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Introduction to Stocks

"What are stocks?" In Finance we use the phrase stocks, shares and equities interchangeably. Prof Aaron Gilbert discusses in this article.

What are Stocks

  • Stocks are a very important asset class for most individual investors as they are relatively cheap, don’t require large initial investments, and are freely accessible.
  • Stocks are a relatively riskier type of investment meaning that they offer a much higher rate of return then most other investment classes open to retail investors.
  • This means that stocks form a large part of many portfolios and are a greater way to build future wealth.
  • Technology has also dramatically improved access to stocks for retail investors. Low cost, or even zero fee, online ‘brokers’ such as Robinhood have dramatically reduced the cost of trading shares, while fractional share trading means that investors now can start buying shares with extremely low initial investments.
  • Additionally, technology is also making it easier for retail investors to trade internationally, opening up a greater range of markets and therefore investment opportunities.
  • However, while stocks offer great opportunities to build wealth and are becoming easier and cheaper to access, many individual investors are still not investing in stocks. Unfortunately, this can be extremely problematic, especially in the current investment environment.
  • Specifically, central bank interest rates, which set the benchmark for things like bank deposit rates and bond coupon rates, have been low since the Global Financial Crisis of 2008, and were driven even lower when the COVID pandemic hit.
  • How low is low, in some countries, individuals who have large deposits earn negative interest rates. Effectively, instead of earning interest to deposit money depositors are paying the bank to hold their cash for them.
  • When you factor in inflation, putting money in the bank is a losing proposition! Even bonds are earning low yields. Currently, shares are one of the few investment options earning decent returns.

Stock Ownership

  • Ownership confers two main rights. Cashflow rights (Get to participate in any capital returns i.e. dividends) and Voting rights.

(Can Include narrated PPT – STOCK OWNERSHIP)

Stock Returns

  • There are two main ways to make money with shares, Capital Gains and Capital Distributions.
  • Capital Gains – buy low, sell high. Very simple in theory. Shares are volatile so the best way to maximise you chances of capital gains is investing for the long term. Works best if you pick high quality companies
  • Capital distributions – several ways that a company can return capital is Dividends, Special dividends, and Share buybacks.
  • Dividends are payments made by a company to shareholders. Usually done on a per share basis. Announced and paid regularly i.e. quarterly or semi-annually. Amount can differ from period to period. Company can also choose not to pay a dividend at all
  • A company may pay a dividend to distribute excess cash. Dividends have become less popular for taxation reasons but are still most common with larger well-established companies.
  • Special Dividends -are one-off extra dividends companies may choose to pay.
  • A share buy back is when companies may opt to repurchase their own shares. This can be done in two ways.
  • On-market -company offers to buy at a set price from anyone willing to sell and can be popular for tax reasons.
  • Off-market – company takes a fixed percentage off all current shareholders.

Stock Risks

  • Are stocks risky? Yes, but remember risk equals opportunity. You can’t get high returns without taking some risk.
  • Risk from stocks comes from two main sources- Price volatility and Bankruptcy.
  • Price volatility is when prices for stocks move frequently up and down. Making price predication difficult therefore capital gains are uncertain.
  • Bankruptcy affects company shareholders the most, frequently will get little or nothing back on their investment.

Better measure for stock price risk

  • Recall from Diversification discussion in Week 1, we assume that people will build a well diversified portfolio. This reduces firm specific risk almost completely. We are left with market risk.
  • We only get compensated for market risk, not total risk!

How do we measure market risk of a single stock?

  • Beta measures the co-movement between a stock and the market index.
  • A positive beta of 1 means if the market increases 1% so does the company. Less then 1 indicates a safer stock that moves less then the market. Greater than 1 indicates a riskier stock the moves more than the market.
  • Bankruptcy risk. Shareholders are residual owners. They own whatever is left over after higher ranking claims are settled.
  • Bankruptcy usually leaves shareholders little- assets rarely sell for full value in an asset sale. As a result, bankruptcy will often wipe out an equity stake.
  • Best protection is to pick sound companies, and diversify your position.

OVER TO YOU

Go to the following link, and collect the daily adjusted price (adj close) for the past twelve months. Calculate the daily returns for Tesla over the past twelve months and then calculate the average daily return and the standard deviation for this period. Do you think Tesla represents a good investment based on these values?

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How to Invest: Modern-Day Financial Decisions

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