Before getting into it, we must ask the question: why? Well, you might know the answer as there is clearly some investing interest. Why else would you google “how to invest” and somehow wind up on this webpage?
Investing is delayed gratification. It is long term thinking. It goes against our human nature. You know ‘the why’ but let’s just make it obvious so we are all on the same page:
To make tomorrow better than today.
Whether that means putting kids through college, saving up for that fancy yacht or just because it seems like a good idea, this principle rings true. You want to make tomorrow better than today. And you want freedom. Freedom from financial stress, working long hours, and not spending enough time doing what you love. So come along on the journey, let’s figure out this whole investing thing together…
Block 2: The What
To lay a strong foundation for our investing city (see what we did there), let’s make sure we understand the mechanics of investing and business and how it all works together…
When an ambitious entrepreneur dreams up a business idea, she needs money to make it happen. She pitches the idea to investors (probably friends and family) and, in return for their money, the investors usually get an ownership stake in the business. Just like Shark Tank! By sacrificing the right to enjoy their money now, the investors require compensation in the future. This is the essence of investing!
When you put money in your savings account, the interest you receive is your compensation (or return, the money that returns to you as an investor). When it comes to investing in businesses though, return is not guaranteed. This means, as an investor in businesses, you take on risk. There is a “risk” that you may not even get your initial investment back if the business fails.
On the other hand, in that savings account, you assume basically no risk, so you settle on a lower return. A higher risk means there is a higher probability you can lose part or all of your investment; so to compensate for that risk, you demand a higher return. For instance, you are going to demand much more money from your friend if he dares you to jump in the Arctic Ocean compared to jumping into Waikiki waters. The risk (of death or maybe just discomfort) of jumping into the Arctic waters is much higher therefore you demand more compensation.
Like in Shark Tank, the sharks will demand a higher ownership stake for a business that looks “risky” to them. If there is a higher probability the business won’t work out, they want to make sure they are getting their money’s worth if it does.
In summary, we covered that investors are seeking return for sacrificing the right to enjoy their money now. We also explored the risk vs. return relationship that is at the heart of investing. A higher probability of failure means investors want to be compensated enough to make that leap of faith. Let’s see what is next…
Block 3: Where Do You Start?
Investing seems intimidating but just like any big problem, when you break it down into a lot of tiny pieces, it becomes simpler. Granted, there is some jargon involved just like anything else (see glossary), but that is why we are here.
To start, let’s make sure we have a firm foundation on what stocks actually are.
Take, for example, the most valuable company on Earth: Apple. You might have heard of it. You might also have heard your haughty neighbor brag about owning stock in Apple. So what exactly does this mean? Put simply, stocks are the vehicle by which public companies can be bought and sold.
Ok, even that definition requires explaining. Vehicle? Like a car? The other vehicle. More like a medium of exchange. For instance, if you have ever traded baseball cards or another type of card (maybe Pokemon?) this might make more sense. The baseball card would be to the stock as the baseball player would be to the business. The card is just a medium of exchange, or vehicle, by which the baseball player can be bought and sold. That’s where the analogy ends; if you own a baseball card you don’t actually own that human being. Whereas, when you buy Apple stock, you are effectively buying into Apple as a business. Don’t miss this: stocks represent ownership of a business.
But what about the ‘public’ companies part? What does that mean in this context? Public companies are businesses that can be bought and sold by the public. Incredible definition huh? All that means is you don’t need any fancy relationships with really rich people or royal blood, you just need a brokerage account.
A brokerage account is to stocks as groceries are to a grocery store. If you want groceries you buy them at a store. If you want stocks you buy them by opening a brokerage account. On the other hand, there are also private companies. The public cannot buy them because they do not have stocks associated with them. For instance, I can’t buy into your Uncle Ned’s landscaping business or that Mom & Pop diner down the street from you. Why? Because those businesses are not publicly traded. How does a business become ‘publicly traded?’ Let’s find out…
Block 4: The Road To Publicity
Let’s go back to circa 2008. Picture Mark Zuckerberg working tirelessly in his dorm room to perfect Facebook. It is growing so fast he doesn’t have any more money to support the expansion, so he decides to “go public.” So why doesn’t Uncle Ned ‘go public’ when he runs out of landscape jobs? Well, the process and qualifications are fairly stringent. For instance, the New York Stock Exchange (NYSE) requires at least $4.5 million in pre-tax income to IPO (initial public offering aka ‘go public’). So not every company has the luxury (or obligation in some cases) to participate in the public markets.
This is a gigantic step in the journey of a business. Very few companies go public, in fact, usually only the best and biggest do. There are around 4,500 publicly traded companies vs. around 6 million businesses in the U.S. alone. Pretty much every big business that we interact with daily is public aside from Patagonia (*a generalization). Facebook, Amazon, Google, Apple, Nike are all public.
