Four Reasons Why You Need to Know About Stocks

September 1, 2016

The same friend of mine who recently asked me about bonds really enjoyed my summary and came back with a predictable follow-up question: “OK, I know about bonds now. So what are stocks?”

The Basics
Simply put, a stock is equity ownership of a corporation. That means you’re buying a share of the ownership in a company. That’s right, if you own stock, you own a part of the company. The ownership is split between many shareholders and the number of shares that you buy represents the size of your ownership stake in the entire corporation. So what does that matter?

The Benefits
As a stockholder you share in the profits or losses of the corporation and you share in the increase or decrease in the value of the firm’s assets. You also have certain rights as an owner of the company.

  • Dividends
    If the company is profitable, then the profits are usually reinvested back into the corporation or paid out to stockholders in the form of a dividend. Over time, most of the return from stock holdings comes actually from dividends, rather than price appreciation. Which leads us to…
  • Returns
    Stocks have been a solid investment historically, especially for long-term investors like those of us investing for retirement. That’s because they also carry the greatest risk (we’ll get to that in a moment). If you weather the volatility of the market, it can pay off in the long-term, which is why most individuals take the “buy and hold” approach. That’s because, generally over longer periods of time stocks go up at about the same rate as the economy grows. As an owner, the value of your stock generally increases both due to the growth of the economy and the reinvestment of earnings back into the company. Just like owning your own house, owning part of a corporation allows your wealth to grow with the economy.
  • Voting
    Shareholders have a say in electing the company’s Board of Directors. The Board hires the management of the company, so you also have a say in the way the corporation is managed. Some of the largest owners of stock are institutional investors like Colorado PERA, and those investors exercise their rights to vote at annual shareholder meetings on behalf of their members. You also have the right to vote (one vote per share) on a variety of issues in addition to electing the board.

The Risks
Stocks go up in value, but they also go down. At any one time you could make or lose money. These different types of risks aren’t the only ones, but they’re some of the most common.

  • Market risk
    If you sell the stock after its gone down in value, you’ll lose money. This market volatility creates risk for investors because ultimately all stockholders are at the whim of the market. Even if the company is doing well, other factors (political, economic, etc) can contribute to a stock’s value declining.
  • Sequential risk
    Let’s say you just made a purchase of some shares of stock, and everything is looking good in the market. The next day, something surprising happens to drive down the price of most stocks, including yours. You had no idea, of course, but the point in time when you bought affected the value of your portfolio. The timing of your purchase can pose a risk.
  • Business risk
    Let’s say those amazing directors you voted for to run the Board of the company made some bad decisions in hiring management. The new CEO decided to do some boneheaded move that lost everyone money. Investors usually see that as a time to jump ship, and if you’re caught holding on to your shares when everyone else sells, the value of those shares probably plummeted. This is one of the biggest risks with holding a lot of stock in an individual corporation (more on mitigating that risk in a bit).

The Strategies
There are several key steps to take if you want to minimize losses and get the best results.

  • Have a long timeframe
    Your stock investments will go up and down with the stock market. Some years will be good and some will be bad. If you are looking out over decades you will generally have a good experience because the value of stocks generally appreciate with the economy but can fluctuate with changes in interest rates and the rate of growth of the economy.
  • Pool your investments
    Buying a mutual fund or an ETF (Exchange Traded Fund) can help with this. Investing in these kinds of products gives you ownership of a broad number of stocks and reduces the risk that any one company will have a bad return that hurts your investments.
  • Dollar cost averaging
    Buying the same amount of shares at regular intervals (e.g. monthly) averages the price level that you invest your money. This strategy is very common with retirement savings plans where your contributions are invested monthly. If you have a 401(k), you’re probably already doing this.
  • Diversify your investments
    Buying across different types of stock funds is key. Start with a broad-based fund and then spread your investments across specialty funds and international funds. This will reduce the volatility of your returns and increase the (relative) safety of your holdings.
  • Know your risk tolerance
    Ultimately, you’re the only person who can determine how much risk you’re willing to take with a particular investment. If you’re going to lose sleep over it, it’s not worth whatever return might be earned in the future. There are a wide range of investments for people of all sorts of risk tolerances, and you can find one that’s right for you.

Finally, always try to learn as much as you can. Keep asking questions and observe the habits of successful investors. Doing your homework will make you a smarter, wiser, and more confident investor.

Do you have any questions about stocks we didn’t cover? Ask them in the comments!