Types of Investments: Stocks
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Types of Investments: Stocks
A stock is an investment product that represents ownership in a company or corporation. When you purchase stock you receive shares of ownership from the company. In most cases these shares are held in some form of an investment account electronically on your behalf.
Things To Know
- By investing in a public company, stock owners have the opportunity to participate in the growth and prosperity of that company.
- Stocks are generally used to meet longer-term financial goals.
By investing in a public company, stock owners have the opportunity to participate in the growth and prosperity of that company. Companies issue/sell stock to create capital—or more simply stated, to raise money, to build new factories, develop new products, improve technology, etc. A company’s goal is to increase its profits by putting its shareholders’ money to work effectively.
Stock investors have the opportunity to grow their money in one of two ways generally. When an investor purchases a stock, he or she pays a specific dollar amount for each share based on the value of each share on the day of the purchase. When purchasing a stock, an investor believes the company will increase its profits in the future and in turn, the stock’s value will increase. The investor can then sell the stock at a profit. This profit is called a capital gain.
A second way a stock investor can make money is when corporations share some of their profits by paying a dividend to all shareholders. Dividends are generally paid by more mature companies that have relatively stable earnings and don’t have a need to reinvest all of their profits to expand their company. Dividends can be very powerful if reinvested over time in new shares of stock.
When you are considering buying a stock, it is important for you to understand the company well so you can make an informed decision. Think as if you were buying the entire company and ask questions about the company to help you make your decision. Here are some questions to help you get started:
- What are the company’s products and are they in demand?
- How is the company’s industry performing as a whole?
- How has the company performed in the past?
- Do they have a strong, experienced leadership team?
- Are operating costs low or too high?
- Is the company in heavy debt?
- What are the obstacles and challenges the company faces?
- Is the stock undervalued?
If you choose to purchase the stock you will need to continually ask these questions to ensure you still want to own it. Monitoring your investments is an important part of the investment process.
Stocks are generally used to meet longer-term financial goals. Most investors should be prepared to hold their stock investments for a minimum of 5 to 10 years. Stock prices change on a daily basis and are subject to many different types of risks that can affect their price. Therefore, investors must be willing to accept the ups and downs of a stock price over a period of time in an effort to see a company grow and have its stock price increase.
Over the long haul, stocks have outperformed every other type of investment (source: Ibbotson Associates). They have also kept ahead of inflation. This is because the returns on stocks are not fixed, as the returns of many other investments are. Stocks have unlimited earning capacity.
Stocks also have much greater risks than cash and bonds. Your investment in a stock has no guarantees, and you could lose principal. If you invested in a stock that performed poorly and ended up going out of business, you could lose the entire investment you made. We will discuss ways to invest wisely in stocks to help reduce this risk of loss and enhance the opportunity for quality returns.
Let’s take a look at the most common risks that impact stocks.
- Company risk: the risk that you will lose money simply because the company you chose to invest in performs poorly. This type of risk could include slumping sales, poor management, rising costs of material, or dramatic events such as a strike or a natural disaster such as a fire.
- Economic risk: the risk that an overall downturn in the economy will result in lower sales and profits (and consequently a lower stock price) for the corporations you invested in.
- Systemic risk: the risk that a breakdown of the American or global financial system will cause panic selling and major losses for investors, no matter what type of investments they hold.
- Market risk: the risk that you’ll have to sell stocks when the markets are down.
Stocks have had an average return of 11.29% over the last 30 years ending December 31, 2019 (source: Chart Source). Inflation has averaged 2.6% over the same period (source: Calculator.net).
Gains. If you sell a stock for more than the price you purchased it for, you will realize a capital gain. There are two types of gains for tax purposes.
- Short-term capital gains: If you sell a stock you have held for one year or less, any profit you make is considered a short-term capital gain. Short-term capital gains are taxed at the same rate as your ordinary income.
- Long-term capital gains: If you hold your stock for longer than one year and sell it for a profit, you will realize a long-term capital gain. You can benefit from a reduced tax rate on these types of gains. Currently, the long-term capital gains tax rates are 0, 15, and 20 percent for most taxpayers. If your ordinary tax rate is already less than 15 percent, you could qualify for the 0 percent long-term capital gains rate.
Dividends. Most qualified dividends are taxed the same as long-term capital gains.
Let’s look at all three of these types of investments at the same time to evaluate their historical risk-and-reward profile. As you can see in the chart below, the more risk you take the higher the returns have been historically. However, the range of returns for higher risk investments is much broader. You must be able to accept the negative returns in any one given year for the opportunity to potentially earn the higher return. This is why for most investors, stocks should not be considered short-term investments.
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