Feb 2020. It came out of a discussion with a friend, who wanted me to help him understand the complex world of stock investing.
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There are many reasons why people invest in the stock market. Some want to make millions overnight (unlikely!). Whilst others may want to invest in businesses that will grow over time. If you have any kind of retirement savings or pension you probably own stocks already.
In this article, we’ll go through the absolute basics of what you need to know to get started.
What is a stock?
Stocks, also called shares or equities, are rights of ownership of a public company. If you own shares of a company like Apple or McDonalds, you own part of that company.
In exchange for holding this share, you get part of that company’s profits every year, called a Dividend. You can also sell the share to other people, and if you sold it for more than you paid for it, you will make a Capital Gain.
Why do people buy and sell stocks?
People buy stocks for two main reasons:
Trading – The price of stocks changes from day to day. If more people are buying the stock the price will go up, and vice versa. Traders try to “buy low” if they think a stock is going to increase in price, and then “sell high”. Because nobody can predict what the stock market will do, trading is a risky activity, even for professionals.
Investing – Investors buy shares in a company they think will grow in the future. They may buy a small company because they think it has potential. Or they may buy a well-established company that makes consistent profits every year. Most people in the stock market are investors who have different strategies and goals.
Which stocks should I buy?
You can pick the stocks yourself or you can buy a fund. Picking stocks is an extremely risky activity, even for seasoned professionals, so it is never recommended for beginners.
The alternative is to invest in a fund. A fund is a big pool of assets, and so by investing in a fund, you are investing in many different stocks at once. Note that funds can contain other assets besides stocks. To find out what a fund invests in, read the Minimum Disclosure Document a.k.a. the Fact Sheet.
What kinds of funds are there?
There are two types of funds:
Active Funds – With an active fund you pay an asset manager to pick stocks for you. These funds will follow certain rules (e.g. no more than 10% of the portfolio can be invested in one company) and have different objectives. But otherwise, the asset managers are free to use their judgment, expertise and research teams to find a winning strategy.
Passive Funds – These funds trade according to a specific algorithm. For instance, the JSE Top 40 invests in the largest 40 companies in South Africa. The S&P 500 invests in the largest 500 companies in the United States. Because passive funds follow set rules and do not have large teams managing them, the fees are significantly cheaper.
How do I know if a fund is performing well?
The average growth of all the companies in an economy is called the market return*. Every year, some companies will earn better profits than the average, and will “beat the market”. Some companies will earn lower profits or even lose money.
It is important to compare how much a fund earns versus the market return. In South Africa, 82% of asset managers failed to beat the market from 2011-2018. In the United States, 92% of asset managers failed to beat the market from 2003-2018. This means the majority of investors would have been better off simply investing in a passive fund.
Note that with a passive fund, you will never earn better or worse returns than the average market return. You will always earn the average, minus the fees you pay.
Where can I buy stocks?
You can purchase stocks or funds through a broker or financial advisor. But note that they will charge you fees for their time.
You can also invest in stocks or funds directly using an online platform, or the website of the company whose funds you wish to purchase.
* Note that the market return is an average weighted by size. Large companies have more impact on how the market does than smaller companies.