Analyzing The Best Retirement Plans And Investment Options: Stocks
- What they are: Securities that represent ownership in the corporation that issued the stock. Stocks are also called equities.
- Pros: Capital appreciation; often outperform other investments; dividend payments; diversity; voting rights.
- Cons: Prices can fluctuate dramatically (volatility); potential to lose entire investment.
- How to invest: You can trade online using your broker’s online trading platform, or by calling your broker’s trade desk to place orders. You can also buy stocks through a dividend reinvestment plan (DRIP).
Stocks represent partial ownership in a corporation. When you purchase a share of stock, or shares or stock, you are essentially buying a piece of the company, albeit a little one. Most individual investors will never own enough stock in a single company to represent a significant ownership stake (to illustrate: Warren Buffett, who will own about 9 million Goldman Sachs (NYSE: GS) shares by October of 2013, will have a stake of about 2%).
Investors purchase stocks for a variety of reasons, including:
- Growth potential
- Liquidity (you can close a position if you need cash quickly)
- Dividend payments (that provide income or that can be reinvested to purchase additional shares)
- Stocks have consistently outperformed other investments
Companies issue stock to raise money for various purposes, such as paying off debt, launching new products, expanding into new markets and building new facilities. Common stock (what most people are referring to when they talk about stocks) gives shareholders the right to vote at shareholder meetings and to receive dividends. Preferred stockholders do not typically have any voting rights; however, they receive dividend payments before common stockholders and have priority over common stockholders (if its assets are liquidated due to bankruptcy).
While stocks can be traded actively (scalp traders, for example, get in and out of trades in a matter of seconds), a buy and hold strategy is popular for many investors. With a buy and hold strategy, investors seek gains over the long-term, riding out any fluctuations in the market.
If you own stock, you can make money when it appreciates in value and you sell it, and/or through dividend payments.
Types of Stocks
There are a number of ways that stocks can be categorized. One method is the size of the company - known as its market capitalization or, simply, market cap. A corporation’s market cap is the total dollar market value of all its outstanding shares, calculated by multiplying its shares outstanding by the current market price of one share. For example, if a company has 1 million shares outstanding, and the current market share price is $50, the company’s market cap would be $50 million (1,000,000 * $50 per share). While there is no universal "cut off" for different caps, the approximate categories are:
- Mega cap: $200 billion +
- Large cap: $10 billion to $200 billion
- Mid cap: $2 billion to $10 billion
- Small cap: $300 million to $2 billion
- Micro cap: $50 million to $300 million
- Nano cap: less than $50 million
Stocks can also be classified based on certain performance characteristics:
- Growth stocks - these stocks have earnings that grow at a faster rate than the market average. Investors typically seek capital appreciation since growth stocks rarely pay dividends.
- Income stocks - these stocks pay consistent dividends, providing an income for its investors.
- Value stocks - these stocks have a low price-to-earnings (PE) ratio. Investors purchase value stocks in the hopes that the stock’s price will rebound.
- Blue-chip stocks - these stocks are from large, well-known and well-established companies with solid growth histories. Blue-chips usually pay dividends.
Taxes on Stocks
There are two ways that you might owe taxes on your stock investment. One is if your stock pays a dividend. If so, they are generally taxed at a rate of up to 15% at the end of each year, even if you never received the cash dividend (e.g. the dividends were automatically reinvested through a DRIP). In addition, if you sell the stock you will have to pay a capital gains tax if you held the stock for more than one year (long-term capital gains), or the gains will be taxed as ordinary income if you held it for less than a year (short-term capital gains).
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