Discover the essentials of stock investing, a dynamic financial instrument that allows you to participate in the growth of companies. Learn how they can impact the dynamics and risk of your portfolio.
There is no doubt that investing in stocks is one of the most popular forms of capital investment, which has been attracting both experienced investors and those taking their first steps in the financial markets for years. Stocks, as securities, allow participation in the success of the world’s largest corporations as well as rapidly growing companies. However, like any form of investment, they are associated with certain risks that are worth understanding before deciding to invest your savings.
In this material, we will present the basics of investing in stocks. From this article, you will learn what stocks are and how stock markets work, as well as the principles of portfolio diversification that can help minimize investment risk. We will also discuss the different types of risks associated with investing in stocks so that you can make more informed investment decisions in the future.
What are stocks?
Stocks are securities that symbolize ownership in a company. When you buy stocks, you become a co-owner of the company whose shares you are buying. This means, among other things, you have the right to share in its profits if the company decides to distribute them in the form of a dividend. Importantly, stocks also grant the right to vote at shareholders’ meetings, which allows you to participate in making key decisions concerning the company.
It is worth noting that there are different types of stocks. The most common are common stocks which grant voting rights at general meetings and entitle the holder to dividends. The second type is preferred stocks which offer special rights such as higher dividends or priority in the event of the company’s liquidation. However, preferred stocks often do not grant voting rights at general meetings and are typically not traded on stock exchanges.
The stock market is widely developed worldwide and trading occurs on stock exchanges such as the Warsaw Stock Exchange (WSE), the New York Stock Exchange (NYSE), or the London Stock Exchange (LSE). These exchanges enable investors to buy and sell stocks, offering liquidity and transaction security.
How do stock markets work?
The stock market primarily operates on stock exchanges, where investors can trade company shares. Exchanges act as intermediaries, connecting buyers and sellers. In the primary market, companies first publicly offer their stocks in a process known as an IPO (Initial Public Offering). After the IPO, stocks are traded on the secondary market, where their prices are determined by supply and demand.
Investors buy and sell stocks through brokerage accounts, which allow them to place orders. There are different types of orders, such as market orders, which are executed at the current market price and limit orders, which are executed only when the price reaches a level specified by the investor.
Exchanges play an important role in the economy by allowing companies to raise capital for development and offering investors the opportunity to profit from the growth of companies. Through exchanges, companies can grow, create new jobs and invest in innovation, while investors gain access to various investment opportunities.
Why do companies issue stocks?
Companies issue stocks primarily to raise capital. Instead of taking out loans, which can burden the company with interest costs, they choose to sell a portion of their ownership to investors. The capital raised in this way can be used for various purposes, such as developing new products, expanding into new markets or acquiring other companies.
Issuing stocks gives companies access to large financial resources, which can contribute to their dynamic growth. For investors, it is an opportunity to participate in the company’s success and potentially achieve high returns in the long term. However, since stocks are a risky instrument, investors must be aware that their value may change depending on the market situation and the company’s condition.
The role of stocks in a diversified portfolio
Principles of diversification
Diversification is one of the fundamental principles of risk management in investing. It involves spreading investments across different assets to minimize the risk associated with holding only one type of investment. The idea of diversification is that if one investment loses value, others may compensate for that loss.
In the context of an investment portfolio, stocks are a significant element of diversification. They can yield higher returns than other assets, but they are also more risky. Therefore, in a well-diversified portfolio, stocks are balanced by other investments, such as bonds, which are usually less risky but offer lower returns.
Diversification not only reduces risk but also allows for more stable returns over the long term. This means that even in challenging market conditions, a well-diversified portfolio has a better chance of protecting capital and generating profits.
Stocks as part of an investment portfolio
Stocks play an important role in any diversified portfolio. However, it is important to remember that not all stocks are the same. They can be categorized into different types, which vary in risk level and potential return.
For example, blue-chip stocks are the stocks of large, stable companies with an established market position. They are usually less risky but offer lower returns compared to small-cap stocks, which, while riskier, can yield significant profits in a short time.
Stocks can also be divided into growth and value stocks. Growth stocks are the stocks of companies that are growing rapidly and offer high potential for value increase. On the other hand, value stocks are stocks of companies that are undervalued in the market and may gain value over the long term.
Selecting different types of stocks for a portfolio allows for better risk management. For instance, investing in stocks of large, established companies may be more stable, while adding stocks of small but rapidly growing companies can increase potential returns.
Stock-related investment strategies
Investing in stocks can be approached in various ways, depending on the investor’s goals and risk tolerance. One popular strategy is the so-called buy and hold, which involves buying stocks and holding them for a long time, regardless of short-term market fluctuations. This strategy is based on the assumption that financial markets generally grow over the long term.
Dividend investing is another popular strategy. It involves buying shares of companies that regularly pay dividends. This strategy can provide a stable cash flow even if stock prices do not rise significantly.
Alternatively, investors can invest in index funds or ETFs (Exchange-Traded Funds), which offer broad exposure to various markets and sectors, further increasing portfolio diversification. They are often cheaper than actively managed funds, making them an attractive option for many investors.
