Investing in Stocks
When you buy shares of a company's stock, you take an ownership stake in that company. As a result, stocks are also called equities. As a shareholder, the entire amount of your investment is at risk. You may lose up to the entire amount if the company fails. However, you also enjoy an opportunity that your shares will increase in value many times over the years.
The size of your equity stake depends on the number of shares you own and number of shares the company has issued. For example, if you own 1,000 shares of a company that has 1 million shares issued and outstanding, your stake is one-tenth of 1 percent. If the company's shares double to 2 million, your stake has been diluted. You now hold one-twentieth of 1 percent. A 2-for-1 stock split doubles both the number of total shares and your shares. As a result, your share is unchanged. Some stock splits have odd ratios, such as 3-for-2 or 5-for-4. In any case, a stock split protects your share in the company, since you receive additional shares in the same proportion as all other shareholders.
As a shareholder, you are entitled to receive income that the company distributes as dividends. Since U.S. companies are required to report earnings results to shareholders every three months, you usually receive dividends at the same interval. (Unless the company doesn't pay a dividend.)
For example, a company may pay out 20% of its profits each quarter to shareholders. If dividends equal $1 a share, your stake would result in $1,000 of dividend income. If the share price were $80, your dividend yield would equal 5%. This is because a $1-per-share dividend in a quarter suggests a total dividend of $4 for the year, assuming no growth. This $4 divided by the current share price of $80 results in a 5% dividend yield.
While you earn dividends when you own stocks, you earn capital gains when you sell them. You earn a capital gain if you sell a stock for more than its basis. The capital gain is the amount on which you owe capital gains taxes. Since 2003, dividends have been taxed at the same rate as your capital gains.
Many companies have dividend reinvestment plans, or DRIPs. Companies offer DRIPs to encourage you to reinvest your dividends. Reinvesting is a way of buying additional shares of the stock. For example, if you were to reinvest the same $1,000 of dividends in additional shares when the share price is $80, you could buy an additional 12.5 shares. DRIPs also reduce or eliminate brokerage commissions and other transaction fees. They also let you take advantage of dollar-cost averaging.
A company often has two classes of stock: common and preferred. If your shares have voting rights, it's likely they are common shares. Voting rights allow you to vote for members of the company's board of directors and on other important corporate matters. In a proxy vote, you can often assign your voting rights to a shareholder group of your choice. As a rule, preferred shares do not have voting rights. Preferred shares are often placed with large investors for strategic financial reasons. Not too many issues of preferred shares trade on the stock market, and it's unlikely that you'll own them as an individual investor.
Investing in stocks is an important part of the asset-allocation process. Over time, stocks have earned an investment return that is substantially higher than bonds or cash. Professional financial planners and advisers routinely recommend an allocation to stocks of at least half an investor's portfolio value. Moreover, are guidelines for a conservative investor. For aggressive investors, a recommended allocation is often 70% or more of a portfolio's value.
When making an investment decision, you need to make realistic assumptions about your expected return. Over long periods, stocks average a yearly rate of return of about 11%. However, these long-term returns are well below the average annual returns of above-20% that investors received over a five-year period through 1999. Financial experts suggest you be conservative in estimating your expected rate of return.
The stock market in the U.S. consists of several thousand stocks. Several thousand more exist outside of the U.S. Major categories include growth, income, value, cyclical, and foreign stocks.
Stocks are also identified by their market capitalization. The three major categories are large-, small-, and mid-cap stocks.
Stock indexes are often used as a barometer of investment performance for the stock market. Stock indexes are put together from a group of stocks whose characteristics, overall, represent a major segment of the stock market. One requirement is that they are widely traded among investors, or have a high degree of liquidity. Investors routinely use major indexes to gauge how well their portfolios are doing, in a process called benchmarking. Major stock indexes in the U.S. include the S&P 500, NASDAQ Composite, Dow Jones Industrial Average, and Russell 2000 indexes. The S&P 500 is the most widely used benchmark index for investors.
There are different approaches to picking stocks. Three major approaches include:
Fundamental analysis. Traders who use fundamental analysis believe a company's future ability to increase revenues, profits and cash flow determines its share price. Fundamental analysis evaluates the basic economic and industry forces that shape a company's growth. It also analyzes the firm's financial statements. Within the fundamental analysis framework, some investors prefer a "top-down" approach that starts with an analysis of the economy. Others prefer a "bottom-up" approach that starts with an analysis of the company's financial statements.
Technical analysis. Traders who focus on technical analysis believe a company's past share price and volume of shares traded determines the future direction of its share price. Technical analysis is a mathematical approach that is also used in the foreign exchange and futures markets to determine future prices.
Index investing. For investors who are happy to earn a rate of return that matches the overall market, index investing is the preferred approach. Index investing is a passive approach to investing. Since it mimics the composition of a major stock index, there is little trading of stocks. As a result of the little trading required, index investors incur less in fees than do active traders who use the fundamental or technical approach.
The share price of a company often rises sharply if it is the target of an acquisition or merger from a stronger suitor. Generally, acquisition announcements boost the share price of the company to be acquired. The share price of the acquiring company generally drops on the news, as investors react to an anticipated drag on future profits.
For example, on May 1, 2001, Pulte Homes Corp. and Del Webb Corp. announced an $800 million merger, with Pulte Homes agreeing to pay a little less than one of its shares for each share of the developer of active-retirement communities. In trading on the New York Stock Exchange that day, Pulte's shares fell 9%, while shares of Del Webb rose more than 13%.
Companies sell their shares to outside investors for the first time in an initial public offering. An IPO is a chance for a company to raise substantial cash to grow faster. It is also a chance for business owners to earn a return on their investment, after a mandatory lock-up period expires. However, IPOs are famous for burning investors, especially individuals. They often generate an initial buzz of excitement when shares first begin trading. However, after an initial "pop" in share price, companies that complete an IPO are soon judged by their abilities to generate revenue, profits, and cash flow.
To buy shares, you need to have a brokerage account. This requires opening an account with a brokerage firm that is licensed to buy and sell stocks. You can use a full-service brokerage or a discount brokerage. Full-service brokers provide more service than discount brokers. Discount brokers tend to focus on the bare-bones features of trading, and thereby charge low brokerage commissions.
Some full-service brokerages also offer a discount-brokerage service. Some Internet-based brokerages focus exclusively on the discount market. The Securities and Exchange Commission (SEC) regulates all securities trading and registration in the U.S., including the supervision of brokerage firms. The SEC fines those firms that break the rules and identifies the improprieties that result in the fine.