Ok, back to Zuckerberg. He decides to “go public.” He starts the process by finding good investment bankers and asking them to help. The investment banker’s job is to underwrite. This means that they assume responsibility for the shares. (A share is just a unit of stock much like how an inch is a unit of measurement). Then the investment bankers go around to a bunch of big-name banks and investment funds and ask them if they’d like to invest in Facebook. This is called the “road show.” This drums up excitement and allows the bankers to get a feel for what the public (meaning you and me but really meaning big bankers) would pay for Facebook’s stock. Then a price per share and IPO date are set for Facebook.
[Again, IPO stands for initial public offering and it is the event when a company becomes publicly traded (also when the company founders can opt to lay on a bed of roses being fed grapes for the rest of their existence, but c’mon these people are entrepreneurs, they wouldn’t do that!). Excuse the tangent.]
Back to IPO’s. For instance, there have been quite a few newsworthy IPO’s lately, including Dropbox, Spotify, and further back, Snapchat. Remember how we said Zuckerberg wanted to “go public” so he could continue to grow his business? When a company IPO’s or goes public, the proceeds from selling the shares of stock result in cash for the company. Only during the IPO does a company actually receive cash. When you or I buy shares of Facebook today, we are not giving Facebook our money, we are giving the person who sold their Facebook shares the money. Facebook only receives cash during the IPO or if they offer up more of their company later down the road. This is an important distinction but if you like the idea of giving your money to Facebook better than that day-trader who screams all day at his computer, I’m not going to stop you from believing that.
So now we have a handle on the whole IPO/going-public process, but what does that have to do with us as investors? Glad you asked…
Block 5: Market Dynamics
We have established that stocks are vehicles by which we can buy and sell shares of public companies. So the stock market is the collection of all the buyers and sellers and companies involved. Millions of people every day buy and sell the group of about 4,500 companies. With all this action comes competition. Everybody is trying to make money and everyone is self-interested so naturally, making money for yourself in the stock market isn’t a cake-walk. It’s life; the more attractive something is, the harder it is to obtain. Who wouldn’t want to be able to make money by simply pressing a few buttons on a computer?
With that said, we believe it is still very possible to make money in the stock market. Or why else would we go to all the trouble to build Investing City? Each one of you reading this right now can do it. All it takes is some knowledge, a good attitude and a lot of patience.
So keep on building your village, we are well on our way…
Block 6: The How
Like we said, buying a stock represents ownership of a business. But what about all the details; how does this stock market thing actually work? Good question once again!...
Let’s say Uncle Ned meets a magic genie and one of his wishes is that his landscape company will grow big enough to IPO (I really hope someone reading this actually has an Uncle Ned with a landscaping business). Ned decides to sell 50% of his company, “Wonderscape” to the public and the ticker (the letters that signify a company’s stock, for instance Apple’s stock ticker is AAPL), is WNDR. Let’s say he sells 10 million shares at a price of $10 per share. He will raise $100 million so he can invest in new landscaping equipment, hire more people, or make a plethora of business decisions. He keeps the other 50% so he, alone, owns 10 million shares.
So WNDR IPO’s and investors buy heavily into the company on the first day. The stock jumps from $10/share to $13/share (this type of first-day return called a “pop” happens often but it is rare that a retail investor, not a fancy banker, can get in “on the floor” at that $10 price). Let’s say you buy in at $12 though and the stock price ends up at $13. That is an 8.3% return. Pretty good! But what caused the price to go up in the first place?
Well the price is determined, like in all markets, by supply and demand. If people are willing to pay a higher price for a stock (i.e. demand is higher), the stock price will increase. Companies are valued pretty much how other goods and services are valued. Things are valued at what people will pay for them. For example, if Nike sets the price of their new shoes at $200 and no one buys them, they will lower the price of the shoes. If people start buying them at $150, $150 becomes the price. The world works with more complexity but this concept of supply and demand is the essence behind price movements. Now that we have covered some of the nitty-gritty, let’s dive into another important idea…
Block 7: Price Vs. Value
Let’s go back to Wonderscape (WNDR). You bought one share at $12 and now it stands at $13. Technically, you can go around bragging that you own a part of your uncle’s business (just don’t mention to your friends that you only own 1/20 millionth of it). Your ownership is 1/20 millionth because there are 20 million outstanding shares of Wonderscape and you bought one. When you multiply this number by the price of a single WNDR share, you get the market capitalization or the market’s value of the company. So 20 million (# of shares) x 13 (price) is 260 million dollars. This is what everyone, or the market, says Wonderscape is worth.
