Finance for the Layperson

Timur Rakhimov

January 2021

1
Contents

1 Introduction 4

2 Notes on Compound Interest 4

3 Companies and Corporations 6

4 Stocks and Shares 7

4.1 Buying Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.2 Stock Markets and Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.3 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
4.4 Initial Public Offering . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

5 Risk 10

6 Investing Strategies 11
6.1 Day Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
6.2 Value Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
6.3 Growth Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
6.4 Momentum Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
6.5 Dividend Investing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
6.6 Dollar-Cost Averaging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

7 Financial Statements 14
7.1 The Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
7.1.1 Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
7.1.2 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
7.2 Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
7.3 Income Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
7.4 Cash-flow Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

8 Indexes 15

2
9 Funds 16
9.1 Mutual Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
9.2 Index Funds and Exchange Traded Funds . . . . . . . . . . . . . . . . . . . . 17
9.3 Fund Management Styles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

3
1 Introduction

It is my belief that the world of finance that is available to the individual, is extremely
important to understand, for a multitude of reasons, the most obvious being that it will
help you achieve your financial goals. This guide is an attempt at introducing some of the
fundamental concepts that are essential for the individual investor to know. The introductory
nature of this guide means that I have limited the scope to what I think is reasonable and
in further reading, you will come to find that there is a much greater breadth and depth of
information about this subject. Within this guide, there could also be some unfamiliar or
confusing terminology. As such I have included a glossary at the end, which you may find
useful.
In the world of finance there are few certainties and you will find many people
holding different viewpoints, which will always be changing. What is good advice for some
people may not work for you. This is why it is important to always do your own ’Due
Diligence’ and come to your own conclusion. The following is not financial advice, but
simply information about the financial markets.

2 Notes on Compound Interest

Lets begin with a simple premise for a thought exercise. If you invest £10,000 at a 10%
annual return at age 20, and you don’t invest any more money a all, how much money would
you have by the time you retire at age 65? The answer is £728.904.84.
Year after year, you begin to earn interest not only on your principal £10,000 but
also on the interest accrued in the previous years. This compounding effect means your
money grows in an exponential manner.
Let’s say the rate of return is increased to 15% with the same principal value of
ten thousand. By the end of the same time period we would have £5,387,692.69. You can
see straight away that a slight change in the rate of return increases our final number by
and order of magnitude. If you could earn 20%, then you would have £36,572,619.88. Your
investment has increased over 3600 times.
If we now take the original rate of return but we begin investing at 35, this gives

4
us only 30 years of compound interest, so our final value is only £174,494.02.
Now one final scenario. Let’s say you lost money and the value of your investments
halved 3 times, every 12 years during the 45-year period, i.e. in years 13, 25, and 37. At the
end of that period you would only have £82,830.10. This is only an 8-fold increase.
The drastic difference even between the first and last scenarios is presented in
Figure 1.

Figure 1:
800
A
700 B

600
Pounds (thousands)

500

400

300

200

100

0
1 6 11 16 21 26 31 36 41 46
Year

There are some key takeaways from this hypothetical scenario:

1. We can see now why Albert Einstein said, “The most powerful force in the world is
compound interest’. As mentioned before, your money grows exponentially.

2. These phenomena give you a sense of why investing is important. Your money works
for you. If we consider the largest number in the above scenarios, you can see that it is
more money that most people earn in income through their whole life. This is money
that you didn’t have to go to a job and spend years of labour to earn.

5
 3. There is great importance in starting early. The earlier you start investing, the more
time there is for the power of compound interest to act. The longer and more consis-
tently that it acts, the greater it becomes.

4. Don’t lose money. While you may want to maximise your returns, the cost of this is
the increased risk of losing money, which you want to minimise. In the last examples,
losing money only three times, inflicted a significant decrease in our final sum.

