Our two sons are in their final stretch of college and will be graduating next year. College is great but unless you major in finance, you don’t always get a good understanding of personal finance so I will be talking about these subjects in upcoming Financial Independence blogs.
Financial Independence 101: What are Stocks?
You probably know people who talk about financial independence and are “in the stock market”. They tend to talk about buying and selling stock. But what is stock?
Stock is simply ownership of a company, so if you have multiple stock owners (shareholders), each own a certain percentage of the company and will benefit as their earnings increase through sales and marketing.
Stock ownership is a key ingredient on your path to financial independence.
Related Blog: Financial Independence 101: What are Bonds?
Do limited liability companies issue stock?
Not all companies issue stock. Small companies structured as a limited liability company (LLC) do not have stock because they don’t want to sell stock to raise money (capital).
Private versus Public Corporations
Companies that plan to raise capital will structure themselves as a corporation and will issue stock. Corporations can be private or public.
Private corporations don’t sell their stock in the stock market. Instead, they issue shares of stock to the founders and sometimes early employees as an incentive to stick around and help grow the company into something larger. If they later sell the company or go public, their stock can be liquidated into cash at that time.
When we owned our last company, we structured it as a private corporation, with my wife and me owning all of the stock. Once we sold the company, the acquiring company paid us for the stock, allowing us to retire and achieve financial independence.
Once a company grows, it may decide to become a public corporation. This means that it will sell its stock in the stock market so that others can purchase it. You may remember hearing about companies going public (think Microsoft, Facebook, etc.) and pushing key employees into financial independence. This is because they owned stock and when the company went public, they could then sell their stock for the market price on the stock exchange.
How do you purchase stock?
Stocks are sold on the stock market exchanges, with the New York stock exchange and NASDAQ being the most popular. To purchase stock, you simply need an account with Fidelity, Vanguard or some other financial institution. Once you have an account, you can buy and sell stock online. This account will become your portal to financial independence.
Is it risky to purchase stock?
It can be risky to purchase a stock because if the company goes belly up, you lose all your money. Imagine investing in Circuit City, they were darlings of the stock market and after being in business for 60 years, they went out of business in 2009. All of the shareholders lost their money.
The reason to purchase stock is that it can be a lucrative tool to help you achieve financial independence. With risk comes rewards. Since 1900, investors have averaged a 7% return on their stock investments per year. That’s a lot better than putting it into a savings account that returns less than 1% per year.
How can you make stocks less risky?
As discussed earlier, if you invest in a single stock, the company could go out of business and you lose all your money. To minimize that risk, it’s a good idea to invest in multiple stocks so that you spread the risk. But to really spread your risk, you need to invest in 100 or more stocks. This can be time-consuming and difficult to manage.
Mutual funds solve this issue. A mutual fund is a collection of stocks (normally hundreds of stocks) that allow you to reduce your risk. The mutual fund is managed by a company and you pay a small fee to the mutual fund management company for having them manage it. The amount you pay is called the expense ratio, so look for mutual funds with low expense ratios (I look for those with an expense ratio of .15% or less).
What is the Dow Jones and S&P 500?
The Dow Jones is an index that shows how 30 large publicly traded companies have fared over time. Companies in the Dow Jones include 3M, Apple, Boeing, American Express and other large companies.
The Standard and Poor’s (or S&P 500) is an index that shows how 500 large companies have fared over time. If the S&P 500 index goes up on a particular day, it means that on average, the 500 stocks in that index went up as a group. Some may have gone down, some may have gone up, but as a group they are worth more than yesterday.
How do you make money in the stock market?
Stocks and mutual funds are traded on the stock exchanges and you purchase them for a specific price. For example, one of my mutual funds has a stock ticker of FUSVX. It is a Fidelity mutual fund that invests in stocks that belong to the S&P 500. It is currently selling for $69.34 per share.
When I initially purchased this 5 years ago, I purchased it for a much lower price than it is selling for today. In fact, it has provided a 15% return each year, averaged over those 5 years. So if I had bought $1,000 of that mutual fund 5 years ago, it would be worth about $2,011 right now. In other words, I would have more than doubled my money. Doubling your money is the path to financial independence!
This is because the price it is selling for now is higher than when I purchased it. So if you purchase a stock or mutual fund and the price goes up, you make money. If the price goes down below what you paid for it, you lose money.
A final way you can make money with stock is through dividends. You can think of dividends as profit-sharing. If a company does well, it wants to reward its investors (shareholders) with some of those profits. Some stocks and mutual funds will pay dividends as they generate profits. Some will pay monthly, some quarterly and some yearly. The dividends can be cashed out or you can automatically reinvest them into buying more stock, it is up to you.
Dividends will become an important part of your retirement plan once you reach financial independence because they provide passive income.
Now that you have an understanding of stocks and financial freedom, let’s get to the bottom line. Once you start your career, set aside money for savings and have that money automatically deducted from your paycheck. Start with 15% of your paycheck, more if you can swing it.
Open up a Fidelity account and begin contributing money to a few mutual funds. If you want to really diversify, I suggest these 4 mutual funds to invest equal amounts in:
- FUSVX – Invests in S&P 500 stocks
- FSEVX – invests in smaller yet stable companies
- FSITX – Invests in bonds (see related blog post)
- FSIVX – Invests in international stocks (like those in Europe).
Finally, track your budget and investments with an online tool. Personal Capital is an excellent tool for this and best of all, it’s free**. This is a great start to financial independence!
If you would like a visual introduction to stocks, watch this Kahn Academy video.
** Note: I have no affiliation with Fidelity nor do I get any compensation, I am just more familiar with their services than other investment companies so that is why I recommend them in this article. I am an affiliate for Personal Capital, it is a totally free and superior way to keep watch over your investments. I would never recommend anything that I don’t personally use and completely believe in, so give it a try.
About this Blog
Steve and his wife built a software company, sold it and retired early. Steve enjoys blogging about lifestyle freedom, financial independence and technology. If you like this blog, subscribe here to get an email each time he posts.
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