Question

Why would someone want to buy stock? Why is stock valuable to an investor? What makes stock different than a bond or a savings account at a bank? How might you determine the risk of a certain firm? How does the risk of the firm relate to the return you expect from the stock?

Answer 1

A stock is a part ownership in the firm. That means that you will be entitled to the residual earnings of the business. These residual earnings may or may not be distributed at the end of the year in the form of a dividend. Hence, these earnings do the work of increasing the stock price and make the company more valuable for the investor. In this way, it is different from a bond or savings account as in both these instruments, the output you will get is fixed and fairly certain (safe) but in equity ownership you receive only after paying everyone else. Hence, this is riskier than the two investments. The risk of a certain firm can be analyzed in many ways. One way is to look at the industry it is in, find the growth of the industry, the position of the firm in the industry and how the company is growing in the industry, etc. In this way, we can try to analyze what will be the future performance and position of the company and whether it will be fruitful to invest money in it. The other way, which is not exhaustive of the previous option, is through analyzing financials of the company. They can tell us a good bit about how the company can protect itself from any difficulties later on. If the risk of the firm we wish to invest in is high, it means that the shareholders will require a higher return from it and hence, this risk is counted in the expected returns.