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STOCKS: AN INTRODUCTION
What are stocks?
Stock equals ownership
Investors who purchase stock are known as the company's stockholders or shareholders. The price of shares reflects the public's level of interest in owning the shares. If a lot of investors want to buy shares, they bid against one another, driving up the market price of the stock. If interest is low, competing bids are few and far between, and the price of shares is likely to fall.
You may hold the stock in the form of a stock certificate, which identifies you as the owner of the stock and the number of shares you own. Alternatively, shares may be held in an account with a brokerage firm.
Stock ownership can give you a share of profits and other perks
Beyond that, depending on the company and the types of shares you have, stock ownership may carry other benefits. Specifically, you may be entitled to dividend payments (which you can generally receive either in cash or additional shares), capital gains payouts, voting rights and other corporate privileges. For example, common stockholders have the right to vote for candidates for the board of directors and on other important issues.
Stock is a means of raising money for a company
Why invest in stocks?
Many investors never venture beyond the world of cash equivalents--bank accounts, CDs, money market accounts and Treasury bills. They take comfort in knowing that these investment vehicles provide maximum safety coupled with liquidity that allows them to access their money easily if they need it. However, while these investments are relatively low risk, they generally yield minimal returns; some may not even keep pace with inflation. At some point, most investors want the potential for greater returns, which is where stocks enter the picture.
A variety of factors motivate people to invest in stocks. Many view equity investments as an opportunity to accumulate wealth or to prevent inflation from eventually reducing the purchasing power of their money. They generally take a long-term view, hoping their stocks will appreciate in value over time. They may also be interested in the dividends that some stocks pay, which shareholders may accept in cash or (in some cases) reinvest in additional shares of the company. Dividends and any increases or drops in the stock's price combine to produce the stock's total return. Investors with a gambler mentality may be attracted by the thrill of playing the market. They may trade actively, sometimes buying and selling the same issue within a few days or a few hours. These day traders try to take advantage of small, intra-day price movements in volatile stocks or indexes.
How do you make money with stocks?
Investors who purchase stock hope to make money in one of two ways--through dividend payments and/or capital gains.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act) and the Tax Increase Prevention and Reconciliation Act of 2005 provide that qualifying dividends received by an individual shareholder from domestic corporations (and qualified foreign corporations) are taxed at lower long-term capital gains tax rates, making dividends more attractive to many investors. This tax treatment is temporary, however, applying to tax years 2003 through 2010 only. In 2011, absent further legislative action, dividends will once again be taxed at the higher ordinary income tax rates under the pre-2003 Tax Act rules.
Not all stock dividends qualify for capital gains tax treatment. Dividends that are ineligible will be taxed at ordinary income tax rates. These include
Further, dividends paid on hybrid preferred stock (i.e., stock that is reported as debt) are also ineligible for capital gains tax treatment.
Capital gains from sale of stock
Capital gains from selling stock result in taxable income; however, such gains, if long term, will generally be taxed at a lower rate than ordinary income tax rates. Also, in any given year, any capital loss you sustain can be used at tax time to offset capital gains. Finally, if unused capital losses remain, they can be used to offset up to $3,000 ($1,500 if married filing separately) of ordinary income for that year or can be carried forward to future years.
Caution: Capital losses cannot be used to offset dividend income taxed at long-term capital gains rates.
What are some things you should consider before buying stock?
The decision to invest in stocks is a personal one that should depend on your individual situation. Before taking this step, and before selecting specific types of stocks to add to your portfolio, there are some issues you should take into account.
Your temperament for risk
Because of the potential reward for long-term price appreciation, stocks generally have a higher level of risk compared to other investments. You can lose a portion of your investment in stocks--or even your entire investment. Among the factors that affect the level of risk you face with stocks are
Different kinds of stocks carry different degrees and types of risk and are therefore suited to different types of investors. For example, if you are fairly conservative and prefer minimal risk, you might think about stable, relatively safe blue-chip stocks. If you are very aggressive, however, you may want to consider riskier investments like aggressive growth and microcap stocks.
Although an investor can screen for potential risks before making an investment, it is virtually impossible to plan for every conceivable contingency that could affect a business. For this reason, stock investors must be prepared for some degree of risk.
Your desired return
Your financial and personal circumstances
Your holding period
What you want your investments to do?
Your own research and beliefs
Where do you buy stock?
As you probably know, hundreds of millions of shares of stock trade daily on the stock market. The stock market is a general term referring to the organized trading of stocks and other securities through various exchanges, including the over-the-counter market. Stocks are generally bought through intermediaries, known as securities brokers and dealers. Investors can also purchase a group of stocks indirectly by owning shares of a mutual fund or an exchange-traded fund (ETF).
In most cases, when you buy or sell stock, you go through a broker rather than deal directly with the issuer of the stock. This is true for most transactions, including initial public offerings (IPOs) and secondary offerings. In exchange for brokerage services, you ordinarily have to pay your broker (including discount brokers) a commission based on the dollar value of a particular transaction or the number of shares purchased. Many brokerage firms also offer so-called wrap fee programs, which are all-inclusive accounts whose fee structure includes commissions and investment advisory services.
Initial public offerings
There are several ways that investors can evaluate the financial health of a company, as well as its prospects for the future. These methods may include an examination of factors specific to the individual company, or they may pertain to the industry as a whole.
Types of stocks
The stock market is enormous; there are many different types of stocks from which you can choose. This should come as no surprise, given the number of companies worldwide that sell stock to the public. The types of stocks that you ultimately pick should depend on your individual circumstances. In narrowing the field to appropriate stocks for your portfolio, your financial professional can be immensely helpful.
Very broadly speaking, stocks can be divided into two general categories--common stock and preferred stock. In many cases, a single company will make both kinds of stock available to investors. Each has its own particular strengths and weaknesses. Stocks can be further broken down into voting stock and nonvoting stock.
Beyond that, there are stocks for investors of all types. For the more conservative investor who wants to keep risk to a minimum, there are blue chip stocks and conservative, income-oriented stocks. For the very aggressive investor who sits at the other end of the spectrum and is more interested in the potential for greater returns, there are aggressive growth stocks, microcap stocks, and emerging market stocks, among others. If you fall somewhere in between these two extremes, you may find a fit with midcap stocks, value stocks and growth stocks. If you closely follow current economic conditions, cyclical stocks may be an appropriate option, just as international stocks may be a good match for an investor who stays attuned to foreign markets and is willing to accept the added risks of foreign investing.
Strategies for stocks
There are several strategies you can adopt to get the most out of your stock investments. These range from very basic strategies appropriate for a novice, to more complex strategies that a sophisticated investor might be inclined to use. Some of the most common strategies available to you include buy low/sell high, buy and hold, and dollar cost averaging.