3 Companies and Corporations

Companies and corporations form the backbone of capitalism so it is important to understand

what they are, especially because it is likely you will be investing in them. A company is
how the law recognises a person or group of people who want to do business that is separate
from the actual people in the business. In general, the purpose of a company is to earn a
profit from whatever it decides to do, which can be a large variety of things. They have
some similarities to a person in a legal sense as it can own property, have debt, sue and be
sued, be taxed, and enter into contracts. There are many types of ways a company can be
organised: corporation, partnership, fund, trust. A charity or a non-profit is different to a
company as different laws apply to them, which is outside the scope of this guide. You may
see suffixes at the end of company names such as ’PLC’ ,’Inc.’, ’Ltd.’, ’LLC’, ’LLP’. These
are all legal ways of recognising different companies.
The type which is of greatest interest to us is the public company. The abbreviation
for a public company is ‘PLC’ in the UK and ‘Inc.’ usually in the US. What makes a company
public instead of private is that it offers shares to the General Public, i.e. any person is able
to buy shares of that company.
A public company is owned by its shareholders and elects a Board of Directors.
The board of directors do not have direct control of the company, instead it hires a CEO to
run the company on its behalf who oversees the day-to-operations as well as strategy. The
CEO is an employee of the shareholders and is responsible for running the business well,
most importantly increasing its profits for the shareholders.

6
4 Stocks and Shares

4.1 Buying Businesses

The word share means owning one ‘slice’ of a company. Shares and stocks are mostly used
interchangeably (although you say that you “own stock” in a company, not “own stocks”.
Owning a company’s shares makes you its shareholder.
The fraction of a company you own can be worked out with the following formulai :

Number of Shares Owned

Ownership Stake =
Total Number of Shares

A company can create new shares and sell them to people which has its own benefits (mainly
that it is a method of raising revenue) and downsides, which we will discuss later. Stocks
are a type of security. There is a lot of money to be made, correctly predicting the price
movement of these securities, something that is not only the job of professional bankers, but
also can be done by ’amateurs’ like you and me.

4.2 Stock Markets and Exchanges

If a market refers to all the buyers of a particular thing, then the stock market refers to all
the present buyers and sellers of stocks, especially in a given region or country. It is made
up of Stock exchanges.
This is where a company’s stock, as well as other types of security trade. Famous
stock exchanges include the New York Stock Exchange, the London Stock Exchange and the
NASDAQ. Here you can buy and sell shares of companies which are listed as well as other
types of securities. Most of the time you are not buying stocks from the respective companies
but from third parties, who are buying and selling between themselves.

A stock exchange is helpful in many ways:

• Buyers and sellers come together in a single place and the exchange facilitates the
transactions between them.

i All the shares that are held by a company’s shareholders are also called the Outstanding Shares.

7
 • The exchange displays the real-time price of the shares listed on the exchange along
with its ticker symbol.

– This information can be also found on apps like the Stocks app on iPhone or
websites like Yahoo Finance or Google.

• You know are paying or receiving the market priceii for the security you are buying.

Buying and selling of stocks used to be done in the physical room of the Stock
Exchange building called the Trading Floor but now it happens almost entirely through the
internet. The New York Stock Exchange is located on Wall Street, which also gives its name
to the New York Financial Sector. You can make trades on an exchange during trading hours
which usually coincide with normal working hours. E.g. The New York Stock Exchange is
open from 9.30 a.m. to 4.30 p.m. The London Stock Exchange is open between 8.00 a.m.
and 4.00 p.m.
Since only members of the exchange can trade on it, brokers are necessary to access
and exchange. They act as middlemen and also charge fees which come in different types:

• Trading fee - This is a fixed fee for every purchase or sale that you make. Usually
between £5 and £15.

• Annual or monthly fee - This is charged by the broker on a periodic basis, usually as
a percentage of the total account value (annually) or at a fixed amount (monthly).

• Commission - A fee from every purchase or sale of a security which is a fixed or varying
proportion of the cost.

Full-service brokers provide a large range of services such as research, retirement planning, tax
help and investment advice. As such they typically charge a larger fee. Discount brokers do
not provide the same services and as such they will have smaller fees. The following are some
well-known brokers in the UK: Hargreaves Lansdown, IG Markets, DEGIRO, Interactive
Brokers, Interactive Investor. This is by no means a comprehensive list. If you want to open
a brokerage account, you should do some of your own ’Due Diligence’ to see which one is
best for you.
ii The market price of security is whatever people are paying for it at the present, and is not necessarily
fair.

