What are stocks? Seems like such a simple question to answer, doesn’t it? Obviously, stocks are these things that you can buy, sell, or hold. And they come in shares. And they let you own a piece of the company that issues them, even if just a tiny piece.
But there’s a good deal more to the story, whether we’re talking about individual stocks or stock funds. And as you learn more, hopefully you’ll also begin to feel more comfortable with your investment decisions – and be able to speak more knowingly with your broker or financial advisor!
How a stock is born
When a company at any stage decides it needs additional funding for operations (employees, materials, planning, marketing, research, etc.) they look for more financing. One option might be to take out a loan or issue bonds or other debt instruments (don’t worry about this now). But that will only add to the amount they owe the outside world — and add monthly debt payments that can eat up cash flow.
To avoid extra monthly debt payments, they can instead decide to bring in “equity partners”, meaning people who will take on an ownership (equity) share of their business. On the TV show Shark Tank, we see wealthy investors who choose whether or not to give their own money to the company in exchange for a piece of the business.
That’s one way to bring in equity partners: find private investors. But the company can also decide to issue public shares of stock. This way anyone (including you and me) can choose to buy in for a piece of the company’s growth and (hopefully) its profits.
And so, in compliance with state and federal laws, in simplest terms, they figure out how many shares, stock types, appropriate stock exchange, and offering price, and then they go live with their IPO (initial public offering). Much more to this, of course, but hopefully you get the basic picture.
How do you find the stock to buy?
Since we’re just talking about the basics here, let’s look at what you generally might do when you get the urge to buy a stock:
If you already know the name of the stock – Even if you’ve already decided on the stock you want, it’s smart to do some research first before giving the go-ahead to buy. I like Morningstar.com and TheStreet.com (I usually look at both), but there are a lot of other good sites to check.
Look at the current price, earnings per share, short- and long-term trading ranges, yield, and any ratings / cautions. Also do some Google snooping for recent news or other mentions, so you go forward with eyes wide open. (Not that it guarantees anything.)
If you don’t know the stock you want yet – There’s no absolute for-sure way to find the stock you want. And of course, it depends on whether you are making a long-term investment or instead trying your hand at trading for short-term gains (and losses).
In some cases, people start watching financial TV shows (like CNBC) or reading financial newspapers & magazines (Forbes, Wall Street Journal, Barron’s, Financial Times) and also the business section of regular newspapers for ideas. Even other non-business specific sections like entertainment, real estate, science, technology, etc. can give you a glimpse of what companies are up to that you might want to invest in.
Some observe the world around them, and buy based on that. Someone I know who’s a broker decided she saw Nike products on more everyday people than she saw Under Armour (a competitor). Then again, others might see Under Armour ads, cool products, and press and say “That’s for me!” despite recent problems. Although in the case of each of these, do your research. They are just examples — NOT recommendations.
What are the ways to make money from stocks?
Well, you don’t always make money. But since that’s the goal, the basic ways to make money are:
- Buy and sell – Buy stocks at a low price and sell them at a higher price, whether the sale happens in the near future or years from now.
- Dividends – Receive dividend payments either directly to you as they are paid out or have them reinvested automatically to help grow the total shares you own. Not all stocks have dividends, and some are higher than others. A portion of my stock portfolio is made up of “high-yield”dividend stocks, meaning the real money value of those stocks is more than just the price increase (or decrease).
- Options (puts and calls) and shorting – I’ll go into this more at another time. Just mentioning it for now. Since these are also a great way to lose tons of money, definitely not for the basic investor.
Isn’t buying stocks essentially gambling?
Yes. Seriously. There are no guarantees your stock will make you money, and also no guarantee even a well-known company won’t go to zero. (Anyone remember Enron?)
But since participating in the market is also one of the best ways not to lose out to inflation, arming yourself with sound knowledge and research — in addition to making sure you do not put all your financial eggs in one or two stocks — is an essential ally for any investor.
What are stock funds?
They are a group of stocks that are selected by the fund for various reasons, i.e. big companies, small companies, solid traditional companies, growth companies, international companies, high-yield companies, market-indicator companies (like index funds that follow an Index like Standard & Poor’s), emerging trends, etc.
You should research them as carefully as you do stocks, with an eye toward a fund philosophy you feel comfortable with. Most stock funds have enough stocks in them to provide the portfolio theory safety of not putting all those eggs in one basket. But if they are specialized in an area that gets hit by bad news, than having a few different funds (not all risky like emerging trends or high growth) may offer you some comforting balance.
One of my favorite funds is a “socially responsible fund.” But since I don’t give specific investment advice, I just want to let you know these exist also. They apply different types of “responsible” criteria, so look for one that fits you best. You can easily find some names by googling the term.
How long should you hold your stock?
This depends on you. Most folks reading this blog are not in it for the fast trade / quick money. So probably wise not to jump in and out when you see markets shifting up or down. You not only lose money in commissions, but hard for non-pros to get back in fast enough to make it profitable.
Then again, if you know / suspect that a company is headed for perpetual doldrums or just feel you are done with that stock or fund for whatever reason, you might want to shift to something with more future potential. If you have a broker / advisor you trust, this is the time to speak to her or him.
Oh … I also should mention that there are tax implications for how long you hold stocks. A stock held more than a year, if profitable, can be taxed at the usually preferential (but not always if income is low enough) capital gains rate. For stocks held short-term (one year or less), profits are taxed at your regular (bracket) tax rate.
What if you sell your stock at a “loss”?
Although of course the idea is not to lose, you may decide to sell your stock at a loss for any number of reasons. If so, there are accounting rules for applying short-term vs long-term losses.
But without getting you (or me) stuck in the tax reporting weeds, basically stock losses are deductible up to $3,000 per year, as long as you also have income for that year to apply against it.
A few more thoughts
Clearly, I can’t give you every single thing you might need to know about stocks on one handy-dandy page. Well, I guess I could, but then I’d never be done — and you wouldn’t be reading this yet. 🙂
The main thing is never to assume anything. No “sure-thing” stock will make you rich, and stocks with some problems are not always a bad investment. Your best course of action is to do your research, trust your gut, and don’t be afraid to clean house now and then.