As a financial professional, you already know why investing is important. But occasionally you meet a client who doesn't understand even the most basic concepts and tools of successful investing. What do you say? The following is an easy to follow explanation to help you explain to clients why they should invest.
What Is a Stock?
Without a doubt, common stocks are one of the greatest tools ever invented for building wealth. Stocks are a part, if not the cornerstone, of all but the most conservative investment portfolios. When you start on your road to financial freedom, you need to have a solid understanding of stocks and how they trade in the market.
A stock represents a single share of ownership in a company. Stock represents a claim on the company's assets and earnings. As you acquire more shares of stock, your ownership stake in the company becomes greater. Whether you say "shares," "equity," or "stock," it all means the same thing. Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim (albeit usually very small) to everything the company owns.
As an owner, you are entitled to your share of the company's earnings (usually paid in the form of dividends) as well as any voting rights attached to the stock. Another extremely important feature of stock is its limited liability, which means that, as an owner of a stock, you are not personally liable if the company is not able to pay its debts.
Companies issue stock because they need to raise money. To do this, they can either borrow it or raise it by selling part of the company, which is known as "issuing stock." A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. On the other hand, issuing stock is called equity financing.
Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the initial public offering(IPO).
It must be emphasized that there are no guarantees when it comes to individual stocks. Some companies pay out dividends, but many others do not. And there is no obligation to pay out dividends even for those firms that have traditionally given them. Without dividends, an investor can make money on a stock only through its appreciation in the open market. On the downside, any stock may go bankrupt, in which case your investment is worth nothing.
Although risk might sound all negative, there is also a bright side. Taking on greater risk usually results in receiving a greater return on your investment. This is the reason why stocks have historically outperformed other investments such as bonds or savings accounts. Over the long term, an investment in stocks has historically had an average annual return of around 8 to 12%.
Types of Stock
There are two main types of stocks: common stock and preferred stock. Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, the majority of stock is issued is in this form. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management.
Preferred stock represents some degree of ownership in a company but usually doesn't come with the same voting rights. Unlike common stock, investors are usually guaranteed a higher fixed dividend that is paid indefinitely. Common stock has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at any time for any reason (usually for a premium).
Most stocks are traded on exchanges where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor, while others are virtual, composed of a network of computers where trades are made electronically. There are several important factors that affect price movement in stocks:
- At the most fundamental level, supply and demand in the market determines stock price.
- Theoretically, earnings are what affect investors' valuation of a company, but there are other indicators that can also indicate stock prices, such as investor sentiment and expectations.
- There are many theories that try to explain the way stock prices move the way they do, but there is no one theory that can explain everything.
Advantages and Disadvantages of Stocks
The primary reason that people invest in stocks is because stocks have outperformed all other asset classes over time. Common stock has historically grown at a rate of 8 to 12% over the decades and many stocks also pay dividends on a regular basis, thus providing investors with additional current income. Of course, stocks also move in two directions, and there have several major corrections and bear markets over the past hundred years that have resulted in severe losses for investors at times.
Taxation of Stocks
Investors who sell stocks must report the gain or loss on their tax return (unless the stock was sold in an IRA or qualified retirement plan). If the investor held the stock for a year to the day or less, then a short-term gain or loss will be reported. If the stock was held for a longer period, then the gain or loss is considered to be long-term. Long-term gains are usually taxed at a lower rate than short-term gains, which are taxed as ordinary income to the investor.
Total capital gains or losses are computed by first netting all short-term gains and losses against each other, then doing the same with long-term gains and losses. The final number from each category is then netted against the other to get a final net long or short-term gain or loss. Dividends are also classified as ordinary income if they are paid out in a taxable account.