Understanding Stocks

Stockholders Share in the Profits and the Losses
Stocks are the smallest unit of ownership in a company. The more shares of stock you have, the more ownership you have in the company. Companies issue stock as a way to raise money for improvements or expansion. If they took out a loan, it would have to be paid back.

To raise capital without incurring debt, they offer shares of their company’s stock to the public. If the company prospers, it will share those profits with the investors. If the company fails, the investor can lose part or all the value of his shares. The stockholder has the benefit of limited liability as part owner of the company; if a company loses a lawsuit and goes bankrupt, the worst that can happen to the investor is that the value of his shares could become worthless. The investor’s personal assets are untouchable.


Two Types of Stock
The two main varieties of stock are common stock and preferred stock.

• Preferred stock pays out a company’s dividends, but the price of the stock will not usually go up by much, so investors generally buy it for income. Preferred stockholders do not get voting rights, but they get priority on dividend payments over common stockholders.

• Common stock is what the majority of the public invests in, in the hope that the price of the stock will go up, and they may or may not receive dividends. Common stockholders are part owners of the company; the investor has the right to vote on members of the board, and other important issues such as mergers and liquidations. Common stocks are highly liquid. Anytime the stock market is open for business, the investor is able to sell his or her shares at the current share price.

Market Capitalization
Market capitalization, or market cap, is the market value of a company, measured by the current share price multiplied by the number of outstanding shares. Companies may be classified as large-cap, mid-cap, and small cap; the value requirement for these classifications can change over time, or depend on whom you’re getting the number from. Keep in mind that these values are approximations, intended to generalize the size category a company should fit into, and allowing comparison to the company’s peers.

• Large-caps are blue-chip companies that have a market value of over 9 billion dollars; these are the household names, the industry leaders. Large-cap stocks tend to be less volatile than stocks from smaller companies, as they are well-established companies with many years in the business. These companies are huge monsters that probably don’t have room for much more growth, so rather than reinvesting capital into the company, it pays out profits to investors in the form of dividends.

• Mid-caps have a market value of 1 to 9 billion dollars. Mid-caps are well-established companies that are projected to have the capacity for much more growth than large-caps. These companies use their profits for growth, meaning improvements and expansion, so investors won’t generally see much in the way of dividends. The company’s goal is to grow to a bigger, more valuable company over the long haul, with the investor benefiting from higher stock prices.

• Small-caps have a market value of less than 1 billion dollars. These emerging companies have huge potential for growth, but carry more risk than larger, more established companies. Be prepared for the time involved in doing your own financial research on these companies before you invest, as these records will not be as easily accessible as the financials of well-known, larger companies. These stocks are highly volatile; little things that may not even affect huge companies can cause the stock price of tiny companies to soar or plummet daily.

• Micro-caps have a market value of less than several million dollars, and nano-caps have a market value of less than fifty million. These companies are the brand new babies in the stock market. While these companies may provide an opportunity to get in on a company in its early stages and possibly strike it rich, they are brand-new companies in the public’s eye, and could fall flat on their face. Be prepared to do some serious research before you invest in these stocks; you probably want to stay away from these stocks unless you truly have the “inside scoop”. These stocks are extremely risky and not for the inexperienced investor.

Market Index
A market index tracks price changes in the overall market. It’s important to know if your stock price is changing due to specifics within the company you’ve invested, or if its fluctuation is only due to changes in the economy in general. It’s also helpful when you want to see how your stock is doing in comparison with the rest of the market. Compare your stock to the appropriate index; the Dow is not where you want to look if you only have stock in a small-cap company. There are indexes for countries across the world, but the ones most commonly used in the U.S. include:

• Dow Jones Industrial Average (DJIA) tracks thirty U.S. Blue-chip stocks.
• Russell 2000 measures the overall performance of small to mid-cap companies.
• S&P 500 tracks the 500 largest companies in America.
• NASDAQ composite includes all common stock available on the NASDAQ stock market.
• Wilshire 5000 tracks the entire stock market in the U.S.

Stock Splits
Splitting stock may happen when a large company has grown so much that its share prices are extremely high. The company may cut the price of the stock in half, and double the number of shares a stockholder owns. This doesn’t change the value of an investor’s holdings; it simply lowers the price of the shares to make the lower price seem more attractive to new investors.


Risk Assessment
It’s important to understand that buying shares of stock is an investment that may or may not reward you with profit. It’s hopeful that after careful research, you invest in a company that profits and grows. While this is your hope, there is always the possibility that all could be lost.

Never invest more than you could afford to do without in the short term. Long-term gains will still take a roller coaster ride of ups and downs; you don’t want money that you need now tied up in a bad market while you’re waiting for the economy to improve. The stock market constantly fluctuates, be prepared for it.

Find your comfort level with risk and reward. The lower the risk, the lower the likely payout, whether in the form of dividends or growth. The stocks that have the potential for enormous growth also have the potential for huge loss. Investing in the stock market probably gives you much better odds than gambling at the casino, but it is not a sure thing. Be aware of how much risk you are willing to take with your money. You might be willing to take a bigger risk for a potentially bigger payout, or you might prefer to accept smaller gains along with more safety.


Asset Allocation
Investing is risky; it is dangerous to count on only stock. I have a friend who had all her money in one well-known tech stock, and she lived very comfortably for many years solely on the income it provided. When the tech industry crashed a few years ago, she lost all her income and her shares were worth half of what they were before the crash. She had no choice but to sell some of her shares every month to pay her living expenses, until she had nothing. She eventually had to sell her house to buy a smaller one and get a job paying considerably less than she had been earning in dividends.

Reduce the potential impact of one stock’s fall by spreading your investments around. Stocks, in general have bigger gains, but you should keep some of your money in stocks, bonds and cash investments to help balance each other out and reduce the possibility of loss.

Financial experts advise that an aggressive investor should have no more than 80% of investments in stocks. The other 20% should be in bonds and cash investments, such as a money market fund. If you are less comfortable with risk, or you have fewer years before you need to cash in your investments, you should have less money in stocks and more in bonds and cash.



Source:
The Everything Personal Finance Book;
F+W Publications 2004