Why do stocks make people money?February 11th, 2020 by Tanner Wrisley
There are a limited number of things in our world that tend to appreciate in value over time:
• Real Estate
• Fine Art
• Precious Metals, like gold and silver
• Certain Gems
• Some Collectible Items
• Stocks, among others
All of these items are called investments and they are crucial for keeping up with inflation, generating wealth, and saving for major life events and purchases. Stocks have been a favorite of investors because of their ability to outperform the other assets listed over extended periods of time. Most people know that buying a stock means you are buying ownership in a company. But, how does this make you money? If the company does well, then you make money, right? Well, sort of. When investing in stocks, it is important to know what you are actually getting into.
First, let’s look at what a stock actually is. In order to keep track of ownership, companies issue shares of stock that represent a portion of ownership. The higher percentage of the total shares a person acquires, the more ownership in the company they have. Remember that owning more shares of one company than you do in another doesn’t mean that you own a larger percentage of that company than the other. For example:
• If Company A has 100 shares outstanding, and you own 10 of them, then you are a 10% owner in that company. Simple enough.
• However, if Company B has 500 shares outstanding and you own 15 of them, then you are a 3% owner.
This is also the reason why just looking at a stock’s price doesn’t tell you about the size of the company – because they have differing number of shares.
Most publicly traded companies have hundreds of millions of outstanding shares. Apple has over 800 million shares in the market right now. So, if you have one share, you own 0.0000001% of Apple. Congratulations! How does such a negligible amount of ownership have value? The short answer is – because somebody else is willing to pay you for it. That is really the basis for any investment. And, the more good things that happen to Apple and its industry, the more the perceived value of that stock you own rises. This is an important distinction to make – the difference between the perceived value and the actual value.
• Stocks move and trade on what people think is going to happen to the company, and this determines their value.
• If the outlook turns positive for one reason or another, someone will be willing to pay more for your stock than before. This causes the price to go up and you have gained capital appreciation.
• If you wait to buy a stock until after the results of a good earnings period or a positive major company event, the market will have already priced in the results, and you will have missed your opportunity for capital appreciation.
So far, I have only made mention of capital appreciation and making money off the increase in a stock’s price. There is another way to make a profit here… and it pays dividends! Sometimes, companies will decide to reward their shareholders by paying out some of their profits to those who own their stock, called a dividend. Typically, companies that pay dividends are more established, like Coca Cola for example. Coke can afford to use some of its retained earnings to reward their owners directly, instead of investing all of their profits back into the business. In fact, Coke has paid and increased their dividend every year for the last 55 years! Many companies like to prove they can do this on a consistent basis like Coke does, making dividends a less volatile type of return than capital appreciation.
At Anchor Bay, we do a deep dive into each company we invest in, looking for opportunities for capital appreciation, dividends, or both. Stocks are a great way to save for retirement, a house, a wedding, or any of life’s major events when you have a long time horizon. But be careful, stock prices can be volatile and can take a steep dive at a moment’s notice. We make sure our portfolios are well prepared for this volatility and invested with an appropriate stock allocation to fit needs and risk tolerance of our investors.