What is a Stock?

What is a stock?

A stock represents the actual ownership of a publicly-traded company. A company's stock is divided into individual units called shares.

The ownership aspect is crucial.

If you can successfully convey to your child the idea that stock ownership makes them part owners of a very real business, you will have given them a powerful investing edge.

In all honesty, even most adults don't get this. What is a stock? It's ownership, pure and simple. When you own a share of stock, you don't just own an equity, a security, a piece of paper - you own a very, very small piece of a very, very real business.

Stocks and Earnings

As a co-owner, you have a claim on your "share" of the earnings, or profits.

Now, obviously, you can't just show up to a company and help yourself to the till. The company of which you're a part owner will have a management team in place to handle both the operations and the finances.

And hopefully, that management team will be responsible with your profits and use them in the company's best interest (which, as part owner, would be in your best interest as well).

Much of the earnings may be retained and used for expansion of the business or buying other businesses outright.

Depending on the company, a portion of the profits will be distributed back to the company's owners (like yourself) in the form of dividends.

Your company will also have a board of directors that will set the company's dividend policy. Dividends are usually paid quarterly (every three months) and on a per share basis - the more shares you own, the more dividends you receive.

Stocks and Diversification

Most forms of passive investing is done in a diversified manner in the form of index funds or actively managed mutual funds:

• An index fund is a mutual fund that attempts to track a large diversified index such as the S&P 500 (500 of the largest U.S. publicly traded companies).
• An actively managed mutual fund is essentially a large basket of stocks selected by a fund manager who is attempting to outperform index funds (news flash - the majority of of fund managers fail to do so over the long term).

By investing in either vehicle, you instantly gain the advantage of diversification. And what is that? You avoid the risk of investing in a single company and potentially losing your entire investment if that single company implodes.

That's the conventional wisdom, in any case, and the standard advice you'll read on just about every personal finance website.

Granted, if you have zero knowledge of investing and zero interest in learning to invest, then the standard faire of broadly diversified index and mutual funds is undoubtedly your best bet.

[And please don't take any offense from the previous sentence - there are many subjects I have zero knowledge of and interest in. We all have different passions and weaknesses - and they don't make us better or worse people.]

The only problem with index and mutual fund investing is that it's not really effective - because you invest in everything, you get everything results. Hint: that means average. Or worse.

Suppose, for example, that you invest in 100 companies. Now 10 may be truly superior businesses with strong balance sheets, consistent and growing profits, and durable competitive advantages. Maybe another 10 are struggling, unprofitable, dying a slow death or else just treading water. And most likely, the other 80 are somewhere in between.

So here's a radical thought - why not just invest in the 10 superior businesses yourself in the first place?

Teaching Kids the Basics of Stock Market Investing

Once you accurately answer the question, What is a stock? and allow the profound implications of co-ownership of a real business to really sink in, you won't need to embrace the mediocrity of the mutual fund industry.

Don't be intimidated by the stock market!

Yes, it can be merciless to the uninitiated. But that's because 95% of market participants have a trading mentality, not an investing mentality.

And once your kids are able to answer the question, What is a stock?, you're ready to move on to the only two other questions that successful investing requires:

• What constitutes a superior business?
• What price should I pay to invest in a superior business?

Honestly, that's all there is to it.

Now obviously, there's a lot that goes into answer those two questions, and your kids aren't going to turn into Warren Buffett overnight, but don't fall for the trap that says investing is too difficult and dangerous and you should always leave it to the "experts" (nice track record, by the way, "experts").

We tell our kids they can grow up to be anything and do anything. Well, in my book, that includes learning the basics of stock market investing.