How stocks work? Stock for beginners

What’s the point of stocks?

Stock for beginners – Different types of assets make up a balanced portfolio. It should be clear that money in a checking account doesn’t grow. Even if you get a daily allowance and money with a fixed term, you can’t count on making a lot of money.

But if you split the amount you’ve saved, you get new chances. This is helped by the effect of interest on interest. In the last few decades, a broad-based stock account has grown in value much more than a savings account. Even with all the crises, stocks have always been a good long-term investment. Studies show that they gave the highest returns compared to safe investments like government bonds and investments with short-term interest. Over the past 44 years, an index fund that tracks the performance of the world stock index MSCI World has given an average return of about 6.7% per year in euros. More than 1,600 companies from 23 countries are part of the MSCI World Index. Researchers have even recalculated until the year 1900 and found the same results.

The next graph also shows that long-term stock prices have gone up in the past. It shows how the MSCI World net has done in US dollars. Net means that taxes that some countries take out of the dividends of the included shares are not taken into account. Since 1970, the graph shows how the value of MSCI World shares has changed as a percentage. Over time, it went up quickly. At the end of April 2022, the price will have gone up by more than 8,000%.

The big question is, of course, why stock prices should keep going up and up in the future. After all, the stock market development is uncertain. No one knows what will happen to the stock market around the world in a few years. From how things have worked out in the past, you can figure out what will happen in the future. But there are still predictions that may or may not come true.

But a theoretical point of view can help in this case. The goal of a business is to make money. This means that it wants to raise more money from the sale of a product or service than its production cost. Sometimes it works better, sometimes it works worse, and sometimes it doesn’t work at all. But if you look at a lot of companies over a long period of time, on average they should all make money. And: It’s likely that the owners, in this case the shareholders, will get more out of it over time than if they put their money in a bank account instead. Because if they didn’t, they would do that anyway—why else bother with running a business?

The “hierarchy of the capital market” is one way to think about this. Banks are where savers put their money. Banks keep lending it out at higher interest rates so that they can make more money. Large borrowers, on the other hand, are companies. They also want to make money, so they want to give their shareholders a return that is higher than what the loans they took out to pay for it cost. This makes the whole thing worth it.

“Chicken Leader on the Capital Market” is another name for this presentation. As a shareholder, you move up the chicken ladder almost all the way to the top. You have people who borrow and people who save. They get picked on by everyone and everything.

As the economy gets better, companies make more money. In turn, profits are what keep stock prices going up over the long term. You don’t have to be an expert to see that when a company makes more money each year, its value goes up. This link is also shown by research. Studies show that stock prices follow profits in the long term. This means that investors have a good reason to hope that stock prices will keep going up as long as the global economy keeps growing. (By the way, economic growth does not automatically have to do with high resource consumption – even a recycling company or a media group can be very profitable and grow.)

Strong fluctuations in the short term

Stock for beginners – But in the short and medium term, which is anything from a month to a few years, share prices don’t always move in the same way as corporate profits. Over time, it’s possible that stock prices will rise more quickly than profits, and vice versa.

At the end of the 1990s, for instance, stock prices went through the roof while profits grew much more slowly. This caused a huge overvaluation on the international stock markets, which caused prices to drop. At that time, the international stock markets had seen the end of the technology bubble.

MSCI is the world stock index. World’s value in euros fell by more than half between 2000 and 2003. This crash was the worst in the last 40 years. From the point of view of a German investor, it took more than 13 years for this price drop to catch up. During the worst of the financial crisis, from 2008 to 2009, stock prices also went down. Since then, investors have had to deal with a 49 percent loss. But in this case, the race to catch up was much faster. The losses were made up for after almost six years.
After the first corona wave in 2020, it went even faster. In less than a year, the loss of more than 30% was made up.
Such examples show that in the short to medium term, investors’ buying and selling decisions can be affected by things other than how much money they are making.

