Financial Literacy – Markets – Basics

There are many different ways to look at the markets. Some people are day traders, attempting to trade stocks on volume and make money on the pricing coming up and going down on a daily basis. There are some other who are speculators and their strategy is to buy stocks like bets, gambling that the price will go up or down based on how they feel. Others still are investors, who look at the numbers and plan to buy companies and hold for the long haul, selling only when fundamentals change. I am a believer of investing. What i mean to say is that you should look at a company and determine basics of the fundamentals of the company. I do not advocate being a trader or a speculator, these endeavors are a waste of time and while many traders and speculators can and have been successful, the amount of people who have failed in those same goals is mind boggling. Understand that i will continue with the assumption that you are not investing money with the goal of becoming a millionaire overnight because many people have lost enormous amounts of money that way.

What are the markets? The stock market is really a marketplace of buyers and sellers coming together to trade financial assets. Nothing more, nothing less. For every person who buys a financial asset, another one sells. It is through this constant buying and selling that the forces of supply and demand meet to settle on a price. This price is not always rational. It does not always make sense and it is a mistake to believe that it does. Traders, who trade financial assets daily, need a quick way to read a situation and determine whether they want to buy or sell an asset and at what price. They typically do this through Technical Analysis. This is a method of looking at charts and other indicators to give a trader information to quickly make these types of decisions. These traders believe that all the information that would affect the price of an asset is already factored into its price and believe that its through the price action, or price movements, that one can determine the fundamentals of a company over a period of time. I do not and will not advocate this style of trading. Many of the most successful investors of all time have made their millions or billions because of pricing inaccuracies. They found companies at a discount to their true value and bought them, meaning that the markets were not efficient, that the markets had indeed not factored all relevant information into its price.

Fundamental Analysis is the opposite side of the coin. It is looking at the fundamental financial circumstances of a company and determining value from that information. It looks at things like revenues, debts, liabilities, and other readily available information to give the investor a look into the financial health of a company. This is several times easier to understand, as you look for information that would make sense to you as an individual in a similar situation. For example, would it make sense to buy part of a company, any company, that did not make ANY money and hadn’t done so for many months at a time? Yet this is exactly what happened during the dot com bubble. Had you simply looked at the fundamentals of some of these companies, you would of seen that you were paying for shares that were actually losing money at a ridiculous rate. Some of the ratios have fancy names but it is a way to gather if a company is profitable and how well or not it is managed. In other chapters we will talk about specifics of evaluating companies, but for now we will cover more basic information.

Speaking of shares, what exactly are they? I am going to illustrate this concept with a pie. Imagine a company is a pie, sliced into many pieces. A share is a piece of that pie and the price of that piece is known as the share price. Why would you want to buy a share of a company? Unlike a pie, who if left alone long enough will spoil, companies make products and provide services that they sell for a profit. These profits are then represented in each piece of this pie, making each piece of the pie worth a certain price. The higher the profitability of a company, generally, the higher the price of each piece of that pie. Some companies pay that profit out directly to shareholders (people who own shares of that company) and some others reinvest those profits back into the company, with the aim that it uses those profits to becomes even more profitable. If you buy a share at a low price and then sell it at a higher price and make money that way, it is called a Capital Gain, because the capital you invested has gained value. If a company instead chooses to pay some of the profits out to shareholders, it is called a dividend. This is important to understand because these two incomes are taxed differently and work differently. If you invest in a company that doesn’t pay dividends for example, you will eventually have to sell your shares to make money, where as with a company that pays dividends, they pay you for holding onto the shares as long as the company is profitable. These two payment concepts make up for the majority of financial assets in the markets, you typically make your profits through one of these two methods.  

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