Let us assume that you are looking to retire some day. Wow, imagine that... A lot of people believe that this day will never come, and therefore never prepare for it. Recently, I said that preparation is how one with anticipated risk, organizes their current situation to eliminate this upcoming risk. Well, simply put, retirement is an anticipated risk, and therefore needs preparation.
Saving for retirement is quite easy. I can already hear the sighs all around. This guy is a joke. No really, it is a simple process. But understanding the process can be complex, and therefore needs explanations.
We will keep it simple for now, but I need to start somewhere. The best place that I can start is with stocks. What is a stock? When I say the word stock, I'm sure many of you are already diverting your attention to Youtube, or Facebook, but stick with me. I will keep this simple, and try my best to keep it interesting.
A stock is simply ownership in a company. Let's say that you bought a candy bar. This chocolaty delight has 10 easily breakable squares. After you buy the candy bar, you return to school and begin to break up those pieces. While you are examining this brown gold, people around you begin to eye your source of wealth. You watch this, and being the nice person you are, you tell everyone around that you are willing to share. You begin to think in your head of the price of the candy bar, let's say it was $1.00. According to this, you decide that each piece is worth 10 cents.
You still with me? $1.00 divided by 10 is 10 cents, therefore each piece you break off should be worth 10 cents. Everyone that is hungry for chocolate must pay 10 cents for that chocolate. Understand? Now let's back off for a minute. This same process is followed by companies. Every company is always in need of money. There are a couple ways that a company can obtain this money. First, they can take out a loan with a bank or a bond. Another, is to sell ownership in the company, or pieces of the chocolate, to investors. The benefits of selling stock in a company are that these funds never need to be repaid. This provides the company with free money in a sense to expand their business and hopefully make it more profitable. The disadvantages are that the company will lose it's primary ownership. Those who purchase stock, gain a percentage share of whatever the company is worth.
Lets analyze this for a moment. Back to the chocolate bar. You have decided that you will sell each piece of chocolate for 10 cents. But you also decide that you will keep 1/2 of the bar for yourself, because in fact you are hungry. Inside your head, you decided that by selling half of the squares you will get 50 cents and then buy a can of Pepsi to wash down the chocolate. Those around you have each gained a piece of chocolate, and each enjoy those benefits.
Let's expand a little bit. So these 5 people who purchased a piece of chocolate each decided to save that piece of chocolate til lunch time. Meanwhile, a very hot sunny day has melted all chocolate candy bars within miles of the school. What implications does this have on the people who purchased a piece of chocolate from you?
I want to take a side step to briefly explain how supply and demand works. Most of us understand it intuitively since we perhaps live it daily. The theory of supply and demand dictates prices. We will keep it simple so that each of us may stay tuned into our chocolate example. Let's suppose that before the crazy meltdown of March 2011, there were 100 candy bars within 2 miles of the school. In this example each price was $1.00. After the meltdown, only 10 candy bars remain intact. What affect will this have on prices?
Each individual candy bar holder will understand the situation. Out of the usual demand of 100 candy bars, only 10 remain intact. The chocaholics nearby will need their fix of chocolate but only 10 of them will be able to fully satisfy it. This creates a dilema. In order to get a candy bar, you will have to be willing to pay more for that candy bar then the other person. This creates a universal price increase on all candy bars. The opposite will follow accordingly in an increase of the supply of candy bars.
Back to our situation. So the chocolate piece holders, who had sense enough to place their candy bars in the refrigerator, now each hold one piece of chocolate. Originally, they bought it for 10 cents, but now everyone who knows they have the chocolate wants to buy their pieces. The supply and demand theory explains that these pieces of chocolate will sell for much more than they bought them for. Let's say that now, each piece is worth $1. That would be an increase of 900%. Or in other words, each person that purchased a piece of chocolate will make 900% off of their 10 cent investment.
This same thing follows in real life. One purchases stock in a company, which contains a valued portion of the whole. That stock will be a small portion of the entire cost of the company, just as the piece of chocolate valued at 10 cents is 1/10 of the entire value of the chocolate bar which is $1. A person buys a stock with the anticipation that that company will increase in value. A company increases in value when they gain new bids, hire more people, build new factories etc. But there is a trick. You need to understand the theory behind buying low and selling high. A lot of people do not understand this theory.
Let's say that when you sold the pieces of chocolate, you were quite creedy and crafty. You decided that you were going to sell the pieces of chocolate for 50 cents each rather than 10 cents (which is the actual worth of each piece). Let's say that you did this, and later when the pieces were selling for $1.00 they sell the same way as before. Their gain will only be 100%. That is a huge difference in return. Rather than making 900% they make 100%. Which would you rather have?
When purchasing stock it can be quite complex. A lot of analyzing can be done to determine the exact value or worth of a stock, and whether or not that stock is selling above or below it's value. Understanding this is key to making a gain. This is exactly how people lose their money. They jump on the rollercoaster when it is at the top, and then, hoping that it will continue to rise, realize that it was over valued and ride it all the way to the bottom. If stocks are overvalued, eventually someone will notice and supply and demand effects will rearrange this inefficiency to the real value.
Let's do an overview. Stocks are nothing more than ownership in a company. In order to gain a return, you must invest in companies that you believe will be profitable in the future. At the same time, remember to analyze the value of a company and the equivalent value per stock. Only purchase those stocks which you believe are at value or below value. These stocks, will generally be the ones that increase in value, consequently increasing the return you receive from purchasing them.
Remember that this is a simple overview of the what a stock is. There are many different types of investments in the market that you can invest in, along with other ways to purchase or sell them. I will go into these details later, but only after you have the general idea behind what a stock is.
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All of this stuff is very confusing to me but you did a pretty good job explaining. The chocolate bar was a great example.
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