Stocks (in Theory)

This is the first blog post on financial investments. I’m starting with stocks because they’re quite mainstream, everybody has heard of this concept and stocks are the basis for a later post on ETFs.

Before the real content of this blog post starts, please enjoy this legal disclaimer:

Keep in mind, that I am not a professional when it comes to finances and investments. It’s completely your decision, how to act on the information I am offering here. In case you want to blame someone when it’s not working out for you – start with yourself. Everything else is ridiculous 😉

This post got longer than initially intended, so I’m dividing it into two smaller ones. This one focuses on the basic ideas behind stocks with the subtopics

  • Stocks? What are Stocks?
  • Strategies

The following second part is „Stock in Practice“ with the following subtopics:

  • How to buy stocks
  • What not to do and how to avoid it

Stocks? What are Stocks?

Stocks are little parts of a company or enterprise. For example in January 2017, there were 850 million Siemens stocks (850.000.000) out there. So if you own one of those, you own 850,000,000th of Siemens. Therefore you can claim the same share of the money this corporation earns.

There are two main reasons that define the characteristics of stocks. Other people who own the remaining stocks and the possibility to reinvest the current earnings in the company to increase the expected earnings

in the future. While some stockholders want to keep their stocks for a long time and are more interested in increased future earnings, other stockholders are interested in what’s happening on the short-term. They all can cast their vote at the stockholder’s meeting and decide how much of the earnings is reinvested and how much is distributed as a dividend to the stockholders. This is the money you might get.

If you think, you can get higher returns on your investments somewhere else, you can sell your shares. And if lots of other people assume the same, the stock price will decrease, until it finds a new equilibrium where the expected return on  investment for this stock is equal to the expected return on other investments. On the opposite, if lots of people have positive expectations, they are willing to pay more money for each stock, until a new equilibrium is reached.

In real life, those price adaptions create the volatility of stock prices: There is lots of information out there influencing the predictions of  investors. You can recognize this in the following figure.

Development of the MSCI World stock market index (screenshot taken at https://www.msci.com/world on 02/21/2017). There are small ups and downs an there is also a long-term upwards trend.

Strategies

Technically, the price development of stocks can be divided into short-term and long-term development. Again, be refered to the figure The short-term dynamics are more or less noise while the longterm developments originate from a combination of reinvesting of earnings and distribution of those earning as dividends.

Based on those different contributions to stock price development, it’s possible to classify the strategies, based on which effect they rely on.

If you’re relying on changing course, buying the stocks at low prices and selling at high prices, then you’re using a trading strategy. With this strategy it’s either lots of effort in analyzing the stocks or simply gambling. Your gains are someone else’s losses, because no value is created.

And if you take the trading fees and commissions into account, that are paid to your bank and the stock exchange, than you and the person on the other end of the transaction end up with less money. Especially if you’re competing with professionals like investment bankers (while you’re using most of your time doing actual research), then you have to decide for yourself if this is going to be your strategy 😉

Personally I’m using the buy-and-hold strategy. I’m buying the stocks, wait and do nothing for the first couple of years. By doing that, I’m avoiding giving too much money way as trading commissions. Also I don’t have to perform analyses all the time, and the time you want to invest in analysis is up to you. At the beginning, I looked for stocks of big, well-known companies (also called blue chip values) and tried to diversify over different countries and different sectors. So the analysis was more based on common knowledge than on facts. And because I only chose stocks of companies I already had heard of, I ended up with a big home bias, with lots of German and European stocks.

Further Information

As mentioned in the beginning, there will be an article on stocks in practice next week. While writing this post I also noticed that I probably have to write an article on investment risks and risk management.

If you want to learn more about stocks, I’m recommending finding a podcast on financial education, financial literacy, investments or something like this and listening to I during sports, car drives or doing the chores. Podcast in the German language I’m recommending are Finanzrocker, “der Finanzwesir rockt” and zendepot.

 

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