(This is the first entry in a regular series, covering some basic information about a variety of investment options in a question and answer format. It'll be witty, informative, and entertaining, just like high school! Or at least, as what we all wished high school was like.)
Q: What are stocks?
A: In a nutshell, stocks are small ownership portions of a company. If you have Microsoft stock, for example, you are a part owner of the Microsoft corporation.
Q: Sounds good! So, when can I start bossing Bill Gates around?
A: Well, two problems with that: first, Bill is essentially retired, and is putting more time into charity work than Microsoft these days. Second, it's unlikely you own enough stock to have a controlling stake in a company as large as Microsoft.
Q: Well, shoot, that's no fun. What determines how much of the company each share of stock represents?
A: It depends on how much of the company's equity is represented by the stock. If, when initially selling the stock, a company decides to sell 40% of its equity (the value of the company and its assets) in the form of stock, and issues 40,000 shares, then each share will represent 0.001% of the total company. If you bought 1000 shares, for instance,you would own 1% of the total company. Most companies put out millions of stock shares, making it all but impossible for regular investors to gain a controlling (that is, more than 50%) share.
Q: That's interesting. But why should I own stocks?
A: Stocks are good investments as they have high rates of return. They tend to outperform many other investment categories, such as bonds and money market funds, over the long run. They are useful for saving and growing money for people who have time and patience.
Q: That all sounds good, but how exactly can stocks make me money?
A: Stocks have two different ways to return your investment: (a) capital growth: when stock prices rise, you can sell your shares for more money than you used to purchase them, and pocket the profits, and (b) dividends: some (but not all) stocks pay out a portion of the company's profits to shareholders once a quarter, essentially rewarding you for holding onto your shares.
Q: Which of those two methods is best? And how should I invest to achieve that goal?
A: Two questions, hunh? Alright, to answer the first one, it depends on your goals; if you are seeking to grow your money, investing for capital growth should be your aim. If you want to gain spendable money (if you're retired and want a steady source of income), investing for dividends might be better.
You can shift your investments to meet your particular goals. If you want dividends, invest in large, well-established companies (known as blue-chips), which tend to pay out more of their income as dividends. Or invest in REITs, specialized stocks that invest in real estate and are required by law to pay out a large amount of their income. For capital growth, consider investing in smaller companies; they have more room to grow and expand.
Q: That's great! How can I lose?
A: Well, there are risks to owning stocks. Stock prices rise and fall, sometimes dramatically and quickly, so if you can't count on regular capital gains. If the stock prices go low enough, you might even find that the stocks are worth less than the money you paid for them. Dividends can be reduced or even cut entirely, sometimes with little warning. And if a company goes bankrupt, as companies sometimes do, the stock holders are unlikely to get any of their money back; they are behind bond holders and other debtors in claiming corporate assets.
Q: This is getting dicey. How can you find good stocks?
A: That's the $64,000 question; there aren't too many ways to ensure your stocks will do well. The single best method is to do careful, thorough, complete research, completely vetting the companies you want to invest in, and continue to follow the stocks regularly, being sure to know when things change with the company you now (partially) own.
Q: That sounds pretty hard. Is there any way to get the benefits of stocks without all this work?
A: The easiest way is to buy mutual funds. This allows you to own dozens, hundreds, or even thousands of stocks with a single investment. As a result, you'll get the dividends and growth potential of stocks with much less risk, and much less work, than hunting down and studying individual stocks. You will give up the potential of finding a superstar stock that drastically increases in value, but you will avoid the possibility of having a large amount of your money tied up in another Bear Stearns.
That wraps up this week's Investing 101 segment; come back next week, when we'll delve into the wonderful world of bonds.