A Beginner's Guide to Investing in Stocks

What Are Stocks and How Can a New Investor Start Buying Them?

Before you can begin investing, you need to understand the answer to a simple question: "What is stock?" A share of stock represents an ownership interest in a business, entitling the owner to a share of the profits or losses.
Before you can begin investing, you need to understand the answer to a simple question: "What is stock?" A share of stock represents an ownership interest in a business, entitling the owner to a share of the profits or losses. Tetra Images/Getty Images

Throughout much of modern history, investing in stocks has been one of the most effective and efficient ways for individuals and families to accumulate capital, build wealth, and grow their passive income. Yet, despite being a topic that is covered daily in the news and discussed regularly on both television and the Internet, stocks remain misunderstood by a vast majority of the population (including those who invest), many of whom look upon a share of stock as being some mysterious force that is beyond rational explanation; a series of letters and numbers that fluctuate on digital ticker tape and cause brokerage and retirement account balances to rise and fall without rhyme or reason.

While the causes of this situation are numerous, I'd like to do my part to help clear up any confusion you might have about stocks. Over the course of the next few minutes, my goal is to provide a foundation that I hope will help you understand not only what stocks are, but how they work and why they can be a useful tool for the right type of investor. I also want to point out some of the more common misconceptions about investing in stocks. Specifically, I want you to be able to answer the following questions:

  • What is stock?
  • How are stocks created and why do they exist?
  • Why would a person consider buying stocks?
  • How can a person research stocks?
  • How can a person acquire stocks?
  • What are some of the considerations and factors that go into selecting stocks?
  • How do investors actually hold their stocks?
  • What is the difference between investing in stocks or investing in a mutual fund, such as an index fund?
  • When you hear a story of some secret millionaire, such as a janitor leaving behind an $8,000,000 fortune in stocks that he acquired from working a near minimum-wage job, where does that money originate? How do stocks, when successful, actually generate a profit for the owner?

While we are going to cover a lot of information, I can say from personal experience that the time and effort required to learn about the topic is not only worth it, it can be life changing.

A well-chosen collection of stocks, particularly as part of a robust balance sheet that includes a multitude of diversified assets and asset classes, such as real estate and fixed-income securities, can provide freedom from financial worry as well as flexibility to pursue your passions on your own time.

What Is Stock?

Put simply, a share of stock represents legal ownership in a business. Corporations issue stock, usually in one of two varieties, common stocks and preferred stocks. Stocks are sometimes interchangeably called "securities", because they are a type of financial security, or "equities", because they represent ownership (equity) in a business.

Common Stocks - These are the stocks to which everyone is usually referring when they use the term in the context of portfolio management or the world of investing. Common stock is entitled to its proportionate share of a company's profits or losses. The stockholders elect the Board of Directors who, in addition to hiring and firing the CEO, decide whether to retain those profits, either for future growth or to strengthen the balance sheet, or whether to send some or all of those profits back to the stockholders in the form of a cash dividend, which is a physical check that gets sent in the mail or an electronic deposit that is sent to the brokerage or retirement account that holds the stock.

In modern times, common stock is virtually always issued as "fully paid and non-assessable", which means once you have acquired it, you can't be forced to come up with any more money, though that wasn't always the case. That is, your potential losses are limited to what you have invested so long as you didn't borrow on margin. While it is standard practice for most or all of the voting power of a corporation to be vested in its ordinary common stock, some companies issue special classes of common stock, such as "Class A common stock" and "Class B common stock", which may have different economic rights and voting rights. For example, companies such as spice manufacturer McCormick and whiskey distiller Brown-Forman have two different classes of stock, one of which has voting rights and one of which doesn't.

Berkshire Hathaway, one of the largest holding companies in the world, has two classes of stock with the Class A stock currently trading at $247,780.00 per share and the Class B stock equal to 1/1,500th the economic interest of a Class A share but with only 1/10,000th the voting rights.

Preferred Stocks - While technically a form of stock, preferred stock is usually thought of as a sort of economic-equivalent to a quasi-stock and quasi-bond. Unless it is special type of preferred stock known as "participating preferred", these shares are not entitled to a cut of the profits and losses but, instead, receive a specific dividend at predetermined times. This dividend ordinarily has to be paid first, before the common stock can receive any dividends, and if the company goes bankrupt, the preferred stock holders outrank the common stock holders in terms of potentially recouping their investment from any sales or recoveries achieved by the bankruptcy trustee. Preferred stocks can be extraordinarily sensitive to interest rates unless they have a mandatory redemption date or the owners have the right to force the issuer to repurchase the shares at a specified time in the near future that acts like a maturity date would on a bond. Some preferred stocks can be converted into common stock. To learn more about this lesser known type of stock, read The Many Flavors of Preferred Stock, an article I wrote to help you understand some of the ins and outs, pros and cons of these securities.