8
4.3 Dividends

When a company earns profits, it can either reinvest them or pay some of the money to
its shareholders. Dividends are a cash payment from a company’s earnings payed to the
shareholders on a per share basis. That means the more shares you own the more money
you will receive. Dividends are usually paid by companies, who have matured and become
large enough that rapid growth is not possible, and they have too much money to reinvest
all of it back into their business. They can pay dividends, to keep investors around. The
company’s board of directors decides what percentage of earnings will be paid as dividends.
US companies tend to pay dividends on a quarterly basis, while UK companies tend to pay
dividends on an annual basis . To be entitled to a dividend, you have to be a shareholder
before the ex-dividend date.
Dividend yield shows how much a company pays out in dividends relative to the
stock price.
Annual Dividends Payed per Share
Dividend Yield =
Share Price

High dividends may be at the cost of potential growth as the company is sacrificing money
that could otherwise be used to improve its business to effectively increase the stock price.
For this reason, start-ups and high-growth companies will usually not offer regular dividends,
because profit will be reinvested into business expansion, research and development, etc.iii
Usually, one of two things happen to a dividend payment once it is received. It either becomes
personal income, or it is reinvested back into the company. Some companies offer dividend
reinvestment plans through which they money earned through dividends is automatically
reinvested into stock at below market price.

4.4 Initial Public Offering

An Initial Public Offering is the method by which a private company becomes a public one,
listing its shares on an exchange for the first time A company will select a price (also called
the offering price) and an exchange and sell some of its shares where they can be publicly
traded and available for the public. The primary aim of an IPO is to raise money for the

iii A similar thing can be said for executive compensation. Money that is paid out to the C-suite, is not

used to improve the running of the business or to increase the salaries of employees.

9
company to help it grow and expand but it also can generate publicity for a company. Angel
investors, private investors, early employees can realise the gains of the stock they own.

5 Risk

The word risk has strong and somewhat unpleasant connotations. However, its use as a
financial term more nuanced than that. Risk is the chance that the outcome or return of an
investment will differ from its predicted outcome or return. One common measure of risk is
the standard deviation, which is something I won’t go into further for obvious reasons. While
riskier assets may result in losses, taking on more risk is usually offset by the opportunity for
greater returns as there will also be a greater chance of you losing your money. Conversely,
low risk investments should have a much lower return. An investor needs to understand his
risk tolerance before making and investment.
Every single investment has some associated risk. However, some have such a low
risk that they are called ‘risk-free’ although of course they are never actually risk-free. The
U.S. Treasury Bond is considered widely as one of the safest investments available and as such
it provides a low rate of return.iv The U.S. Treasury Bond is a low risk investment because
people have high levels of trust that the U.S. government, which backs the security, will not
fail to miss a payment as it is, among other things, backed by one of the strongest economies
and stable governments in the world.v Other low risk assets include Savings accounts, cash,
government bonds of some other governments, certificates of deposit, etc. On the opposite
side of the spectrum, but not by any means on the end of the spectrum, risky assets include,
junk bonds, derivatives such as futures and options, commodities, etc.
One way risk is rated is through credit ratings agencies, which measure the ability
of a corporation or government that issues debt to pay that debt back. The ‘Big Three’
credit ratings agencies are Moody’s, Standard & Poor’s and Fitch, which control about 95%
of the global ratings market. These agencies give the debt and other securities a letter grade
based on the risk associated with that asset. AAA is the highest rating and therefore the
lowest risk category.

iv At the time of writing, albeit during a recession, the yield on a 12 Month Treasury Bond is 0.09%.
v Not all governments are risk free to lend to. E.g. Greece

10
 As with most of the topics covered, the topic of risk is highly nuanced, and this is
just a brief overview.

6 Investing Strategies

Indeed, there have been and is a great number of investment strategies invented and while
I assume the vast majority are ones used by professional City banker types, if I were to
write about only the ones available to retail investors, this guide would have to be split up
into several volumes. Notwithstanding, it would be useful to get a brief overview of some,
but not all, of the common investment strategies and some recommendations and warnings
accompanying them. Furthermore, the decision to select a strategy and stick to it is more
important than the strategy itself. Knowing what you will do will make sure that you will
act rationally during times of market uncertainty. Picking a strategy earlier, as stated before,
will increase the effects of compounding.

6.1 Day Trading

I would like to preface this section by noting that I would not consider this an investment
strategy. Day traders execute trades over the short term. i.e. in the span of a single day but
not overnight. It uses a wide variety of techniques which mostly include technical analysis.
Due to the high level of risk associated with this method due to high leverage and volatile
assets, it can be easy to lose money. In fact, the overwhelming majority of retail day traders
fail to make consistent returns.vi

6.2 Value Investing

Value Investors look for stocks that they believe are undervalued, for companies with great
performance and perhaps a low P/E ratio. Warren Buffet, perhaps the most famous and the
wealthiest investor is a value investor as well as the wealthiest. Investing of this type has to
be done over the long term, over time periods which often span decades. Benjamin Graham’s
1949 book ‘The Intelligent Investor’ popularised value investing and it is still widely read,
vi Online broker eToro found that 80% of day-traders lose money. A single internet search will yield many

statistics like this.

