Editor’s note: This article was first published in June 2012. The year-to-date returns of Inditex (+44%) and Gamesa (−41%) and the comparison of their prospects refer to the first half of 2012. Gamesa later merged with Siemens’ wind business (Siemens Gamesa, 2017) and is no longer listed on its own.
When I talk to people on the street about investing in the stock market, I usually come across the same thought: “Ooh, investing in the stock market is very dangerous, you can lose everything.” For most people, the stock market is a kind of casino where you place your bet and, in a very short time, you can win or lose.
“Well, I’ll give it a go, who knows? Maybe it’ll go up.” Of course, it could also go down. If we go back to the dot-coms, we’d find two very different scenarios: people who literally made a fortune and people who literally lost the shirt off their back. The reality was that some investors rode the bubble and got out in time, while others got in at the end of the bubble or simply stayed in until it burst. It was the same investment mechanism in both cases, with two very different end results.
Those who lost probably don’t want to hear another word about the stock market, and those who won, naturally, will keep investing in it. Clearly, I would never advise anyone who thinks the stock market is a casino to invest. That’s why it’s worth grasping a few basic concepts, which will also help in following some of the articles still to come. In my view, everyone should, if not invest in the stock market, at least understand it, because although this kind of investment can be intimidating, it becomes much easier once you’ve taken the concepts on board.
When we buy shares in a company, we’re not spinning a roulette wheel in a casino; we’re buying a percentage of a company. By buying shares, you become part of the company (a shareholder). So you’ve acquired part of the company’s building, its profits, its future acquisitions and, yes, its losses too if there are any.
Why would a company want to share its assets with the public? When a company sells shares, it’s because it needs money to finance itself. It could take out a bank loan and pay interest on that money, but by selling shares it raises money while spreading the risk among a group of investors, that is, among the shareholders.
An example: why does a company sell shares?
Imagine you own a clothes shop. The shop makes a profit, but you want to grow, open new shops and enter new markets. Imagine you work out the numbers for a new production line (€120,000), a building in the town centre valued at €500,000 and more staff, and practically all of it would have to be paid up front. In other words, with the same sales you’d be taking on €620,000. You could go to a bank to finance the project, but if it took 12 months to get going the repayments would drown you, because you also need capital reserves to cover the new hires while the business takes off.
So in the end you decide to take your company public. First you work out how much money you need, how many shares you’ll put on the market, the share price, whether you want to keep a controlling stake in your company, and so on.
Above all, investors will have to trust that the business will be profitable and keep moving forward year after year, quarter after quarter. Shareholders will only invest if they believe the company will work. Obviously, if they think you’re heading for a fall, nobody would buy into your company.
How does the stock market work?
Going back to the clothes shop, suppose you decide to sell your shares outside the stock market. You find a few investors and sell them “little pieces” of your company in the form of promissory notes or shares. Months or years later, your company isn’t doing as well as it should and some of these investors decide they want their money back, that is, to sell their shares. That’s where the problem lies: to sell their shares they have to find another buyer who wants them and, with your company doing badly, nobody is going to want to “buy back” the shares the original investor wants to offload.
That’s the problem the stock market, or stock exchange, solves: a place where “little pieces” (shares) of listed companies are bought and sold every day. Without this market, companies would have to look for investors by advertising in newspapers or on the radio.
So, just as when you walk into a supermarket and look at the shelves, at the fruit that’s in good condition and well priced, the deals of the day and the new promotions, on the stock market you can see from your own computer which companies there are and which ones are on offer, or which you think would be a good investment for the future.
The stock market is transparent: you can follow share prices in real time and see how they change with the news affecting each company. Likewise, listed companies are required to file quarterly reports with the CNMV (Spain’s securities market regulator), where we can see whether a company has made a profit or a loss.
If the results aren’t good, some investors might decide to sell their shares, which would push the price down. Of course, on the other side there would be investors who hadn’t bought into your company because they thought your shares were expensive, and now, thanks to the fall, they’ll buy, so the price would go back up again. It’s a bit more complex than that, but that’s basically what a stock’s volatility is.
So… what exactly are stock market investors (shareholders)?
Obviously, a shareholder isn’t someone playing slot machines or casino games, but an investor who is part of a company and has a voice and a vote in the decisions it takes. That’s why listed companies hold shareholders’ meetings: whether you own one share or 100 million, you have the right to attend. Read: What are your rights as a shareholder?
Where is the risk in stock market investing?
The market goes up and/or down. When it will go up or down is the great mystery that scares people, and it’s what makes short-term stock market investing so risky. Although there are known and unknown forces behind market movements, it basically all comes down to supply and demand. Prices fall when there are more sellers than buyers, and vice versa.
Why would there be more sellers than buyers tomorrow? What has to happen for investors to decide to dump the shares of the company I’ve invested in? There are many factors, from circumstances that have nothing to do with the company to news about the company coming out at that very moment.
The biggest risk in the stock market is not knowing what you’re doing, not the investment itself. In a casino, you place your bet and wait to see whether it comes up red, black, odd or even. In the stock market, you buy into a company and need to keep an eye on what’s happening in the index where it’s listed, in the country that is its main market and in the company’s own material announcements.
If you own shares in an airline and three of its planes crash on the same day, sell your shares quickly before everyone else starts selling, because you can be sure the shares will fall that day. Maybe later on you’ll be able to buy them back cheaper.
So, for those who think the stock market means putting your money into a stock at random and checking it next year to collect the profits: on the one hand, that can work on the stock market, but if you keep an eye on the market you’ll probably find new investment opportunities every month, whether companies that have posted good quarterly results (which will rise) or companies that have had a weak quarter, which will fall and which you might be able to pick up at a good price, hoping the next quarter will be better.
Important!
Going back to the dot-coms, investors who followed share prices every day could see that something was happening and that their shares were starting to lose value steadily, and they were able to sell while still in profit.
Of those who didn’t follow prices, some found their shares had gone to zero, and others who had handed their investments over to third parties got the call: “Mr X, I’m sorry to tell you we’ve lost everything. Nobody expected this.”
Shares are an asset and, like any asset, they need checking to make sure everything is going well.
Choosing the stock
Another risk, although you could say it’s a controlled one, is choosing the right stock, one that will be profitable in the long term.
To give an example, those who invested in Inditex (the owner of Zara) at the start of the year have gained 44% on average. Those who invested in Gamesa (the wind turbine maker) have lost 41%. Does that mean that today you’d make more money buying Inditex shares than Gamesa shares?
In principle nobody knows. The second stock, Gamesa, depends on certain national and international regulations, although it’s in a sector that could be the future and it’s also a stock that has been hit very hard by the market. Of course, a single piece of news about a change in that sector’s regulation could send the company’s share price soaring.
In the most basic scenario, over the medium term Gamesa would have more upside than Inditex, although Inditex inspires far more confidence than Gamesa today.
Inditex would be the safer stock, Gamesa the riskier one. The higher the risk, the bigger the profit or the loss.
In short, there’s no casino, just a few choices:
- Choosing a stock you like.
- A stock with room to grow.
- The right moment to buy in (market, price, etc.).
When some people make money on the stock market and others lose it, it’s because the winners do something the losers don’t. Among other factors, that usually means preparation and keeping a constant eye on the markets.
Further reading
See also: 10 ways the rich think differently from everyone else
Featured image: Håkan Dahlström, CC BY 2.0, via Flickr.
