Recently I participated on a panel where we fielded investment/finance related questions from members of a small business owners’ networking group. There were three professionals: a real estate investor / realtor, a sole practitioner in the entertainment industry, and me. I left this experience with one overarching thought: The audience was highly skeptical of the stock market and the statistics I was sharing regarding historical growth of the stock market.
We discussed the importance of maximizing the growth of your money by contributing to tax-deferred investment accounts (i.e., Solo 401(k) plans, SEP IRA’s) and within these account(s) invest in equity-based investments (i.e., individual stocks, mutual funds, ETFs). Sole proprietors have the opportunity to contribute a lot of their income into these tax deferred accounts and quite frankly if you have the wherewithal to make these large contributions and keep them invested for the long-term you are positioning yourself for a wonderful retirement. But, even sharing this information, I was asked a few times “How can you be certain your money will grow?”
Of course, no one can predict the future. We can only use history to guide us when projecting investment returns. But as I reflected on the skeptics, I realized the majority of these folks didn’t know what stocks actually represent. They were clear that when buying real estate, you are buying dirt. It’s not going anywhere. But when buying stocks, what am I actually getting? Am I just hoping they go up in value somehow? Obviously, there is much more to stock investing and I thought I’d give a high-level overview here.
Simply, stocks represent ownership in a company. When you want to buy a stock, you go out into the stock market and buy shares from someone who wishes to sell their shares. (On a side note: the company does not get any of the money you spend to buy the stock (unless it’s an IPO). Some people get confused with this.). So, now you are a shareholder of Company ABC. Company management now works for you. Their job is to run this business successfully.
If management performs and subsequently the business makes money (i.e., increases profits, creates lots of cash, etc.) the stock will ultimately reflect this success by increasing in value. The main point of this is to show you that a stock’s price going up or down is based on how successful the business is today and will be in the future. A stock’s future price is not based on perception or luck or anything else that is non-finance related. The price will ultimately be supported by the company’s finances.
For us, we look to invest in companies that we can see has a bright future, that has sound financials, creates lots of cash flow, has overperforming management that is focused on allocating their capital to achieve a return that is greater than their cost of capital. When we can do this, we typically have a great long-term investment that we can hold onto through the ups and downs of the market because we know what the company is worth.
I guess the best way to explain a stock is that it’s not the actual piece of paper (I.e., the stock certificate) that is worth something… It is what that certificate represents. The assets, the ability to create positive cash flow, the ability to sell more products/services, etc. is what you are investing in. And it is this that may very well be worth more than a piece of dirt. So, knowing that you actually own something as a stockholder hopefully gives you piece of mind and excitement that your investment grows for a reason… not due to luck!