No-Frills Money Skills: Get Into Stocks – Episode 3
No-Frills Money Skills is a video series that covers a variety of personal finance topics. The brief videos use clear, simple language and graphic elements so that students can better visualize the personal finance content being presented. In the end, they will see how important these concepts are to their everyday lives.
“Get Into Stocks” is the third video in the Federal Reserve Bank of St. Louis series, “No-Frills Money Skills.” Through the story of a local ice-cream cart owner trying to expand her business, students learn about the process by which companies become publicly owned and traded by issuing stock. Students learn key terms, such as capital gains and dividends, and discover how the prices of stocks are affected by how successful a company is in its respective industry.
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Dana: Um, why am I in this contraption?
Stock Owner: Well, these stocks are used as a form of punishment, and public shame. Humiliating, isn’t it?
Dana: I guess so; I just wanted to learn about stocks.
Stock Owner: Well, you’ve come to the right place! I can teach you everything you need to know about stocks. These stocks are made of solid oak. They are strong, they are sturdy and they’re designed to be escape proof. Another significant feature of these stocks…
Dana: Wait just a minute. It seems like we have a misunderstanding. These are not the kind of stocks I had in mind.
Kris: There was a time in history when a common use of the word stocks had a different meaning than it does today.
My guess is that you haven’t seen anyone in stocks in your town square lately, right? Yet, people talk about stocks all the time.
You’ve probably have heard people say, “I am in stocks, bonds and mutual funds,” or “I have invested in stocks.”
On today’s episode of No Frills Money Skills, we’ll shed some light on the mystery of stocks.
Today, people generally buy stocks for one of two purposes: to earn capital gains or to receive dividends. Let’s talk about capital gains first and dividends later. A capital gain simply means that the price of the asset—in this case, the stock—increased from the time it was purchased to the time it was sold. You may be familiar with the term “buy low and sell high,” which is a phrase that applies to capital gains, but just what exactly is a stock?
A stock is a share of ownership in a publicly traded company. A publicly traded company issues stock that is traded on a stock exchange, such as the New York Stock Exchange, or on the over-the-counter market. Individuals and institutions that own shares of stock are the owners of a publicly traded company. A stockholder’s ownership in the company is equal to the number of shares they own, relative to the total amount of outstanding stock.
Meet Dana. Dana has worked hard to build a successful, neighborhood ice cream business, and wants to add an additional ice cream cart to meet the increasing demand. To raise the needed funds to expand the business, Dana is considering issuing stock in the ice cream company and wants to “go public”—that’s the term for becoming a publicly traded company.
In the financial world, businesses trying to raise funds by going public have investment banks assist them in calculating the number of shares of stock to be issued. They also help determine the initial price of the stock.
Oftentimes, investment banks go to their own best customers and offer shares of the new stock before it enters a stock exchange. There are many stock exchanges around the world.
Back to Dana.
For simplicity, let’s assume Dana needs a total of $1,000 for the additional cart. Dana decides to sell 100 shares of stock in the ice cream company at an initial price of $10 each.
Let’s assume Dana’s company is profitable. Dana should be able to sell the stock to potential investors.
Keep in mind, people buy stock in the hope of making a capital gain. If Dana’s business grows and is more profitable, this will be reflected in the price of the stock.
Here’s why: if Dana’s business continues to expand, the price of the company’s stock will most likely increase because stockholder demand for shares will drive up the price. On the other hand, if Dana’s business doesn’t do well, the price of the stock will most likely decrease.
Common stock is a form of corporate ownership. It is called common stock to distinguish it from preferred stock. Common stock holders are considered company owners and may vote in matters affecting the company. Most large companies pay dividends on common stock, and the stock may appreciate in value if the company does well. Most people own common stock.
Preferred stock holders do not have voting rights in the company, but receive dividends before any return is paid to common stock holders. Some investors feel safer buying preferred stocks because, in the event of liquidation—that is, selling all the company assets and closing the doors—preferred stock holders would receive payment before common stock holders.
For business owners—like investors—there are costs and benefits to remaining privately held or going public. Dana will want to make a careful decision about whether to take the ice cream company public, or not. One benefit for Dana is access to funds that she can use to expand her business—funds that might be more difficult to come by through other sources. This is money that she does not have to repay, unlike a loan. Instead, she gives up shares of ownership in the company—which is one cost.
This brings us to the second basic reason people buy stocks. Some investors use stocks for income, say during retirement, and would prefer to earn dividends. A dividend is a share in the company’s profit.
In the same way a business owner must consider the costs and benefits of their decisions, individual investors must carefully consider the risk and potential reward of investment options.
Let’s watch this short film to learn more about risk and reward.
It is important to have an investment plan, and to understand risk before buying any financial instrument. Investors face different types of risk, but risk is basically the uncertainty that an investment will gain, or even retain, its value. In general, the higher the risk of loss of principal for an investment, the greater the potential reward, and conversely, the lower the risk of loss of principal for an investment, the lower the potential reward. A risk pyramid gives a general idea of how investments compare to one another.
Take a look at a various investment options on the pyramid to see the relationship between risk and potential rewards. At the top of the pyramid with the highest risk and highest potential for return are commodities, followed by antiques and collectibles, real estate, stocks, mutual funds, corporate bonds, Treasury securities or government bonds, certificates of deposit, and savings accounts. At the bottom of the pyramid, with the lowest risk and lowest potential for reward, are cash and checking accounts.
Secure investments, like FDIC-insured savings and checking accounts do not offer a high potential for reward because they are essentially free of risk. At the other extreme, you find commodities such as gold, oil or livestock. The prices of commodities are more volatile—that is they change frequently. So, the potential for risk of loss of principal is high for commodities, but the potential for return is also high.
So, now you know a little about risk and reward. We now return to your previously scheduled program.
You’ll notice that stocks do have some risk. Obviously, the stock risk depends on a number of factors, including the financial health of the company, the potential demand for the good or service the company provides and how competitive the company is in its respective industry. As an investor, it is important to diversify your portfolio of investments. That is, don’t put all your eggs in one basket. Diversification reduces your risk and increases your opportunity for return.
You certainly wouldn’t want to invest your entire life savings in a stuffed animal collection. And, it wouldn’t be wise to invest all of your retirement savings in a single company’s stock. Dana’s business sounds like a good investment, but would you stake your retirement savings on the success of a neighborhood ice cream business? Think about this: what if you invested all your savings in Dana’s company, and one morning you read that the company closed its doors the night before leaving nothing to pay shareholders? You will have lost your savings—talk about depressing! The odds of losing everything are less likely if you own many different investments with varying amounts of risk and return.
Stock Owner: Well, it’s a good thing we cleared up that misunderstanding about stocks.
Dana: Yeah, you can say that again! I know that investing can be risky, but it probably isn’t as uncomfortable as those stocks!
Investment Banker: And you certainly wouldn’t benefit from capital gains or dividends in those things either.
Kris: Well, there’s much more to learn about investing, and you’ve only just begun to “stock up” on investment knowledge. I’m Kris Bertelsen, and I’ll see you next time on No-Frills Money Skills.