So, it’s not a good idea to be too naive about stocks. Prices on the stock market go up and down, sometimes very quickly, and you can’t be sure that your shares will be worth a certain amount on a certain date. Chances come with a risk, but you can reduce it. In the next part, we’ll tell you why.

What dangers do stocks have?

Stock for beginners – But the high risks that came with stocks in the past made up for their relatively high returns. This is one of the few financial market laws that can’t be argued with: Where there are high returns, there is always a big chance of losing a lot of money. On the capital markets, there is nothing for gifts.

On the other hand, overnight and fixed-term deposits are very safe, but they pay for this with a lower return. Stocks, on the other hand, can change a lot. It’s not unusual for prices to drop for a short time by more than 10%, especially after prices have gone up for a long time. Even though crashes that are much worse are less common, they still need to be taken into account.

The most important basic rule is diversification.

Market risk is the chance that stock prices will fall on average around the world or even just in one area. There is also what is known as “corporate risk.” This could, for example, refer to mistakes in management that hurt the growth of a group’s profits. Bankruptcies are another risk for the company.

Here’s what I mean: In August 2018, a US court told Monsanto that it had to pay a large amount of money in damages. Monsanto hid the fact that glyphosate, the main ingredient in a plant protection product, can cause cancer. On the day of the verdict, the value of a share of Bayer, the chemical company that owns Monsanto, dropped by 14%. Since the decision only affects Bayer and not other companies, it is called “corporate risk.” For example, if all you had at the time was Bayer stock, the 14 percent hit you hard. If, on the other hand, Bayer shares were just one of many stocks in your custody account, the loss wouldn’t have hurt you as much. Maybe price hikes at other businesses have even made up for him.

So, investors can easily avoid the risks of investing in something that is too unique by putting their money in a lot of different companies from different industries and countries. If a company isn’t doing so well, it is made up for by companies whose business and share prices are doing better. This is called diversification or spreading out risks.

Mutual Fund

You don’t have to handle this balancing yourself through a lot of different companies. You can instead bet on a mutual fund. He gets money from investors and puts it into shares of different companies for them. The German Stock Institute says that in 2022, 7.6 million people only bought shares through investment funds. From the point of view of Finanztip, the cheapest and most sensible way to do this is through an ETF on a global stock index.

Market risk, on the other hand, can’t be solved quickly like corporate risk. Investors can only slow it down by putting their money into more than just stocks. For example, they could put some of their money into overnight and fixed-term deposits. Bonds, pension funds, and real estate funds can also be used. On the other hand, a well-balanced equity portfolio doesn’t have as much market risk over the long term. The more you wear it, the more it sinks. For example, people who invested in the 30 Dax companies for 13 years (there have been 40 since 2021) haven’t lost any money in the last 50 years, no matter when they got into the market.

Time Period

Iyou can find out what the average annual return of the Dax has been for any time period.  It gives a good idea of how time affects investments in stocks. For example, it can be seen that the time of entry and exit becomes less important as the amount of time spent investing goes up.

Even if you invest for 15 years and the returns are all positive, the average annual return still depends a lot on when you start. In the best case, 15.4% a year could have been gained over the past 50 years (end of 1985 to the end of 1999). In the worst case, the return per year was only 2.3%. (end of 1999 to the end of 2014). About 13 percentage points separate the two groups. The longer the Dax portfolio is held, the less this gap grows. After 30 years, there are only 4 percentage points between the best and worst time to enter.

Even a portfolio that had almost all of its money in the MSCI World world stock index would have made money every year over the past 40 years after 15 years. This is what we worked out in the Investment Guide.
What’s the point of all this? Because the second basic rule of investing in stocks comes from these facts:

Don’t invest money you’ll need in the next 5 to 10 years.

If you won’t need the money for a long time, that’s best. The longer you can wait, the less likely it is that you’ll have to sell in a bad time. If you keep this in mind and, with the help of the yield triangle, remember that time is running out for you on the stock market, you can sit back and relax even if the stock markets crash again.“

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