How Are Stocks Created and Why Do They Exist?

Stocks exist for several reasons but among the most important are the following:

  • Stocks allow companies to raise capital (money) to turn good ideas into viable businesses, which ultimately benefits civilization. Without capitalism and well-functioning capital markets, most of the modern comforts you take for granted wouldn't exist or be available to you.
  • Stocks provide a place for investors to potentially earn satisfactory returns on capital that might allow them to achieve their financial goals more quickly than they otherwise could.
  • Stocks separate ownership from management, allowing those who have no interest, ability, or time to run an enterprise to still participate economically and through voting rights, resulting in a more efficient allocation of resources, including human capital.
  • With few exceptions, equity capital on the balance sheet doesn't have a date by which it must be repaid, it doesn't have a guaranteed dividend rate, and it acts as a cushion for the lenders, who offer lower interest rates as risk is reduced, reducing the cost of capital. Lenders do this because they know there are assets on the balance sheet to absorb losses before they have to step in and throw the company into bankruptcy if the bills aren't paid. A lower cost of capital means higher profits (or, at least, lower losses), resulting in a greater chance of economic success.

A hypothetical illustration might be useful to understanding the mechanics of stocks. Imagine you wanted to start a retail store with members of your family. You decide you need $100,000 to get the business off the ground so you incorporate a new company. You divide the company into 1,000 shares of stock. You price each new share of stock at $100. If you can sell all of the shares to your family members, you should have the $100,000 you need (1,000 shares x $100 contributed capital per share = $100,000 cash raised for the company).

If the store earned $50,000 after taxes during its first year, each share of stock would be entitled to 1/1,000th of the profit. You'd take $50,000 and divide it by 1,000, resulting in $50.00 earnings per share (or EPS as it is often called on Wall Street). You could call a meeting of the company's Board of Directors and decide to use the money to pay cash dividends, repurchase stock, or expand the company by reinvesting in the retail store.

At some point, you may decide you want to sell your shares of the family retailer. If the company is large enough, you could have an initial public offering, or IPO, allowing you to sell your stock on a stock exchange or the over-the-counter market. In fact, that is precisely what happens when you buy or sell shares of a company through a stock broker. You are telling the market you are interested in acquiring or selling shares of a certain company, Wall Street matches you up with someone willing to take the other side of the trade, and takes fees and commissions for doing it. Alternatively, shares of stock could be issued to raise millions, or even billions, of dollars for expansion. To provide a real-world, historical illustration, when Sam Walton formed Wal-Mart Stores, Inc., the initial public offering that resulted from him selling newly created shares of stock in his company gave him enough cash to pay off most of his debt and fund Wal-Mart's nationwide expansion. It ultimately led to his private family holding company, Walton Enterprises, LLC, through which the family holds the bulk of its Wal-Mart stock, transforming into the vehicle through which his heirs control one of the largest fortunes in human history.

This core principle - that it doesn't matter if you invest in shares of stock of multi-billion dollar conglomerates or tiny publicly traded retailers, when you buy a share of stock, you are purchasing a pro-rata piece of a company - is powerful and essential to wisely managing your investment portfolio. I'm always a fan of using actual examples from life that most people can understand and with which they can connect because I believe it makes it easier to internalize a concept. To that end, let's talk about the world's largest restaurant chain, McDonald's Corporation. When I first wrote this piece years ago, McDonald's Corporation had divided itself into 1,079,186,614 shares of common stock. Over the twelve months before I penned the original words, the company had earned net income of $4,176,452,196.18 so management took that profit and divided it by the shares outstanding, resulting in earnings per share of $3.87. Of that, the company's Board of Directors voted to pay $2.20 out in the form of a cash dividend, leaving $1.67 per share for the company to devote to other causes such as expansion, debt reduction, share repurchases, or whatever else it decided was necessary to produce a good return for its owners, the stockholders.

At that time, the stock price of McDonald's was $61.66 per share. The stock market was, and is, nothing more than an auction. Individual men and women working on behalf of themselves and institutions are making decisions with their own money and their institution's money in a real-time auction. If someone wanted to sell their shares of McDonald's and there were no buyers at $61.66, the price would have had to continually fall until someone else stepped in and placed a buy order with their broker. If investors thought McDonald's was going to grow its profits faster than other companies relative to the price they had to pay for that ownership stake, they most likely would be willing to bid up the price of the stock (which is affected by supply and demand because there are only a fixed amount of shares in existence, in this case 1,079,186,614 shares). Likewise, if a large investor were to dump his or her shares on the market, the supply could temporarily overwhelm the demand and drive the stock price lower.

What should you have done if you believed McDonald's would generate far higher earnings per share of stock within five years? Say you bought 1,000 shares at $61.66 for a total investment of $61,660 and, the very next day, the stock fell to $30 per share. Should you have been upset? No. Not if your thesis about the underlying operating performance was correct relative to the price you paid.

