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What Is a Stock and How Does It Work? (FOR ABSOLUTE BEGINNERS)

June 10, 2019
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YouTuber, Money Expert, Educator, Traveler, Rebel, and #1 Book Nerd. My mission is to empower you with the mindset and financial know-how to get more of what you want out of life.

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I bought my first stock when I was 13 years old, but I was lucky enough to have a dad who could explain to me what a stock is and help me learn about investing. But if you didn’t have someone to teach you this stuff, how else would you know how to put your money to work? It’s not like they teach us this stuff in school.

That’s why in this post, I’m going to talk about some of the very very basics of investing, starting with: WHAT EVEN IS A STOCK? This post will help you wrap your head around concepts like:

  • What drives the stock market?
  • What impacts the price of a stock?
  • What does the stock price actually mean?
  • What IS a stock?

Watch the video below or keep reading!

To understand what a stock is, let’s go back in time and do a little history lesson…

The origins of the stock market started way back when in the age of Christopher Columbus, in the 16th century. A group of enterprising Dutch merchants wanted to send huge ships over to the New World to start trading spices, silk, and all kinds of other foreign, exotic goods.

This required lots of capital that no single merchant could come up with on their own. So groups of investors started coming together to pool their money and become co-owners in these trading companies. These ventures were called joint-stock companies, and shareholders started buying and selling their stock with other shareholders and investors. And thus, the stock market was born!

The idea was so successful that joint-stock companies started popping up all over Europe. As the volume of shares increased, it became critical to have some sort of organized marketplace to buy and sell these shares.

So stock traders started meeting up at a London coffeehouse, which they became the centralized marketplace to buy and sell shares. Eventually, they took over that coffeehouse and changed its name to the “stock exchange”.

So that’s how the first stock exchange was born…

…the London Stock Exchange. Today, there’s stock exchanges all over the world, with the NYSE and the NASDAQ being two of the largest and most important exchanges.

OK so that’s it for our little history lesson on the stock market.

Now you know that a stock is a piece of ownership in a company, and its origins came from the need to pool money together in order to fund big business ventures.

This concept of pooled ownership in businesses IS what makes it possible to build huge companies like AAPL, WMT, LUV, and KO. It takes billions and billions of dollars to build companies like that, and most people don’t have that kind of money to do it on their own.

Unless you’re Elon Musk.

Elon Musk started Tesla on his own, with tens of millions of dollars of his own personal money. But even Elon Musk eventually had to bring in outside investors in order to keep scaling Tesla. That’s why on June 29, 2010, he did an IPO, or Initial Public Offering.

An IPO is when a private company first starts offering its shares to the public

Before the IPO, the only way to buy shares in Tesla was to call up Elon Musk and ask him to let you in on a piece of the company… which ain’t gonna happen for most of us!

But now, after the IPO, Tesla’s shares now trade freely on a stock exchange, so anyone who has a brokerage account can buy stock and become a part-owner in Tesla.

So that’s the difference between shares of private companies vs. shares of public companies. You generally can’t buy shares of private companies because there’s no centralized, standardized place to buy them, but ANYONE can buy shares of public companies easily and conveniently.

So the stock market is where you can buy and sell shares of these publicly traded companies. Most companies start out as private companies, and when they get big enough, they do an IPO and become publicly traded companies.

Notice that I’m using the words stock and shares interchangeably. They’re basically mean the same thing, except that Shares are the units of measurement. So you would say, “I own STOCK in Tesla” or you could be more specific and say “I own 50 SHARES of Tesla STOCK.”

Now let’s talk about stock prices.

This is what comes up when you Google AAPL (the stock ticker symbol for Apple):

You see here that the stock price is $186.60, and the market cap is $858.56 billion. Market cap is the total market value of a company’s outstanding shares. So all the investors out there who own AAPL stock, their shares collectively are worth $858.56 billion. So that means for $186.60, you can become a 0.0000000002% owner in the company.

When you become a 0.0000000002% owner in AAPL, that means you own 0.0000000002% of everything the company owns. It also means you own 0.0000000002% of the company’s profits.

Get the point?

So $186.60 represents what people want to pay to own 0.0000000002% of AAPL right now, at this very moment in time.

But is it worth it?

How do I know if $186.60 is a good price to pay for AAPL or not?

To understand this, let’s go back to the story of our Dutch merchants.

Their trading company is absolutely killing it and they’re making huge profits. There’s 10 shareholders, which means the profits get split up 10 ways, putting $100K in each shareholder’s pocket every year. If one of the shareholders offered to sell you his piece of the company for $100K – would you do it?

The answer is HELL YES – since each shareholder gets $100k every year, if I buy his piece of the business for $100k, I’ll make back the purchase price in just ONE YEAR!

Now what if he offered to sell it to you for $1M? Then I’d have to think about it some more… for $1M it would take 10 years to make back the purchase price. And that’s IF the company is still in business for 10 years and nothing bad happens.

So the moral of the story is this: The price of a stock is driven by the company’s PROFITS. Stock prices go up and down because the market thinks profits will go up and down.

Profitability is the foundation of what creates a stock price.

This is how it works in the long-term, but in the short-term sometimes stock prices have no connection to profits. For example, right before the dotcom bubble crashed in 2000, there were Internet companies with no prospects of revenue in the near future, but they were trading for crazy high prices due to the dotcom mania.

This happens when market participants who lack knowledge get greedy, and this happens more often than you think. I want you to be very aware of this. Stock prices that have no connection to profits ultimately correct. It might take a while, and you might even get lucky and make a quick buck or two, but stock prices always always always come back to true value, which is linked to the company’s profitability. This goes both ways: if a company’s stock price is too low relative to its profits then the stock price WILL eventually go up.

Benjamin Graham, one of the greatest investors of our time, explained this concept in his book The Intelligent Investor. He said that in the short run, the market is like a voting machine – so it’s a popularity contest between the hottest firms and the ones that are out of favor with the general public. But in the long run, the market is like a weighing machine that assesses the substance of a company.

So if there’s just ONE thing you take away from this video, let it be this:

What drives stock prices in the long run is a company’s actual underlying business performance and not the public’s emotional opinions about the company in the short run.

For more beginner-friendly resources on stock investing, subscribe to my YouTube channel. I post new videos every week, and it’s going to help you learn a TON. So make sure to subscribe so you don’t miss anything!

Always remember to go after your dreams unapologetically, and to live life on your terms – cheers!

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YouTuber, Money Expert, Educator, Traveler, Rebel, and #1 Book Nerd. My mission is to empower you with the mindset and financial know-how to create a life of TOTAL freedom.

Rose.

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Rose

YouTuber, Money Expert, Educator, Traveler, Rebel, and #1 Book Nerd. My mission is to empower you with the mindset and financial know-how to get more of what you want out of life.

The weekly email that spills all the secrets on what it really takes to create a life of total financial freedom

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