What comes to your mind when you hear a conversation about investing in stocks?
Do you think about gambling, or Wall Street, or stock brokers, or the most recent financial crisis? Perhaps you’ve heard the media use all of these terms interchangeably, creating more confusion about stock ownership.
Instead of relying on loosely defined financial jargon, this article will explain what stocks represent, and why you might be interested in owning them.
What are Stocks?
Stocks represent ownership interest in a company. When you purchase the stock of a particular company, you become a “shareholder” in that business. Stocks are often called equities because the shareholders legally own the net assets of a company, which is also known as equity.
Companies issue stock to raise investment capital that is needed to grow the business or create new projects. If a company decides to raise capital through a public stock offering, the stock shares can then be bought and sold by investors on the stock exchange where the company is listed.
There are two main types of stock, called common stock and preferred stock.
The majority of publicly issued (and traded) stock is common stock, which is what most people think about when discussing “stocks.”
The remainder of this article will focus on common stock, but feel free to also visit my guide to preferred stock if you are interested.
Why Do Investors Choose Stocks?
Stock ownership provides several benefits that attract investors.
1) Share in the company’s profits
When you purchase the stock of a publicly traded company, you are entitled to a portion of the company’s financial gains.
Company profits are the foundation of any stock’s value, and profits depend on earnings. For this reason, stocks are often valued in relation to earnings. For example, a stock’s price will often fall if a company misses their estimated quarterly earnings. Similarly, the stock price will increase following positive earnings news.
As a shareholder, you can share in a company’s profits in the following ways:
Dividends – A dividend is a payment to shareholders as a distribution of profits. Dividends are typically paid to shareholders quarterly (four times per year), but companies may issue special dividends at any time. Not every company issues dividends and a company may increase, decrease, or eliminate future dividend payments, depending on the performance of the business. The most common type of dividend is a cash payment to shareholders, although firms can issue dividends in the form of more stock.
Capital Appreciation – Instead of paying dividends, a company might decide to retain earnings. It can reinvest the earnings into future growth by creating more products, hiring more employees, increasing advertising, or any number of capital expenditures that are expected to increase earnings over time. By creating additional earnings, the company becomes more valuable, which increases the stock price per share. When the value of your stock increases over time, you can sell the shares to another investor and realize a profit (known as a capital gain).
You may be wondering if dividends are a magical source of free money. The answer is no.
Dividends + Capital Appreciation = Your Total Return.
Dividends are one way a company can distribute earnings. But after paying a dividend, the value of a stock actually declines to reflect the reduction in earnings. If a stock is trading at $50 per share, and the company declares a $5 dividend, the price per share falls to roughly $45 after the dividend payment is made. If instead, the company decided to retain the $5 in earnings per share, the value of the stock would remain $50.
Remember to focus on the total return of your investment. You can always sell shares to generate income if that is what you desire.
2) The right to vote in shareholder meetings
As a shareholder, you are entitled to receive (quarterly/annual) reports which discuss the financial health of the company.
Corporations are usually required by law to hold annual shareholder meetings, during which the shareholders elect the corporation’s board of directors. If you are a shareholder, you can attend the annual meeting and vote. If you cannot attend the annual shareholder’s meeting, you can request an absentee ballot to voice your opinion.
Shareholders control the direction of a company by appointing the board of directors. The board of directors is responsible for increasing the value of the corporation while protecting shareholder interest, and does so by appointing professional managers and officers in the corporation, such as the Chief Executive Officer (CEO). Managers are responsible for running the company on a daily basis, improving productivity, and ultimately increasing revenue, which increases the value of outstanding shares (stock).
This distribution of power is known as corporate governance. For the most part, corporate governance is highly effective in protecting shareholder interest. The biggest problem is that shareholders need to own a large percentage a company’s stock to influence important votes or decisions. Most investors do not have adequate ownership interest because many large firms issue millions or billions of outstanding stock shares.
As a result, few individuals attend shareholder meetings on a regular basis.
Are Stocks Risky?
There are significant risks associated with stock ownership. These include:
1) Price Fluctuations:
Above, I described the importance of capital appreciation in stock ownership. But stocks don’t always increase in value. Take a look at this chart showing U.S. stock market performance over a recent 15-year period:
Performance represented by Vanguard U.S. Total Stock Market Index (VTI)
As you can see, the overall trend is positive, and stocks have provided an average return of approximately 10% each year over the last century.
However, there are times when the stock market delivers extreme losses. In these years, the economic environment takes a downward turn and companies experience a significant reduction in earnings. In reaction, many investors get scared and sell their shares of stock. When most stock market participants are trying to sell, and very few are trying to buy, a company’s stock price will continue declining until sentiment reverses and investors return to purchasing.
If a stock falls in value after you purchase it, you can continue holding the stock and hope the stock price will rebound (which is usually the case unless the firm is going bankrupt). Or, you can sell your shares and realize a capital loss.
2) Residual Claim in Bankruptcy:
If a publicly traded company goes bankrupt, the company’s assets are usually liquidated and sold. The common shareholders are the last in line to share in the proceeds and will receive nothing until the other claimants have been paid (including the tax authorities, employees, suppliers, bondholders, and preferred shareholders).
Thus, if you are a common stockholder, you have what is called a residual claim (which may be nothing). You could lose your entire initial investment in the event of bankruptcy. However, you cannot lose anything more than your initial investment because shareholders have limited liability under the law.
Should You Invest in Stocks?
Over the last 100 years, stocks have provided exceptional growth. There have been years with large gains and years with large losses, but the overall trend has remained positive and many investors have built substantial wealth by staying invested in the stock market.
It’s not a good idea to invest all of your money in the stock of one company because your entire investment portfolio would be tied to the earnings of that particular company. If the company experiences problems, the value of your stock will most likely fall, and you could lose your entire investment if the company goes bankrupt.
To mitigate that risk, you can invest in thousands of different stocks through a diversified fund or robo-advisor. In doing so, you can own the entire U.S. stock market and foreign markets at a very low cost. To determine how much to invest in stocks, you should first consider your financial goals. Stocks are best held for many years, making them an investment most suitable for your long-term goals.
Is there anything else you would like to know about stocks? Please share with a comment below.