As of today, April 28, 2017, McDonald's stock price is $140.87 per share. The reason investors are willing to pay more for it is because new management has done a good job of increasing profits and raising dividends. Thanks to the introduction of all day breakfast and some other initiatives, the world's largest restaurant earns $5.44 per share after taxes, not $3.87. It sends out $3.76 in per share cash dividends to owners, not $2.20. Under most probabilistic scenarios, no matter what the stock market does in the short term, whether it be bidding McDonald's shares up to $200 each or down to $50 each, ultimately, the experience you are going to have as an owner is tied to the earnings and dividend figures absent some extraordinary circumstances. If the business, the actual operating company, keeps pumping out more and more cash, and sending more and more of that cash to you, whether it is undervalued or overvalued at any given price doesn't mean a whole lot to a long-term owner except in the most extreme situations. That is the key. That is the secret. Personally, my husband and I have both owned shares of McDonald's for years. We don't spend a lot of time thinking about the stock price on any given day.  We're much more interested in 1.) what we paid for our ownership stakes and 2.) what we expect the company to be earning five years, ten years, and twenty-five years from now relative to that purchase price. (For those of you who are interested in how this approach works, and reasons behind it, I wrote an extended passage on the broader philosophy in the 4th quarter 2016 private client letter for our global asset management firm, Kennon-Green & Co. That letter is around 15,000 words and it would be far too long to include here.)

Had you allowed yourself to get upset about McDonald's hypothetical decline in value, growing more miserable as the share price collapsed, you would be allowing yourself to suffer misery due to "other peoples' mistakes in judgment", to borrow a phrase from the legendary Benjamin Graham. The share price of McDonald's may move around wildly as millions of investors throughout the world make decisions about how much they are willing to pay for one piece of ownership, but the ultimate value of your shares will come from the profit the company generates and the dividends it sends to you.  Never forget it. Throughout your lifetime you will witness manias, panics, and crashes. Friends, family, financial institutions, and even some professionals will conspire to convince you otherwise. Ignore them. It is a mathematical, fundamental law. You cannot disregard basic arithmetic indefinitely. If history is any guide, and there is no guarantee it is, the odds are overwhelming that you will see your stocks decline by 30% to 50% or more in any given year depending upon how long you invest. You're going to be happiest in the long-run if you accept and deal with this inescapable reality.

How Does an Investor Actually Make Money By Owning Stocks?

As I explain in an article called The 3 Ways You Can Make Money Investing in a Stock, if you are an outside, passive stockholder, there are only three ways you can profit from your investment under ordinary circumstances. To slightly rephrase the content of that piece, firstly, you collect cash dividends that are sent to you for your part of any profits generated by the company. Secondly, you enjoy any increase in the market value of the stock, which arises from the interaction of 1.) any growth in intrinsic value per share and 2.) the change in valuation applied to the firm's earnings or other assets. Combined, this concept is represented by something known as an investment's total return.

How Can Someone Invest in Stocks?

Once you've decided that you want to own stocks, the next step is to learn how to begin buying them.  While I touched on this topic in-depth in an article called, appropriately enough, How To Invest in Stocks, for the sake of clarity and expansion, it's best to think of stocks as being acquired through one of a handful of ways:

How you actually acquire the stocks will depend on the account through which you are making the acquisition. For example, in a taxable brokerage account, Traditional IRA, or Roth IRA, you can actually have your stock broker buy shares of whatever company or companies you want, provided the stock is publicly traded and not privately held. That is, you could decide to become an owner of The Coca-Cola Company by specifically depositing cash and having that cash used to complete a trade. On the other hand, many retirement plans, such as 401(k) accounts, only let you invest in mutual funds or index funds.  Those mutual funds and index funds, in turn, invest in stocks so it's really only an intermediary mechanism; a legal structure in the middle that is holding your stocks for you.

That decision - whether to hold stocks yourself or whether to do it through a middleman such as an index fund - is a much more expansive topic for another day. The most important essay I've written on the subject here at The Balance is called Investing in Index Funds for Beginners. I highly encourage you to read it. The short version: While index funds can be a great choice under the right circumstances for the right investor, they are not a type of investment as they are still just a collection of individual stocks (in the case of equity index funds). Instead of you choosing your stocks yourself, or hiring an asset management company to do it for you, perhaps through something like an individually managed account, which is typically only available to wealthier investors, you are outsourcing the task to a committee of men and women who work for one of a handful of Wall Street institutions. It's all individual stocks. That's it. That's the bottom line. You cannot get away from that economic foundation.

On that note, if you decide to select your own stock holdings, how do you determine which ones make it into your portfolio?

