Lesson 4

Shares: becoming a business owner

You already know that a share is a stake in a company and that you can earn money from dividends or on the increase in the price of shares. Let's take a closer look at how you can earn money with stocks.

What you will learn:

  • Why stock prices rise and fall
  • What bears and bulls are and what they have to do with investment
  • How to invest in shares efficiently.

How Shares Work

Suppose you own a business, and you want to expand. You don’t have the cash on hand right now, as most is still tied up in your business. But you also don’t want to go to the bank for a loan, as the rates they’re offering you are bad.

A third solution is to sell shares in your business. You divide the company ownership, or equity, into for example 1,000 pieces, and let’s say you sell 400 of those in the open market. You’ve effectively sold off 40% of your business, which keeps you in control, but has brought new money that you don’t need to repay. Everyone who bought at least one of those shares is now a co-owner of the business with you, and they’re entitled to the profits the same way you are. This is called an initial public offering, or IPO.

The process here is the same as with bonds: the company issues shares and announces the price at which it will sell them (there’s a bit more that happens here, called bookkeeping, that involves how banks get involved and figure out what a good share price would be, but that’s not important for our understanding.)

The first investors buy shares directly from the company, so the company receives money for development. Investors then resell each other's shares on the stock exchange. And at the moment of resale of shares the price can already be very different from when it started: it depends on the company’s situation and investors’ mood. Let’s take a look at why this happens

Why stock prices rise and fall

There’s many reasons why share prices rise and fall, some of them well known, and others esoteric. But they all boil down to a basic law: supply and demand.

New example: you’re running a vegetable stand at a farmer’s market. You have about 200 carrots to sell that day, but as you arrive you realize that there are 500 people there, all hoping to buy carrots. There’s not enough carrots to go around. Because the demand is high and the supply is low, you can charge more for the carrots.

The next day, the other farmers who saw you make bank the other day want a piece of the business and have brought 200 carrots each, and there are still only 500 people who want a carrot. Now there’s too many carrots, and not enough people. Demand is low, supply is high. You’ll have to sell your carrots at a discount if you want to get rid of them. Everyone else will do the same to stay competitive with you.

Company shares work the same. When someone buys a share, they’re making a bet that the company will do well in the future, which will make the share price rise. When information arrives that confirms or invalidates this idea, people buy or sell the shares.

For example, let’s say you buy a share in Company A, making a bet that they’ll do well and the share price will rise. The company then publishes a quarterly report that shows the business is doing even better than they had previously thought. The order books are full and profit is rolling in. Suddenly more people want to buy these shares, as they’ve realized the chances of the company doing well in the future are good. They’ll start offering more money to own a share because they think the company is worth even more than the premium they’re paying. Because the demand has increased, the share price goes up. Since you already had a share, you’ve just made a nice little bit of profit.

Now let’s say the opposite happens, and the quarterly report shows the company is weaker than expected. Investors will rush to sell shares, but there won’t be any buyers at yesterday's price: no one wants to buy shares of a company that’s not doing well. Then supply will exceed demand, and the share price will drop.

The share price constantly fluctuates as sellers and buyers come together and agree on a transaction. The purpose of the exchange is to bring buyers together with sellers. The price of shares is constantly changing: sometimes by a percentage per day, and sometimes by several percent per hour.

If you dig deeper, in the long run, the price of shares depends on the potential income or losses of the company, the economy, and even sometimes the share price itself. Investors study the company's business, events and management's comments, economic releases like unemployment numbers and GDP growth, and others. From all this investors draw conclusions and buy or sell shares.

Here’s a few more examples of news that can move share prices.

↗ Expansion.

If the company opens new stores, starts a new plant or enters a new market, then it is doing well, so investors believe in the company and want to buy its shares.

Example: on July 3, 2014, German carmaker BMW announced it was opening up a new assembly plant in Mexico. This was a huge announcement, as factories are often 20 or 30-year decisions. That day alone, the stock climbed 2.6%.

↗ Growing demand for a product or service.

If a company keeps adding customers, then money follows. They can either win those customers from competitors, or the market for those customers can grow.

Example: In 2002, when Amazon was still mostly an online bookstore, it quietly launched its web services division, which allows customers to rent computing space and power in the cloud. Over time, the market for that kind of business exploded, and now a significant part of the internet runs on AWS. It also makes up more than half of Amazon’s profit. And the Amazon share price, well, you know how that’s gone.

↗ The company reduces the debt and begins to pay the dividends — that is, to share profits with its shareholders. Most companies have debts: they take loans to hire more people, release more products, and update production. Most of a company's income goes to investments and interest payments.

When that debt gets repaid faster, and dividend payments to shareholders start happening or increase, it’s a good sign of the company’s health.

↗ Share buybacks.

This used to be a controversial tactic that’s become much more common in recent times. Companies can buy their own shares on the open market, lowering the number of shares circulating, which lowers supply, and makes the share price rise. Unlike the other reasons, this is not a statement about the company’s health, but a function of the supply of shares.

↗ ↘ Economic situation.

Large parts of the economy are cyclical — they go up and down in a regular rhythm. Let’s say a country finishes a recession. It has more money for once, and wants to use that to improve infrastructure. This will increase demand in the construction industry, as buildings are built and renovated. This boosts demand for steel, concrete and other raw materials. Eventually, the demand in construction goes down as the demand for apartments is met. Demand for steel and concrete falls and so does the price of both commodities. Some steel companies might not survive the drop in steel price and go bankrupt. This leads to less steel in the market, making the price go up again, and so on.

↗ ↘ Regulation.

New laws can restrict the business of some companies and give impetus to the development of others. It can also open up the competitive landscape for new companies, or open up new markets and opportunities.

A good example is global warming. Laws restricting the amount of CO2 companies can produce have made business harder for fossil fuel producers, carmakers and other industrial companies. But it’s also opened the market for renewable energy companies, electric carmakers, and other kinds of innovators. Think of Tesla, whose share price development will go down in history books (though what exactly moves the share price of Tesla to record heights goes beyond just simple regulation.)

↘ Political sanctions.

They can block companies from entering the foreign market or increase costs if they have to pay higher trade duties.

In April 2018, the United States imposed sanctions against a number of Russian companies and businessmen. The sanctions included freezing their assets in the United States and prohibiting American companies from doing any business with members of this blacklist. After the news, investors got scared and started selling stocks.

Shares of Rusal, which before the sanctions earned 14% of its income on sales in the United States, fell in the next five months and were 40% cheaper by September. In the end of 2018, the sanctions were lifted. At the same time, the company was able to neutralize this negative effect and earn even more than in 2017. However, investors were still afraid that sanctions would be restored, so the price of shares did not recover to the previous level.

↘ Accidents and other force majeure.

Companies that extract or process natural resources always have the risk of accidents and catastrophes at the enterprise. The more severely the accident affects production, the higher the likelihood that profits and share prices will fall.

On August 4, 2017, a water breakthrough occurred at the Alrosa’ Mir diamond mine. The mine was flooded and became unsuitable for diamond mining. The company immediately lost the mine where 10% of its diamonds were mined, and the proceeds from their sale accordingly. In a month, its shares fell by 8% and did not return to previous levels until the end of the year. But the company instead increased production in its other mines. As a result, total production in 2017 increased by 6%. This was reported by the company in early 2018. Investors calmed down, and the forecasts returned to growth.

It’s not just producers of raw materials that can face force majeure. The coronavirus pandemic is a great example — it shut down everything from movie theatres to car dealerships.

↘ Fall in sales.

Sometimes a competitor makes a better product, sometimes your product just isn’t popular anymore. Either way, it’s not good news for your company.

At the end of June 2007, Apple released its first iPhone. After Apple shares grew, the shares of its competitor Nokia also rose, as people expected every cellphone maker to be able to benefit and match what Apple was introducing. But the Finnish company failed to make anything close to the iPhone. It missed the rapid growth of the smartphone market and eventually sold its mobile business to Microsoft. After that, its shares fell almost 90% and never came back even close to their highs in mid-2007.

So let’s recap: when a company is doing well, or expected to do well, stocks go up. If it does poorly, or is expected to, stocks go down. Sounds simple enough, right?

Unfortunately it’s not.

Bears and Bulls

The problem with stock moves is that they can happen for seemingly inexplicable reasons. Sometimes it can be simply because of the share price itself, or the reasoning of some automated trading algorithm that made a decision no one can understand.

One big reason for what looks like illogical behaviour of stock prices is the investors themselves. Investors are emotional creatures and can easily create panic or euphoria, neither of which is good for stocks in the long run. They see someone selling or buying stocks and rush to do the same, creating a movement in the stock that is completely divorced from the actual health of the company.

A great example is Hertz, the U.S. rental car firm. In May 2020, the firm went bankrupt — no one was renting cars in the middle of a global pandemic. The shares dropped to under a dollar a share.

Then something weird happened: Americans got a $1,200 stimulus check from the government. Suddenly, Americans had cash and a lot of time on their hands. Stuck at home, many of them unemployed, they turned to online trading. Some of them started buying Hertz stock. Then more and more joined in. The price of Hertz skyrocketed from 56 cents to $5.53, a nearly 10-fold increase. And nothing had changed about the company’s health: it was still bankrupt.

At some point, the company even tried selling new shares at the high price, in order to finance the bankruptcy, though a court eventually stopped that. These days, Hertz trades closer to its bankruptcy price.

