The glamourizing of Wall Street and stock investing is a favorite Hollywood topic. Dozens of films have successfully promoted fast living and fast money from the stock market. The truth is that stock market investing can be as risky or conservative as you need it to be. There are large foundational companies represented, as well as up and coming ‘hot shots’ that see a rapid growth in stock price making some investors millionaires.
How will the stock market work for you? Here are ten fundamental things you should know about buying stocks before you begin investing.
What are you buying when you purchase a stock? Stock certificates give you partial ownership in the company. Large companies issue millions of stock certificates, meaning you own a very small percentage of the company. As a shareholder, you have voting rights and can attend annual shareholder meetings. You also have the right to quarterly financial information on the company’s performance, management, and future direction.
IPO’s versus stock trades. When a company first goes public, they extend an IPO or Initial Public Offering. The company receives the capital and spread ownership among a range of investors. Trading after the IPO is between individual or institutional buyers and sellers. Gains or losses from these sales go directly to the buyer or seller, not the company.
Types of stocks. The two primary classes of stocks are common and preferred. Common stocks are what most individuals purchase, carry the highest risk, but have the highest potential upside. Preferred stocks act more like bonds and pay a set dividend each quarter, giving investors a more consistent rate of return.
Market volatility is the industry term for fluctuating stock prices. The stock market moves up and down throughout the day based on the overall performance of individual stocks. When the market is positive, it is said to be a ‘bull’ market, and when the overall market is on a downward trend, it is said to be in a ‘bear’ market.
Markets can react very rashly to industry factors and current events. When gains are less than predicted, the stock price could drop, even though the company is still profitable. A change in management could impact the stock price as well as the retirement of a key company figure. A news report of unrest in a strategic country could send the entire market up or down. Government unrest, an election result, and civil disobedience all impact market trends.
Overall the stock market has trended upward for many decades, while individual stocks perform based on quarterly numbers, the popularity of the company’s products and services, and company management.
Beating the market is not the goal. Life is unpredictable, making it nearly impossible to predict future stock market pricing. Even fund managers with access to detailed company information cannot predict and beat the market consistently. The goal is to build a well-balanced portfolio with your feet in many industries and a variety of companies to decrease fluctuations and maximize gains. It takes a lot of time, money, and research to do this one stock at a time.
Average investors tend to buy high and sell low when it is the opposite that will make the most money. When you see a stock rising, you want to get in on the action. So you watch it for a while before jumping in. The result is buying the stock at a higher price than those who jumped in earlier. When the market adjusts, as it always does, the stock reduces in value. Individuals tend to panic and sell the position because of the fear of mounting losses.
How do stocks make money? Gains in the stock market come from either Capital gains and/or dividends. Capital gains are the rise in stock price that occurs as the company grows and profits increase. Dividends are typically paid quarterly and give back to investors as the company realizes profits. Investors do not make or lose money with market fluctuations. Market declines are called ‘paper gains’ or ‘losses’ because they are not realized until the sale of the stock. Dividend paying stocks are more conservative than stocks that only rely on capital gains.
Value stocks versus growth stocks. Value stocks are more likely to pay dividends and focus on the steady growth of the company in a mature industry. The stock price is more reliable and has less volatility. Growth stocks are innovative companies that tend to succeed big and fail big. They are the ones coming out with new technology, new medicines, and new ideas that change the way we live and work. These companies are riskier because for every one that succeeds there are 10 (or 100) that fail before one succeeds. As a result, they have higher volatility and the stock price can move rapidly based on market conditions.
Stock Sales and Taxes. Gains in stocks are either in the form of dividends or capital gains. Capital gains can be either short term or long term gains. When dividends are paid out, they come to you they are taxed as ordinary income (at the same rate as W-2 or 1099 income). Stocks held for more than 12 months are long-term capital gains and taxed at the lower, capital gains rate. Stocks sold in less than 12 months from the purchase date will pay gains as ordinary income. Deductions are allowed for a stock sale in a brokerage account that results in a loss, to the extent the losses reduce gains. Sales within a tax preferred account, such as a retirement account, will be taxed based on the tax treatment of the account.
Long term perspective should be the goal for all stock investments. Consider where the company is today and their anticipated direction over the next decade. Research the company extensively and stay on top of company and industry news as long as you own the stock. Holding an individual stock is riskier than a mutual fund, which combines many stocks in different industries to level out volatility.
Know your goals and risk comfort levels. All stocks require risk. Even major companies have seen major changes in their industry. Those who do not stay on top of industry movement lose ground in market share and stock price. For example; AT&T, which was once the leading provider in the telephone industry had to reinvent itself when cell phones overtook land lines in popularity. Market changes and conditions will impact how a stock performs and create different winners and losers each year as the market cycles. Lining up your investment strategy to meet your long-term goals and risk comfort, will help balance out the ebbs and flows that come with market investing.