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Have you ever really thought about how it works? Everybody knows a little about the stock market, but not everyone understands how the stock market works. Many investors see the stock market as a way to get rich quickly, but if they don’t understand their investment or how stock works, they could be in trouble. Before investing, it’s a good idea to get a handle on some of the primary risks and benefits of owning stocks.
Stock is a security in the form of shares representing partial ownership in a company. Stockholders are also called shareholders, and shareholders who buy stock buy an interest in the company. Shareholders then hold a claim on the part of the company’s earnings and assets, and collectively, shareholders own that company. Each shareholder’s ownership depends on the percentage of shares purchased, or the number of shares held by a given individual divided by the total number of shares sold by the company.
A company can raise money in two ways: by borrowing money, referred to as debt financing, or by selling a portion of the company through stock, known as equity financing. Shareholders who purchase the stock have the potential to make money in two ways: through dividends and/or through capital appreciation.
Dividends are taxable payments paid to shareholders through the company’s earnings. Dividends are based on the company’s performance and are not guaranteed. When a company is profitable, it may decide to pay dividends to shareholders or reinvest profits back into the company. Shareholders can also earn money through capital appreciation. Capital appreciation increases the market price for a stock or the difference between the amount paid initially and the stock’s current value when resold.
The value of stocks is based on a company’s performance on the stock exchange. Shareholders can trade their stocks on the stock exchange, and when sold, the shares can be worth more or less than their original cost. Shareholders have the potential to make money from dividends and/or from capital appreciation, but they can also lose money if the company performs poorly.
There are two kinds of stocks: common stock and preferred stock. Both represent a share of ownership in a company, but each type is slightly different. Shareholders of common stock typically have voting rights on major company decisions, such as electing the company’s board of directors, with one vote for each share of common stock owned. Shareholders of preferred stock do not have voting rights. However, if a company pays dividends, preferred stockholders receive their dividends before common stockholders, who may or may not receive dividends depending on the board of directors’ decision. Investors who plan to make more substantial sums of money in capital appreciation often choose common stock, while investors seeking steady dividends often choose preferred stock.
Stockholders can make money from dividends as well as from capital appreciation if the stocks increase in value. Stockholders also have the potential to lose money if the company does poorly and stocks decrease in value. The value of the shares fluctuates with changes in market conditions. Investing in stocks involves risk, and a general rule of thumb is that the higher the risk, the greater the potential reward. However, a risk is always involved, and investors should be sure they know the risks and the potential benefits before deciding to invest in stocks.
Speaking of risk, make sure you know your exposure to risk and how it might affect your overall investments. As an example, if you are 30 years old, you have more time to recover from an up or down market swing than, say, someone in their 60s. As we age, the reduction of risk becomes more and more critical; we begin to move from accumulation to preservation. Being too cautious can also be dangerous if your asset allocation does not match inflation.
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