We hope we are easing you in gently to the concept of investing! In the third post of our “Not Another Boring Article About Investment” series, we are going to look at why the stock market exists in the first place and the different types of investments that you can make. If you missed the last post, you can check it out here, and if you want to skip ahead the full online course is available here.
Why does the Stock Market Exist?
You might have wondered why the stock market exists and why companies want to sell shares in their company? It boils down to a simple fact, everything costs money! Companies need money to operate for everything from buying equipment to paying employees and this is where stocks come in.
There are two ways for companies to raise money. They can issue debt and owe money or they can sell shares. When a company sells a share, they are selling a part of the company to the investors. When you buy a share, technically, you own a piece of the company, no matter how small the investment.
The share’s price for a small business can be negotiated directly among the owners and the prospective investors. But for really big companies like Apple, it would be impossible to negotiate in person for each transaction. That’s why they created Exchanges like the Toronto Stock Exchange or the New York Stock Exchange. A little bit like a farmers market, those exchanges were specific places where investors would come to buy and sell shares.
Today, most exchanges do not have a trading floor, which means that they’re mainly digital platforms where buyers and sellers meet digitally. It’s similar to eBay, but for securities instead of fake bags and second-hand iPhones.
There are different ways to invest in companies, namely stocks, bonds, ETF’s and mutual funds. We are going to take a look at each of these, what they are and what some of their advantages are.
What is a share?
Hardbacon is a company, but we are not listed on the stock market, so don't look for us! To make it simple, imagine the two co-founders are 50:50 owners and, at the end of the year, there is a 1000 dollars profit. We could decide two things:
- To reinvest the profit for growing the company.
- To give a dividend of 500 dollars to each founder.
Let’s use the example of a large public company such as Facebook. If you own a couple shares of the company, you do not really have any say in how the company is run or what is done with the profit. If you’re not happy about how Facebook is managed, however, you can still vote on the composition of directors… although most public companies only nominate one candidate for each position on the board. But a significant shareholder can have a say in the running of the company.
What is a bond?
If you were to lend a friend ten dollars and they gave you an IOU promising to pay you back 10 dollars plus 10 percent interest annually on the original loan, this would be similar to a bond. You are guaranteed to make ten percent per year on your investment unless your friend goes bankrupt or dies.
A bond is a form of debt where the company borrows the money under specific terms, much like the IOU between friends. For a company that is profitable, it makes a lot of sense to get the cash it needs through a bonds offering rather than stocks offering, as it allows its current shareholders to hold on to their ownership percentage in the company.
As for people buying the bonds, they don’t own the company, but they have the advantage of knowing they will get their money back unless the company files for bankruptcy. On the other hand, if the company is doing fantastic, a bondholder will not make more money than the agreed interest.
ETFs or Mutual Funds
ETF stands for Exchange Traded Fund. One of the cool things about them is they are a not an operating company. The only thing they do is to invest in companies and various other financial products. You can, therefore, own a bunch of different stocks, bonds, and even commodities by buying a single ETF.
Many ETFs focus on specific sectors. Say you are really interested in technology stocks like Google, Apple or Netflix, and you want to own a piece of each. Doing so will end up costing a lot of money since you’re paying fees for each of the trades. This is where the ETF comes in by offering a package with a little bit of everything. Therefore they are a really good way for a small investor to diversify without having to buy everything separately.
Mutual funds are very similar to ETFs, but they tend to come with much higher fees; in Canada, many mutual funds will charge you 3% of your assets manually to invest your money, while a typical ETF will charge around 0.20%. Mutual funds are more expensive for two reasons. 1. They are usually distributed through advisors, who get a commission when selling them to their customers. 2. They are usually actively managed, which means they need to hire portfolio managers and analysts and spend more on trading fees.
So there you have it, the various types of investments available. Traditional stocks with more risk, a steady guaranteed return with a bond and finally ETF’s that allow you to diversify your portfolio at a lower cost. In the next post, we are going to look at how to get started investing.