Deciding Which Stocks Might Be Worth Owning

Before I delve into this question - a question that is, frankly, probably the most common one I see asked by those interested in investing in stocks - it is important to note that what I am about to write is not intended to be, nor should it be construed as, investment advice. Although I serve in a fiduciary capacity as a Managing Director of Kennon-Green & Co., our discussion of stocks, including stocks that might be worth owning, is merely a broad, academic overview of some of the general concerns or considerations a reasonable person might want to take into account when developing a financial strategy. Any specific stocks mentioned here, or elsewhere in this essay, are solely for illustrative purposes and not a recommendation to buy or sell any specific security. You need to talk with your own qualified advisers to determine if an investment is right for your unique circumstances, risk tolerance, needs, and preferences.

With that said, determining which stocks you want to hold in an investment portfolio is going to depend upon numerous factors. It is a common error for beginners to think that the objective of any given stock portfolio is to maximize absolute return; e.g., in some cases, it might be to attempt to achieve satisfactory returns while minimizing risk, while, in other cases, it might be to attempt to increase cash income by focusing on higher-than-average-yielding securities, such as blue chip stocks with rich dividends.

As a steadfast believer in a philosophy known as value investing, I spend most of my day looking for companies that have one or more of a handful of characteristics. These characteristics might include things such as:

  • Stocks of businesses that possess a long, established history of sustained or increasing profitability through an entire business cycle, which includes at least one recession.
  • Stocks of businesses that have a shareholder-friendly management and Board of Directors willing to return excess capital to owners through ever-increasing dividends and share repurchases. (A share repurchase program - at least one that matters to the stockholders - is when a company buys back its own stock, reducing the total shares outstanding. This means future profits and losses are divided among fewer shares. If the business is successful, this is good for owners who stick around to enjoy the fact each of their shares represents a higher percentage ownership than it did prior to the repurchase plan being completed.)
  • Stocks of businesses that have high returns on tangible capital (meaning it doesn't take a lot of investment in property, plant, and equipment, or large amounts of restricted working capital, to generate a dollar of earnings).
  • Stocks of businesses that have some sort of significant competitive advantage that makes it difficult for competitors to unseat the enterprises.  
  • Stocks of businesses that are trading at cyclically-adjusted low p/e ratios, PEG ratios, and/or dividend-adjusted PEG ratios.

We then look at how different stocks fit together as part of an overall portfolio. We wouldn't want all of our, or a private client's, money in, say, banking or industrial manufacturing. Rather, we want to look for ways to attempt to offset things like correlated risk.

To learn more about this topic and some of the other aspects of investing in stocks so far, you should read Business-Like Investing for Picking Better Long-Term Stocks.

What Is the Ultimate Goal of Investing in Stocks?

Wise investors understand that the end game for most owners of stocks is to end up with a collection of wonderful businesses that throw off large gushers of cash they can use to enjoy their life; to give to charity, to fund other investments, to add to their cash reserves. In fact, I'd go so far as to argue that a truly great investment in stocks is not a company you buy at one price and quickly sell at another, hoping for an outsized profit in a short amount of time, but, rather, one that you can buy and then sit on for 25+ years as the underlying earnings per share continue to grow towards the sky even while the stock price itself is volatile.

That is precisely what happens when you hear stories of people like Anne Scheiber, a retired IRS agent, amassing tens of millions of dollars from her apartment by spending her free time studying and analyzing stocks, which she then acquired and sat on for decades. I've done numerous case studies of these secret millionaires; janitor Ronald Read with his $8 million fortune, Lewis David Zagor with his $18 million fortune, Jack MacDonald with his $188 million fortune. Over and over again, the same pattern emerges.  It was rarely a case of luck. Instead, these people loved spending their free time finding businesses they wanted to acquire; businesses that many people would consider to be boring but that had real sales with real profits - not something that was going to make them rich overnight. They then bought them and locked them away, letting time do the heavy lifting, while making sure to never put too much of their personal net worth in a single enterprise so if one or more failed, the compounding machine they built kept churning out increases in intrinsic value.

It's a wonderful feeling. One of the great joys of my life is having the freedom to do what I want, when I want; a joy made possible by the fact that, as I write this to you, not only the private businesses, but the collection of stocks I've accumulated over the past decades, is working for me. Through my family's investment holdings, my husband and I are indirectly enjoying the fruits from the companies we own selling jet engines, insurance policies, chocolate bars, automobiles, coffee, tea, soda, hot cocoa, elevators, escalators, doughnuts, ice cream, oil, natural gas, mortgages, credit cards, student loans, athletic shoes, automobile parks, whiskey, vodka, wind turbines, lumber, diamond rings, watches, freight and logistic services, spices, pharmaceuticals, and much, much more. Even though it's unlikely you've ever met us, you can hardly live or work anywhere in the developed world without somehow putting cash into our pockets.  

That is the power of investing in stocks.