25 Investments: Common Stock

Common stocks (or equity) represent ownership claims in publicly traded corporations.  The ownership stake if a single share is incredibly small, especially for large companies such as Proctor & Gamble or General Electric, but common stock investors can claim ownership and call themselves shareholders.  With ownership includes the ability to vote on company matters, such as approving members of the board of directors, choosing the annual auditor, or other items that come up in annual meetings.

Shareholders are also entitled to receive dividend payments, which are at the discretion of the board of directors.  Unlike the income investors receive in bonds, which are obligations, dividend payments can be stopped without any liability on the part of the company.  Of course, the share price can fall, but shareholders have no recourse.  (To learn more about stocks, see our Stock Basics Tutorial.)

Objectives and Risks

Equities are among the most liquid financial assets.  They can be bought and sold within three days (the trading day, plus an additional two days to settle).  They also have among the highest long-term returns.  On average, stocks have returned 10% annually over the past century.  Stocks also offer reasonable inflation protection –companies can pass along price increases to customers to offset higher wage and related inflationary pressures.

Of course, risk comes with these high solid relative returns above “safer” asset classes.  Stocks can experience daily, monthly, and even annual volatility (as measured by ups and downs compared to a benchmark equity return, such as the S&P 500).  For this reason a long-term investment horizon is needed, and generally runs a full market cycle of three to five years.  This helps ride out economic ups and downs (the business cycle) and fluctuations in investor sentiment in regard to stocks.

How to Buy or Sell It

Stocks are extremely liquid and easy to buy and sell.  Online brokers charge as low as $4.95 per trade to buy and sell stocks.  Capital gains rates are quite reasonable for stocks held more than a year.  Short-term capital gains are taxed at personal income tax rates in the United States.  Of course, taxes are deferred in qualified accounts, such as individual retirement accounts (IRAs) or company 401(k)/related retirement plans.

Strengths

Common stock is very convenient to buy and sell.

Investors are owners in the underlying corporation.

Common equities are also very liquid.

There are literally thousands of stocks to trade in the United States, and even more in foreign markets.

Weaknesses

Stocks can exhibit significant short-term trading volatility.

Short-term capital gains rates can be high

Stocks are subject to supply and demand and emotions that can put them heavily out of favor over short periods of time.

Key Considerations

Liquidity:  High

Historical Returns:  High

Inflation Protection:  Medium