11
and its principles are put into practice to this day. Key things to consider about a company
in value investing are past performance, debt, profit margins, competitive advantage, if the
shares are trading at a discount. As value investors are focused on long term growth, they
are not worried by day to day fluctuations of the market and what others are doing. Their
primary concern is whether a company is in a solid position to make money in the long
term. It must be noted however, over the past decade, value investing has significantly
under-performed other investment strategies.

6.3 Growth Investing

Growth Investors look for investments that offer strong upside potential for earnings in the
future. In essence they are looking for the ‘next big thing’. This involves careful evaluation
of a company’s current health and its potential for growth. Think about how the world will
change over the next 10 or 20 years. If you can anticipate what the needs of the future will
be, you can predict which companies will benefit from these changes. Three areas which
come to mind are:

• Technology, as there will be a greater shift towards online products and services, and
a greater need for cyber-security.

• Healthcare, as people begin to live longer around the world, how will that change
human’s needs.

• Climate Change, as we begin to use more electric cars and renewable energy.

There is some guesswork involved in predicting trends, and additionally investors must anal-
yse whether the specific company is suited to taking advantage of these new changes, and
if is able to grow. It is important to analyse the management capabilities of the executive
team. This is because growth is one of the greatest challenges a company can face, so this
requires stellar leadership.

6.4 Momentum Investing

Momentum investing involves following the market trend. It is based on the idea that
stocks that are performing well, will carry on performing well, and conversely, stocks that

12
are performing poorly will carry on performing poorly. Leading on from this realisation,
momentum investors would take a long position on the former, and a short position on the
latter. Beyond this, momentum investing gets very complicated, very quickly.

6.5 Dividend Investing

Dividend investing requires buying the stocks of dividend paying companies, especially those
with high yields i.e. a large dividend when compared to the price of a stock. Typically, div-
idend paying companies are established companies and have finished most of their growth.
Conversely, high growth companies do not pay dividends, as their earnings are retained and
reinvested to maintain the growth of their business, through research and development, train-
ing employees and retaining talented ones, mergers and acquisitions and capital expansion.
In the event of a recession or economic downturn, companies tend to cut their dividends, as
money is needed to fund their operations if revenues and profitability decrease. If a com-
pany’s stock price declines significantly, it will have a very high dividend yield, which can be
a trap for investors, if they purchase it off the expectation of a large dividend.

6.6 Dollar-Cost Averaging

Unlike the previous strategies, this one can be used in conjunction with some of the previously
mentioned ones. You invest a fixed amount of money into an asset over a period of time, at
regular intervals. You have to consider:

• The total sum to be invested.

• The window of time in which the investments will be made.

• The frequency of purchases.

As the price of an asset fluctuates, the investor captures both the low and the high prices,
reducing the level of risk and the effects of volatility. The actual cost of the purchase becomes
an average of the purchase prices, which can help minimise downside risk and potential
feelings of regret resulting from a lump-sum investment before a market downturn.

13
7 Financial Statements

Financial statements are documents, published to the public about a company’s activities
and its financial performance. Public companies are required to submit these documents and
they are checked by governments, external auditors and the firms themselves to make sure
they are accurate for tax and investment purposes.

7.1 The Balance Sheet

The balance sheet is a picture of a company’s finances at a moment in time. It contains

terms that we must familiarise ourselves with.

7.1.1 Assets

An asset is any resource with economic value. On a balance sheet these are listed in order
of their liquidity, i.e. how easy it is to turn them into cash. We can split assets fixed
assets and current assets. Current assets include Cash; Securities; Accounts Receivable,
which is money that customers owe the company; Inventory, which is the goods for sale; and
prepaid expenses, which is the value of contracts that have already been paid for such as
rent, insurance, advertising contracts, etc. Fixed assets include any equipment, land, real
estate, machinery. There is another type of asset called intangible assets such as intellectual
property or goodwill, although these are generally omitted from a balance sheet. This may
include the value of the brand and any trademarks owned.

