Financial Literacy Month: What are Equities?

You may not know this, but April is financial literacy month. To my knowledge, there are no parades or government holidays scheduled in its honor, but April 15^th is Tax Day, so that means a lot of Americans are taking a hard look at their finances for the first – and most likely the last – time this year.

If financial literacy month were celebrated, it would probably be a very confusing holiday. A study by the National Bureau of Economic Research last year found that most Americans lack even the most basic knowledge of finance, economics and investing. Therefore, many Americans, shell out a lot of money to pay people to handle their finances, like accountants to do their taxes or mutual fund managers to invest their savings. The fees that these professionals extract are a high price to pay for financial ignorance.

So to do our part, Mint Life will be taking a look at one basic investing topic every week this month. Today we will be focusing on equities.

What does equity mean?

The word equity basically denotes some sort of ownership in an asset. You have equity in your home, car, Beanie Baby collection, etc. Your equity is the difference between the market value of the item minus whatever debt you owe on it. It isn’t always a positive number. For example, a lot of Americans owe the bank more money for their home than what they could get if they sold it today. That means they have “negative equity” in their homes.

Then, what are “equities?”

When people talk about “equities” they are usually referring to stocks issued by companies. So if you buy stock in Apple, you actually own a piece of the Silicon Valley dynamo. The stock of a company is divided into shares, allowing many people to own small slivers of the company. Owning one share of Apple won’t give you much influence in the company, as there are millions of Apple shares outstanding. But owning one share does allow you to attend the annual shareholders meeting and vote on important issues.

Companies issue shares as a way to raise money for two main reasons: to grow the company or to pay out their original investors. The first time a private company issues shares to the general public is called an initial public offering or IPO. This is also known as “going public”.

The money you invest in a company is linked to how well that company performs. If it does well (makes a big profit) or people think it will do well in the near future, the company becomes more valuable. That pushes the value of your stock up. If the company performs poorly (loses lots of money) or if the company’s outlook is bleak, then the opposite occurs and its stock price falls.

What is margin?

The value of your equity in a company grows when the market value of your shares exceeds the price you originally paid for them, minus any fees associated with buying and selling the stock. If you borrowed money to buy the stock, which is called margin, you need to subtract that amount plus the fee associated with borrowing the cash.

How and where can I buy and sell shares?

To buy and sell shares in a company you need to open an account with a Wall Street broker-dealer that has the right to buy and sell stocks on an exchange. Brokers-dealers, like Fidelity and Scott Trade, charge you a fee to trade though them because they take on risk by matching up buyers and sellers. Exchanges, like the New York Stock Exchange or Nasdaq, also get a fee because they ensure an orderly marketplace. The fees associated with brokers and exchanges vary widely. Faceless internet brokers are usually the cheapest, while brokers that give their clients personal service from an actual human naturally charge more.

Which stock should I invest in?

Choosing which stock to invest in is the hardest part of the game. There are thousands of companies to choose from these days. In general, a stock is valued by the market based on its expected future earnings. So if you don’t want to take much risk, you can buy a big company that has a stable earnings outlook. Those big and stable companies usually divvy out a portion of their profits to shareholders every year, something called a dividend. They also use some of their profits to buy back their shares from investors. This shrinks the number of available shares outstanding, which makes your shares more valuable.

If you want to take on more risk you can buy shares in a high growth company where its future earnings growth is unknown. These companies are usually technology and biotech companies that require a lot of upfront capital. If they are successful in whatever they are doing then the value of the stock shoots up and you make a killing. But if they fail, you could potentially lose your entire investment.

Where can I learn more about stock valuation?

There are literally hundreds of things to consider when you try to assess a company’s future growth potential; ranging from the state of the economy, to the sector the company trades in, to the competence of the company’s management. If you want to really delve into valuation you should pick up a copy of Security Analysis by Benjamin Graham and David Dodd. Written in 1934, the book is known as the bible for value investors, like Warren Buffett, who try to find and invest in stocks that are undervalued.

Investing is not a spectator sport. If the last decade has taught us anything it’s that we need to watch our money and know how and where it’s invested at all times. But many Americans continue to invest passively, shying away from getting directly involved in their finances. Investing in equities isn’t as complicated as you probably think. If you do your homework and keep your eyes on the market, you can take control of your financial destiny.