The fundamentals of investing in stocks

In this section, we will look at the fundamentals of investing. The questions you If you know the fundamentals of investing in stocks then you can move on to the detailed discussion on investing in stocks in Germany.  Again, there are many resources on the basics of investing. However, this section gives a quick and simple guide to stocks and investing in a company

How does stocks/share work?

So, how does your money work when you invest in a stock of a company?

Owning a share of the company in form of a stock will make you in part an owner of the company. When the company makes a product and sell them, the company makes a profit. Depending on the company, the profit may either be given back to the owners or retained by the company.

Now since you are a stockholder and own a small part of the company, you will be given a part of the profit in accordance with what you own if the company decides to give a part of the profit to the owners. This giving back of the profit to the shareholders is called as a dividend.

On the other hand, even if the company retains a part of the profit, this should lead to an increase in the value of the company. Therefore, since you now own a certain percentage of the company in form of a stock, your share in the company is now worth more than you actually bought it for. This share can now be sold to someone else for the higher price, thereby making you a profit on your initial investment. This is where stock market comes in.

Please note that sometimes, the terms share and stocks are used interchangeably depending on if it is British or American English.

How do stock markets work?

You buy a stock of the company through someone called a broker or a broker house. They will trade (buy or sell) the stocks of a company for your from other people in a marketplace called a stock exchange (e.g New York Stock Exchange NYSE). The broker charges you a brokerage fee for this service.

Once the broker buys a share (in electronic form), the stock will be stored in your depository account where all financial instruments (stock) can be stored. Think of it as an account for storing stocks. The deposit account could be with a bank or financial institution (broker house). When you want to sell your share, the broker takes the share from your deposit account on your instruction and sells it in the exchange for money. This money (minus the broker fees) will be deposited back to your account.

Most of the times people do not have enough time to research which is a good company to invest in. Also, some of the stocks are expensive so you cannot buy the shares with a small sum of money. Enter – Mutual fund (Funds).

What are Mutual Funds? How do mutual funds work?

Mutual fund is made up of pooled money collected from many investors for the purpose of investing in stocks. Think of it as a company which collects money from people. In return, the company now gives each person something called unit, which is similar to a share in the mutual fund, depending on how much they deposit to invest.

 

Using this collected money, a manager of the mutual fund decides on which share to buy, when and how much, then buys it.

If the investors of the fund wants his money, he can either sell his units on the exchange, or redeem it from the company for what the value of the unit (what it is worth at the date). The worth of the unit is calculated daily by the company as is called as a net asset value (NAV).

The performance of the fund depends on how good the fund manager is. So if the fund manager is experienced and can spot good companies before others, the fund will perform better than the other funds. However, a fund manager charges somewhere between 1% to 3% for managing the fund for actively managing the funds. Therefore these funds are also called active managed mutual funds.

Maybe you are here because you have heard about Vanguard ETF’s. If you haven’t don’t worry. In a study by the founder of Vanguard, it was demonstrated that over a long term period, only 25% of the funds would perform better than the index in general. Enter – Index funds or commonly called ETF’s

What are exchange traded funds (ETF)?

As the name suggests, an exchange traded fund (ETF) is a fund which is traded in the exchange. This allows the investor of the ETF to sell his units to another investor, just like he would sell the stocks. In the beginning, only index funds were traded on the exchange. Therefore, the name ETF is now used synonymous with Index funds. Note that normal mutual funds which do not track an index can also be traded in the exchange, therefore called an ETF. So, do not confuse a normal ETF with an index fund ETF.

An index is a portfolio consisting of number shares from the list of certain companies which belong to the index. For example, the S&P500 is an index consisting of 500 biggest companies in USA and the DAX index comprises the 30 biggest German companies. The value of the index depends on how the companies on the index are doing.

So an ETF is a fund which tries to exactly invests in the companies in a particular index. For example, an index fund ETF which tries imitate DAX index will invest in the 30 biggest German companies. The advantage of an ETF Index fund is that the manager does not have actively analyze the company and merely has to imitate the index which already has the list of companies. Therefore, ETF is also called as passive investing and has a very low management fee of between 0.1% to under 0.7%.

Where to invest? Stocks, funds or ETF’s?

If you have no experience or time to analyze a company and follow its development, you should stay away from directly investing in a company and buying shares of the company. Keep away from the temptation of buying stocks directly at least till you are fully familiar with the concept of investing.

As a beginner to investing you should use a fund to invest your money. The decision of whether to select between an actively managed fund or a passive managed mutual fund is your decision.

There are actively managed mutual funds which have given phenomenally good returns and consistently performed better than the index. However, there are some which perform well for a couple of years and  then under-perform the following year. So if you want to leave the decision to the experienced manager who manages the mutual fund, then go for an active managed fund.

However, as noted in the study by Vanguard, 3 out of 4 times you may be better off investing in an Index ETF in the long term. One more factor to note is that the management fees eats up a lot of profit overtime, especially due to the compounding effect.

In either case, selecting an active or passive managed fund will most certainly give you a better return in the long term than your bank account will. So it is important to start investing as early as possible.

Next  – Part II: Investing in Germany : Where and how: