During this lesson, we will discuss stocks as an asset class. Learn why companies issue stocks and why people buy them.
First of all, let's define what stocks are:
Stocks are a type of security representing the ownership of the company. They are also called equities.
Why do companies issue stocks?
Companies issue stocks to raise capital. Whether funds are needed to expand into new markets, develop new products, or pay a debt, there are several ways to achieve this; besides borrowing money from someone, companies may go public and sell their shares.
But what do people get in return for buying stocks?
- Capital gain is when stock price increases over time;
- Dividends are when a company distributes its earnings among its shareholders.
Historical returns
The return of the stock market (based on the S&P500 (one of the world's major stock indices, which includes the 500 largest US companies)) is approximately 10% per year.
But, of course, there is a but. This figure is the average annual return over a long time.
That is, having bought today an instrument that correlates with the S&P500 index, it is not at all necessary that in a year, we will receive a profit of 10%.
For example, S&P500 ended 2020 at about +16%, while in March, due to the global pandemic, it declined by as much as -12%.
One of the worst years was 2008 when the index fell about 38%.
Dividends account for a significant share of investment income from stocks. On average, 2-6% per year, followed by reinvestment of dividend income.
Dividend income becomes especially relevant in times of recessions and declining stock markets.
So what are pros and cons of the stock market?
Pros:
Relatively high long-term returns;
Relatively high liquidity if we are talking about large companies;
Easily accessible investing instrument.
Cons:
Risk and possible volatility;
Certain knowledge and involvement is needed.
Casino or not?
Indeed, financial markets have much in common with casinos. Will the market go up or down, red or black… There are many people who regard it as a game. Usually, they are called speculators.
For many others, the market is an opportunity to allocate capital and participate in the global economy.
The bottom line
Stock markets and financial markets, in general, have existed for a very long time and are effective investment tools. Despite a lot of declines and uncertainties, in the long run, the stock market performs quite well in terms of both return and risk.
