Stocks: The Basics

What are Stocks?

Also known as shares or equity, a stock is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings. Today, millions of people in the U.S. own stock in publicly traded companies or in equity mutual funds that invest in stocks.

The value of a stock depends on whether its shareholders want to hold it or sell it, and on how much other investors are willing to pay for it. For example, if a company is doing well or investors have confidence in the company’s future, the stock’s value may go up. Not all stocks are fairly valued. Some stocks sell for less than analysts think they are worth and therefore are undervalued, while others are overvalued.

Benefits of Investing in Stocks

Investors see a capital gain as the stocks in which they invest rise in its value. Investors can also profit by receiving dividends, which is the portion of a corporation’s earnings that is paid to stockholders.

There is wide variation in the performance of common stocks. However, the long-term value of stock market investments tends to grow with the economy. Through 1994, stock prices, as measured by the S&P 500 (an index based on the stock of 500 large companies), rose in 16 of the previous 20 years. The annual performance ranged from a 32% rise in 1975 to a 30% decline the year before. Also, holders of common stock can receive dividends, which averaged more than 4% annually based on their investments’ market value. Over this 20-year period, the stock market’s compound annual total return, including both price increases and dividends, was about 15%. In comparison, consumer prices advanced at about a 5% compound annual rate during the same period.

The Risk of Investing in Stocks

Investment products are ruled by the risk reward tradeoff. Banks can get away with offering a low interest rate to savings account holders, since the money is guaranteed to be safe. Stock investing, on the other hand, can potentially deliver much higher returns because they are a riskier investment. Shares in a company can depreciate and lose value if the company is poorly managed, underperforms, or the stock simply draws no interest from investors. Some stocks are riskier than others. Here’s a stock tip, check the beta value (a measurement of risk) of each stock before making a decision.

Purchasing Stocks

A typical Investor would usually buy stocks through a traditional or online brokerage firm. Also known as broker/dealers, these are investment firms that are licensed to buy and sell securities by the Securities and Exchange Commission (SEC). Investors may also buy stock directly from the company that issues it through a dividend reinvestment plan (DRIP).