Panic and hype can affect not only a particular company, but also the whole industry, and sometimes even the market as a whole.

The dot-com boom is a famous example of this. Investors were desperate to grab a slice of the boom of internet companies, which meant that even small or poorly-run companies that had anything to do with the internet were seeing their shares get bought in record amounts.

None of these prices were supported by the actual health of the companies. In the beginning of the 2000s, investors realized that most of the companies they had invested in were not able to make profits. The bubble peaked in March 2000 and then burst. As a result, thousands of new firms went bankrupt and investors lost trillions of dollars. Even the shares of such giants as Cisco, Intel and Oracle lost more than 80% of their value then.

Both of these events are classic examples of bull and bear behaviour. When people classify investors, they often sort them into one of these two categories.

Bulls are aggressive: they charge ahead, buy everything, and don’t care what is in their way. Think of the investors buying stock in Hertz despite the company being bankrupt.

Bears are the opposite. They’re afraid of everything, and try desperately not to lose money. They’ll sell shares at the slightest news of something going bad. Think of the investors panic selling their shares in Intel when the dot-com bubble burst. The company was not one of the inflated new internet firms, but investors were still scared the bubble bursting could hurt the company.

Bulls and bears are used to describe behaviour, not just investors. Sure, there may be investors who fit more into a bull or bear profile, but most of us have a bit of both in us.

But market or stock movements are easier to describe. When stocks are consistently going up you call it a bull market. When they’re going down or retracting it’s a bear market. Similarly, you can be bullish or bearish on a stock: you think it’s going up or down.

These examples are important because as an investor you need to sometimes resist joining the crowd. Don’t just buy a stock because everyone else is buying it. Don’t just sell it because it looks like everyone else is. Of course, if a stock is really rising, you can absolutely try to be a part of that rise, and a falling stock is always worth examining if you’re invested in it. But make your decision on more than just what the crowd is doing.

How you should choose your shares

If you’re going to invest in individual shares you should be following the companies closely. Check their finances, read their reports, read the news reports on them, and stay on top of any development that might affect their share price. Your reward, if you do well, is a higher return than bonds or a savings return could ever give.

In the Vivid app, you’ve already got a bunch of tools to help you do this.   We have news reports and a daily market update for you that lets you know what may be moving shares that day. Keep in mind that daily share moves are generally more noise than signal — unless they’re related to a big corporate action — an earnings report, a bankruptcy declaration, a merger or acquisition — daily share moves are part of the general movements of markets. Far more important are the long-term moves: how much a stock has gained or lost in the past few weeks or months.

Or you can invest into an ETF, which tracks a collection of shares, usually an index. Your main benefit here is risk hedging. If one stock drops, it only makes up a part of the ETF, and the other stocks should protect you. We’ll talk about ETFs in the next lesson.

If you still want to try to buy stocks yourself try to stick to the following principles.

Often professional investors like investment funds will sometimes invest 60% in equities  and the remaining 40% in bonds. This ratio roughly reflects the percentage of stocks and bonds in the worldwide market. You can also invest in bond ETFs in the place of actual bonds.

Diversification. Investing in stocks of different companies from different industries and countries helps mitigate losses from one drop. If shares from one company exceed 5% of your portfolio, you’ll feel the effects of that stock’s moves more directly overall. Diversification can help you offset the losses from a company or country or even sector doing bad.

Don't get hyped or panicked. Extreme bull and bear behaviour almost never helps. If you see people talking about the next hype stock, take a closer look than you would a normal stock. If a company you’re invested in drops a little and you hear people panicking that this is the beginning of a collapse, be just as skeptical.

If you’re new, speculation is a risky tactic. Short-term investing requires more luck than skill, and most active money managers, even those with decades of experience, don’t beat the market.

Read the analysts. Investment banks and brokers have analyst departments who study stocks and offer investment ideas. But remember that only you will be responsible for your actions: analysts can't guarantee their investment thesis will work.

To summarize:

No one knows how exactly a stock or market will move tomorrow. If you want to increase your chances of success, you need to do your research, read analyst reports, manage risk, and avoid copying what other people do.

Alright, it’s our favorite time. Are you ready for the quiz?

What's next?

It's time for a quiz!

You now understand the basics. Let’s test your knowledge, and then go a bit deeper.
Your result

It's time for a quiz!

You now understand the basics. Let’s test your knowledge, and then go a bit deeper.
Lesson 5

ETFs: how to invest in hundreds of companies easily

Lesson 5

ETFs: how to invest in hundreds of companies easily

It's a bit early to start this lesson

Our lessons built to be finished in order. Every lesson requires some knowledge from a previous one. Please procede to the last lesson you’ve started.