This is not to say value and price are the same thing. Value is what you get, price is what you pay. Let us explain. The price of a share of WNDR is $13. However, if you think Wonderscape could grow more and become more valuable you’ll be happy to pay $13. If, in a year, Wonderscape shares are at $20, you got a great value at $13.
Price is what people are willing to pay right now, but the value is what you get. For instance, you buy a car for $10,000 and it lasts you 20 years and you have no mechanical issues you got a great value. The value was probably greater than the price of $10,000. This is a key concept when it comes to buying stocks. You’re looking for an eventual greater value than the price you pay. When you buy shares of stock in a company, you’re effectively saying, “I believe this company will be more valuable in the future.” You are searching for return! Now it’s coming full circle huh?
Let’s say you buy Wonderscape shares for $12 and sell them in a year for $15. Ignoring taxes, you made 25%! This is your return. And this is the stock market: a collection of publicly traded businesses where investors are vying for return. But this begs the age-old question, which stocks should I buy? It’s not that easy but let’s find out…
Block 8: To Buy Or Not To Buy
Historically the market (generally meaning the S&P (Standard and Poor's) 500, a collection of 500 American-based stocks) has climbed, on average, around 10% per year. Certainly not bad! Then again, that number is an average. Some years are terrible and some years are much better. For instance, in 2008, the Financial Crisis, the market fell 37%. However, the next year it was up almost 27%. That is just to say patience pays. You can’t control the market, all you need to focus on is what you can control.
One thing you can control is if you decide to invest at all. If the market goes up 10% a year, that is the opportunity cost you are implicitly giving up for every dollar you are not investing.
Let us add to the argument. There is a little something called compound interest. Warren Buffett, the world’s greatest investor, uses a snowball analogy to explain it. When you roll a small snowball down a hill, more and more snow sticks to it and eventually a giant snowball is formed. Compound interest is the same. If you put $100 into a bank account with simple annual interest of 5%, you get $5 every year. But if that interest compounds, in the second year, the bank will pay you $5.25 (5% of $105). That extra 25 cents doesn’t seem like a whole lot but just like that snowball, it all adds up.
Apparently Einstein called compound interest the 8th wonder of the world. He probably said that because our brain has a hard time comprehending it. Our brains are really good at figuring out linear functions. 1 hour of work = $10, 2 hours of work = $20 and so on. That’s linearity. But compound interest isn’t linear. It seems like it is but it is an exponential function, meaning it is actually like a hockey-stock curve.
For instance, if you have $5,000 in your piggy bank (a very large ceramic pig indeed) and you save 10% of your income (the median income is $57,000) so let’s say you add $5,700 to the stock market every year, after 10 years of 10% returns, you end up with a nest-egg of $113,000. Not bad! But here’s where our brain has a hard time figuring out this whole compound interest thing. If you keep that same routine going for 35 years, you end up with…dun, dun, dun…$1.84 million. Pretty solid! More than 16x the amount after 10 years. Don’t even get me started on 50 years.
So the question isn’t so much, to buy stocks or not to buy stocks, that seems fairly clear. The question then becomes, what about my individual situation? You are really good at asking questions, you know that?
Block 9: For Me?
A lot of people view investing like gambling. You throw money into a few hot stocks tips and hope your “investments” increase. Investing, rather, is a process of intentional fact-finding to provide a foundation for thoughtful analysis. Phew, that was a mouthful. In other words, investing takes effort. You mean I can’t double my money overnight after googling “Best Stocks to Buy?” Sorry to tell you, but it doesn’t work that way.
Investing does take effort but we believe you can do it! It does take time and at least some interest but if you have those two things, you’re on the right path.
Another important concept in investing is opportunity cost. Opportunity cost is the implicit cost that accompanies every decision. For instance, if you choose to watch 1 hour of TV, you implicitly not choose to go for a run, read a book, spend time with friends, or learn something new. All of those things that you could do in that hour are the opportunity costs. With that said, we know the market (essentially the S&P 500 index fund) goes up about 10% a year. So by choosing to buy an individual stock you are implicitly not choosing to buy the S&P 500. Therefore, in order to make that individual stock purchase worth it, it needs to outpace the market returns.
So if you can get 10% returns with an index fund, then why should you learn how to invest at all? Can’t you just buy the S&P 500 and call it a day? Well let’s do the math…
Block 10: Beating the Market
As we have learned, compound interest is an amazing thing. Growing your money at 10% resulted in impressive results. But is it worth it to try to go above and beyond?
Well, remember in Block 8 we did some calculations? In short, you could have $1.84 million after starting with $5,000 and adding $5,700 every year for 35 years at 10%.
What about if you beat the market and get 15% under those same conditions? Well, you will have $6.44 million. Don’t trust that? Click here.
What about a miraculous 20%? $23.12 million.
Those are convincing numbers but we still a lot to learn to get to that point…