The key to success in stock investing is also regularly monitoring and adjusting the portfolio to maintain the desired level of risk and returns. Portfolio rebalancing involves selling assets that have gained value and buying those that have lost value to maintain the originally planned portfolio structure.
Types of risks associated with investing in stocks
Investing in stocks can offer attractive returns, but it is also associated with certain risks. Understanding these risks is crucial to making informed investment decisions and effectively managing your portfolio. In this section, we will look at the main types of risks that accompany stock investing.
Market risk (systematic)
Market risk, also known as systematic risk, involves factors that affect the entire financial market and, thus, all stocks, regardless of how well a company is doing. Interest rate fluctuations, inflation, recessions or global economic crises can lead to a decline in stock values across the market, even if individual companies are doing well.
Example: When interest rates rise, the cost of borrowing increases, which can negatively impact companies’ profits, thereby lowering their stock prices. Similarly, if inflation rises, consumers’ purchasing power decreases, which can reduce companies’ revenues and, consequently, their stock values.
Market risk is unavoidable and affects all investors. However, understanding it helps better prepare for potential changes and adjust investment strategies accordingly.
Company-specific risk (unsystematic)
Company-specific risk, also known as unsystematic risk, is related to specific factors that affect the financial performance and value of a particular company’s shares. This may involve management decisions, industry competition, operational issues or even random events such as natural disasters.
Example: If a company’s management makes poor decisions, it can lead to a decline in profits and, consequently, a decrease in its stock value. The emergence of strong competition can weaken the company’s market position, which will also be reflected in the stock valuation.
The good news is that unsystematic risk can be mitigated through portfolio diversification, i.e., investing in stocks of different companies from various sectors. This way, problems in one company will not significantly impact the entire portfolio.
Liquidity risk
Liquidity risk refers to the difficulties that may arise when trying to sell stocks without significantly losing their value. This particularly applies to stocks of smaller companies, which may be less liquid, meaning they may not have enough buyers to quickly sell them at a fair price.
Example: Imagine you own shares of a small company that is not frequently traded on the stock exchange. If you suddenly want to sell them, it may turn out that it is difficult to find a buyer, forcing you to lower the sale price.
To minimize liquidity risk, it is advisable to invest in shares of large companies that are regularly traded on exchanges and have a larger number of potential buyers.
Currency risk
Currency risk concerns investors who invest in shares of foreign companies or companies operating in multiple countries. The value of the investment may change depending on exchange rate fluctuations, which can lead to unexpected gains or losses.
Example: If you invest in shares of an American company and the dollar weakens against the Polish zloty, the value of the investment in zlotys may decrease, even if the share value in dollars does not change.
There is no simple way to protect yourself against currency risk when investing in foreign stocks. You can avoid it by limiting investments to local market companies or indirectly minimize it by choosing currency-diversified assets. A common tactic among more advanced investors is currency hedging, though this requires greater experience and the use of derivatives.
Political and regulatory risk
Political and regulatory risk arises from unpredictable political decisions and changes in legal regulations that can impact companies’ operations and stock values. Such changes may involve taxes, industry regulations or trade policies.
Example: A change in tax laws that increases capital gains taxation may reduce investors’ profits. Similarly, new environmental regulations may increase companies’ operational costs, lowering their profits and stock values.
Political and regulatory risk can be mitigated by diversifying investments geographically and across industries, as well as by monitoring policy and regulatory changes, allowing for quick responses to new circumstances.
Summary
Investing in stocks can be a fascinating journey, offering the opportunity to participate in the growth of both the world’s largest corporations and rapidly growing smaller companies. However, to navigate the stock market effectively, it is essential to understand the basics of this form of investment.
Awareness of the various types of risk – from market risk to company-specific, liquidity, currency, or political risk – allows for better preparation for the challenges posed by the market. This enables us to make more informed investment decisions, which, in the long run, increases our chances of achieving profits.
We encourage you to continue deepening your knowledge of investing, following markets and current economic events, to make informed decisions. Remember that success in the stock market requires not only knowledge but also patience and the right approach to risk management.
FAQ
What are stocks?
Stocks are securities that represent ownership in a company’s share capital. By owning stocks, you become a co-owner of the company, giving you, among other things, the right to share in its profits and vote at shareholders’ meetings.
Why is diversification important in stock investing?
Diversification involves spreading investments across different assets to minimize risk. Through diversification, potential losses related to one investment can be offset by gains from others, stabilizing the overall portfolio performance.
What is market risk, and how can I respond to it?
Market risk, also known as systematic risk, refers to the impact of general market conditions on stock values, such as interest rate changes or recessions. Although it cannot be avoided, understanding this risk allows for better preparation for changes and appropriate adjustment of investment strategies.
How can I reduce the risk associated with investing in individual companies?
Company-specific risk can be reduced through portfolio diversification, i.e., investing in stocks of different companies from various economic sectors. This way, problems in one company will not significantly impact the entire portfolio.
Does investing in foreign stocks involve additional risks?
Yes, investing in foreign stocks carries currency risk, which results from exchange rate fluctuations. The value of investments may change depending on currency movements, leading to unexpected gains or losses.