TOPIC: Understanding stock investment

Understanding stock investment 2 years 2 weeks ago #3139


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You and I make an arrangement. I will sell you a piece of my company which is worth $10.0000 for $1000.
I will use this money to increase the value of my company from $10.000 to $20.000. Your piece of my company, being 10%, increases from $1000 to $2000. Are you willing to invest?

When the price of your piece of my company is $2000 you decide to sell. You won a significant amount of money, it doubled. You sell it to your aunt for $2000. She keeps the stake and in the mean time my company value increased to $30.000 and with that her stake from $2000 to $3000. Her gain is as much as yours absolute and less relative. There are only winners, my company value increased with your investment and because of that your stake increased as well.

However, I did not mention one piece of information. When I sold you part of my company, things could have turned out worse as well. Would my investment of your $1000 have gone wrong, my product would have been a failure and the value of my company would have been $3000. Your stake would have been $300, losing $700.

When looking at a simple stock (portfolio) this is how you can evaluate: you have a certain profit which is based on a certain risk. You need to understand why I made yo owner for $1000 and did not borrow $1000 from the bank (there are several reasons for this).

In a complex portfolio which has stock, bonds, real estate and other investments things are more complex. I might invest in stock for a piece of the portfolio not only for additional profit, but also to counter certain movements on the bond market (assuming the two move somewhat contrary). In this case I have build a portfolio for stability and not for maximising profit. Here overall I might accept lower gains or even some losses because I also have decreased risk of losing money over long periods of time.

When you invest you have to understand the investments.
Understand the risks involved and the assumed returns. Understand how these assumed (read future) returns are calculated and based on which conditions.
Understand the market, when normal risk/return ratio is 1/5 and additional money flows into the market (or single stock) you might find that the risk/return ratio changes from 1/5 to 1/3, indicating that investment risk increased. The reason is that increased money puts upwards pressure on the price and increased price with the same risk means a worse ratio. When you buy or keep your money is at more risk than before, even though risk itself did not change.

Losing money happens to all (accidents happen, crops fail and diseases spread, not to mention inventions that replace products). Yet when understanding the investment this risk is calculated and understood. On most deals both parties will gain, else trading would have stopped ages ago.

Jos Buurman
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