What Everyone Should Know About Buying Stocks

I read an interesting article “The Number One Misconception That Most People Have About Investing” on Business Insider (BI), and thought I’d pen down some thoughts on it. It makes two important points:

  1. When we buy stocks in the market, we’re not really ‘investing’. We’re allocating a portion of our savings into a vehicle that potentially generates a higher return than our bank account interest rate.
  2. True investing means spending to improve our future production.

I’ve been giving this matter a great deal of thought of late. As a self-employed person running my own business, there are two things I can do with my surplus income.

  1. I can either grow it to reach my personal savings goals; or
  2. I can invest it into my business to increase my production for next year.

According to the BI article, only #2 is truly an investment.

When we truly invest, it means spending to improve ourselves such as going for further studies, taking a course to certify ourselves, improve our qualifications, learning a new skill, etc. This allows us to command a higher salary from our current or future employer(s).

Here’s an analogy

Now, let’s say your monthly salary is $3,000 and you want to go for an MBA. It’s going to cost you $40,000. You have only $10,000 in your savings, so you’re going to ask for your family members for help. In exchange, you promise to give them a share of your future earnings.

You have two parents and one husband, and each person contributes $10,000 to your education fund. As part of the promise, your financially savvy parents make you sign a legal contract to document your promise. This document entitles its holder to receive one quarter of your future earnings above $3,000. This is called a stock.

Now you have enough money to go take your MBA.

[Note: This is an Initial Public Offering (IPO).]

Fast forward two years and you’re now earning $2,000 more than you used to. But because you agreed to share your future earnings, your personal income is actually $3,500 and the remaining $1,500 is distributed equally among your parents and husband.

[Note: These are dividends from the shares held by the primary market, the ones who bought the stocks directly from the IPO.]

Now, the only person who has actually made an investment is you. What your parents and husband have done is to put a part of their savings with you, so that you can make the investment. In exchange, they have received a stream of income which could continue for as long as you work.

In this sense, it is still an investment, because they have spent to have a higher income. But from here on, it gets confusing.

Your husband, seeing your success, decides to go take his MBA as well. He needs $40,000 for it. Not having the money, he decides to sell his stock, his share of your income to his best friend for $40,000.

What happens now is that as long as your husband’s best friend holds this stock, you are required to share one third of your future earnings increase with him. (Yes, he’s the same one who takes your husband drinking every weekend.)

Every month henceforth, $500 of your income goes to this best friend while your husband studies for his MBA.

[Note: Your husband has used the proceeds of a financial investment to invest in himself.]

Your husband’s best friend is happy, because he has spent $40,000 to get an increased passive income of $500 per month. Higher income means more money for beer. It sounds like a good investment, doesn’t it?

[Note: Really, it sounds awesome, doesn’t it? Wait till you see what happens next.]

Meanwhile, your parents don’t really need the additional income because they’ve already planned for their retirement. So they’ve sold their stocks to a young couple in their neighbourhood who are looking for a potentially endless stream of passive income.

The young couple is relatively new to investing and they take your parents at their word, since your parents are obviously financially savvy because they have enough passive income to retire. Your parents then put their $80,000 into the bank. For the retired, cash is king.

[Note: Your husband’s best friend and the young couple are called the secondary market. The profit made from selling the shares is called capital gain.]

However, after your husband finishes his MBA, he’s earning more money than you now, and you decide to stop work to look after the kids.

Your parents don’t mind because they’ve sold off their shares. But your husband’s best friend — and the young couple you don’t know — throw a fit. Because if you don’t work, you don’t earn money and if you don’t earn money, he doesn’t collect money. The source of passive income has suddenly dried up. But you don’t really care, do you?

He could sell off his share, but would anyone want to buy it since it won’t earn them any money in the near future? What if you decide to become a homemaker for life and never go back to work?

So now he’s stuck holding a stock that cost him $40,000 and earned him only $12,000. In effect, he’s actually lost 70% of his ‘investment’.

And that’s how people get burnt when they buy stocks.

[Note: Let’s throw in one more spanner into the works.]

Now the young couple and your husband’s best friend have been holding on to a seemingly worthless stock for a couple of years.

Your parents — ever financially savvy — offer to buy it from them for $10,000 apiece. The three of them, eager to recoup even a small part of their losses, readily agree. Your parents use some of that money they’ve got stashed in the bank.

[Note: Each of the secondary market ‘investors’ put in $40,000 and took back only $22,000. Not such a good investment now, is it?]

The young ones think they’ve successfully conned an old couple into buying a worthless share. Actually, your parents did this because, having played a part in taking care of your children, knew that they were going to school soon and you were thinking of going back to work and therefore, the share is about to start paying dividends again.

[Note: This is called insider trading. It is illegal if caught.]

How does this affect your financial investments?

What I’ve described above is pretty much what happens in the stock market every day.

  1. You represent the company that’s going to make the IPO.
  2. Your husband represents the company’s initial investors.
  3. Your parents represent the big banks that arrange the IPO.
  4. The young couple and your husband’s best friend represent retail investors like you and me.

There are a few lessons to take away from this:

  1. When you buy a share, understand the company that you’re buying into. Do your research carefully and don’t rely only on hearsay.
  2. You’re not smarter than the market. You can’t beat the big boys. They are more savvy, have more money and holding power than you do.
  3. Recognise that the companies whose shares you buy and the people you buy your shares from don’t know and don’t care about you or your finances.
  4. The stock market is there to help the companies raise capital for their investments, not yours. The stock market doesn’t exist to make you rich.
  5. Avoid taking on more risk than you have to. This means spreading your risks around as much as possible by diversifying across asset classes (not just stocks), geographical locations, and time.
  6. Your aim is simply to beat the interest rates that the bank gives you for your savings. Don’t chase returns.
  7. Most importantly, if you truly want to invest and get a manifold return, invest in yourself and your future.

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