7.1.2 Liabilities

This is anything that the company owes to other parties. These are also split into current
and fixed. Current Liabilities can be interest, wages, dividends, accounts payable, tax etc.
Fixed Liabilities include term debt, pension fund liability.

7.2 Shareholders’ Equity

The shareholder’s equity is the value given back to the company’s shareholders if all its assets
were sold and all its debts were paid off. This is important for working out the value of the

14
business. The equity can be found on a company’s balance sheet. And can be calculated
using the formula:

Total Shareholders’ Equity = Total Assets − Total Liabilities

Or more commonly on a balance sheet:

Total Assets = Total Shareholders’ Equity + Total Liabilities

A balance sheet gives you a snapshot in time of a company’s finances. By itself, a single
balance sheet has limited utility, and must be compared with other balance sheets and other
documents such as the Cash Flow Statement.

7.3 Income Statement

7.4 Cash-flow Statement

8 Indexes

An index measures the performance of a group of assets in a particular way. Typically they
measure the performance of the market, or a certain section of the market. Each index is
calculated in a certain way. Perhaps the most famous and important index is the Standard
& Poor’s 500 (S&P 500) index.vii It is considered and essential benchmark for the U.S. stock
market and economy. The performance of stocks, funds and other indices is often compared
to the performance of the S&P 500. It consists of the 500 largest public companies in the U.S.
weighted by market capitalisation. This means this index only contains large cap companies,
but not small and medium cap. The proportion of the index that a company occupies is
calculated using the following formula.

Company Market Capitalisation

Company Weighting in the S&P 500 =
Total Index Capitalisation

vii This is the same Standard and Poor’s as the credit rating agency mentioned earlier.

15
This means that companies with large market capitalisation are over-represented in this
index and have a larger effect on the index’s value.
The Dow Jones Industrial Average (DJIA) is another well- known index. It tracks
the 30 largest companies in the US. While this used to be an important gauge of the U.S.
stock market, it contains companies from fewer sectors as fewer companies are represented. It
is a price-weighted index, which means companies with higher prices have a higher weighting
in the index. There also exist indices to measure the performance of stocks on the London
Stock Exchange such as the FTSE 100, FTSE 350, etc. Many indices exist that track the
performance of certain industrial sectors, such as healthcare, technology.

9 Funds

A fund is a pool of money allocated for a specific purpose. Many types of funds exist, such as
emergency funds, trust funds, endowments, hedge funds, retirement funds, etc. Our primary
focus is on a specific few, especially those that use this money to invest in the stock market.

9.1 Mutual Fund

This fund allows money from many investors to be invested in securities such as stocks,
bonds, etc.by professional money managers who are in control of the process of what to
invest in. The value of the fund is derived solely by the aggregate of all the investments.
This total is called the net asset value (NAV), which is used to track the performance of the
fund, and is analogous to the market cap of a company.
Much like companies, an individual investor buys a share of the mutual fund, so
that his gains and losses are proportional to the performance of the fund. The price of a
mutual fund share is called the net asset value per share (NAVPS).
However, unlike a share of a company, an investment in a mutual fund represents
an investment in many different securities, although you do not get voting rights from the
assets. Funds expose you to diversification at a lower price, since you don’t have to buy all
the individual shares the fund is composed of. For their services, funds will charge you fees.
Annual fees, are charged (annually) as a percentage of your funds under manage-

16
ment, known as the expense ratio. Shareholder fees come from sales charges, commissions
and other fees paid by investors when purchasing or selling funds. Mutual Funds’ price does
not vary over the course of any single day, rather all transactions with regards to buying and
selling of shares, happen once at a certain time each day.

9.2 Index Funds and Exchange Traded Funds

An index fund is a specific type of fund that tracks an underlying index i.e. its price is
determined by the underlying index. These can be mutual funds, but often times they
are exchange traded funds. Exchange traded funds, are a type of fund that are listed on
exchanges and are traded throughout the day just like ordinary stocks. By being on an
exchange, it is easier to sell and purchase them on a more frequent basis. A well-known
example is the SPDR S&P 500 ETF (ticker symbol SPY), which tracks the S&P 500 index.

9.3 Fund Management Styles

17
Glossary

’Due Diligence’ The examination of financial information and any other research you do
before making a transaction.. 4, 8

18