New investors are often confused about the vast array of investment options available today. A common question is “Where do I start?” If you’re investing for the long term, investing in stocks might be a good place for you to start. Stock ownership in the United States is relatively concentrated. The St. Louis Federal Reserve Bank says that only about half of all Americans have direct or indirect exposure to the stock market, and the wealthiest 10% of Americans hold 83% of the stock market wealth. Still, owning stocks has the potential to help you save for important goals, such as retirement. Here’s what you need to know about investing in this asset.
What is a stock?
A share of stock represents an ownership interest in a corporation. Most publicly traded companies issue common stock, though some companies also issue preferred stock. The latter have a “preferred” interest in the company’s assets if it is liquidated as well as first call on any dividends the company pays. However, most preferred stockholders don’t have rights to vote on matters that the company puts to a shareholder vote.
Stock in a public company is typically traded on a so-called secondary market, where you buy and sell stock to other investors. (The primary market is where new securities are issued for the first time, and you purchase stock directly from the company issuing it.) In the U.S., most stocks trade on the New York Stock Exchange or the NASDAQ.
To buy (and sell) shares of a public company, you need the help of a broker. A broker charges you a fee called a commission for making the transaction on your behalf. Brokers also help maintain an orderly market for shares, matching up purchases and sales.
Why do investors buy stocks?
As a holder of common stock, you have certain rights. You typically have the right to vote your shares at the company’s annual meeting. Shareholders might vote on members of the Board of Directors, on the accounting firm that will provide the company with auditing services or on certain employee benefit-related matters, particularly for top executives. Holders of common stock may also vote on corporate reorganizations and mergers.
Of course, the goal of many stock investors is to make money off their shares. A simple way to do that is to buy a stock that pays a dividend. Companies pay dividends to share their profits with their investors. Dividends are often paid four times a year (quarterly), and you’ll likely receive a check or a deposit to your brokerage account for your share of the dividends, based on the number of shares you own.
For example, if ABC Company pays a quarterly dividend of $1.00 a share and you own 100 shares, your dividend payment will be $100. Most dividends are fully taxable, but some are eligible for special tax treatment. Each year at tax time, companies that paid you dividends will send you a form telling you how much they paid you in the prior year and how much of those dividends are eligible for special treatment.
The second way to make money from stock is to sell it for more than you paid for it. If Earl buys 200 shares of ABC Company stock for $2,000 and later sells the stock for $3,000, he has earned a $1,000 profit — known as a capital gain.
How much tax you pay on your capital gains will depend on how long you owned the stock you sold. If you held the stock for one year or less, the gain is short-term and taxable at your normal income tax rate. If you held the stock for more than one year, the gain is long-term and might be taxed at a lower rate.
What are the risks of owning stock?
As with any investment, there are risks to investing in the stock market. Stock prices are subject to a variety of influences both within the industry the company operates in and in the overall economy. Other things that may cause a specific company’s stock to decline in value include changes in the company’s leadership, product flaws, labor issues or any other event that may hurt the business’s bottom line.
If a stock’s price declines, you have the choice of selling the stock at a loss or hanging on to your investment until the price improves. If a company goes bankrupt, that typically leads to a plan to get out of bankruptcy or a merger with a stronger company. Only rarely does a company decide to liquidate its assets and pay off shareholders.
Because there are risks to owning stock, it’s important to put together a diversified portfolio to spread out the risk.
Are stocks right for you?
Buying stock in a particular company isn’t the only way to invest in the stock market. Investors can also buy a stock mutual fund that invests in a portfolio of several stocks. Funds may invest in stocks from a particular industry (for example, financial service companies such as banks, insurance companies and brokerage firms), or in companies of a particular size (for example, stocks of smaller companies, popularly known as “small caps”).
Mutual funds share the dividends those stocks pay with shareholders, as well as any capital gains they earn on stocks they sell. A prime advantage of a mutual fund is its diversity. Because the fund owns multiple stocks, this helps to minimize the risk of owning a single stock by spreading that risk across several different assets.
How do you know if investing in stocks or stock mutual funds is a good idea for you? Part of that decision may be based on your age. Experts frequently recommend that younger investors put the majority of their portfolio into stocks. Why? At 25 or 30, most investors are saving for long-term goals like retirement, which could be as long as 40 years away. Stocks are considered a good way to build wealth over time by way of dividends and capital gains. With interest rates still near historic lows, the returns from stocks have the potential to be significantly higher than if you invested in things like certificates of deposit or money market funds.
Once you have decided that you want to invest in the stock market, what’s next? Most investors will want to contact a broker or investment adviser. Not only can he or she help you make the transaction, but they can also talk to you about your long-term goals and recommend stocks or stock mutual funds that will help you meet those goals.