There's no doubt that investing in the stock market can be one of the most exciting ways of making money. Nothing quite compares with the thrill of seeing the little-known stock you picked become a hot property, perhaps doubling in price—and then doubling again and again. But as with any investment, the potential risks are equal to the rewards, so investors who want to play the market owe it to themselves to become fully informed before getting involved.
How Does the Stock Market Work?
A share of stock represents a unit of ownership in a corporation. When you buy stock, you are be coming a part owner of the business. Therefore, you benefit from any increase in the value of the corporation and you suffer when the corporation performs badly. You're also entitled to share in the profits earned by the corporation.
Stocks are bought and sold in marketplaces known as stock exchanges. The exchange itself does not buy or sell stock, nor does it set the price of stock; the exchange is simply a forum in which individuals and institutions may trade in stocks. Stock exchanges play a vital role in a capitalist economy. They provide a way for individuals to purchase shares in thousands of businesses, and they provide businesses with an important source of capital for expansion, growth, and research and development.
How Does an Investor Purchase Stock?
Here, in two steps, is what happens when an investor decides to buy or sell a particular stock. First, an account executive at the brokerage house receives the buy or sell order, which may take any of several forms:
- Round-lot order. An order to buy or sell 100 shares, considered the standard trading unit
- Odd-lot order. An order to buy or sell fewer than 100 shares
- Market order. An order to buy or sell at the best available price
- Limit order. An order to buy or sell at a specified price
- Stop order. An order designated to protect profits or limit losses by calling for sale of the stock when its price falls to a specified level
- Good till canceled order (GTC). An order that remains open until it is executed or canceled by the investor
Second, after the order is received, it is sent to the floor of the stock exchange. The brokerage firm's floor broker receives the order and executes it at the appropriate trading post. Confirmation of the transaction is reported back to the account executive at the local office, who notifies the investor. Remarkably, the entire process may take as little as two or three minutes.
What Kinds of Stocks Are Available?
There are two kinds of stocks: common and preferred.
Common Stock Each year, hundreds of new issues of stock, known as initial public offerings (IPOs), are sold to the public. Although human life ends at the hands of the undertaker, it begins for common stock at the hands of the underwriter, who sells the stock, at a fixed price, to a group of initial buyers who in turn "farm out" the investment until it reaches the "street"—which is you, the investor. IPOs have their fans and detractors. If you're anxious to make big money on an IPO, then the letters stand for "immediate profit opportunity." If you're a skeptic, the acronym has only one meaning— "it's probably overpriced."
A share of common stock represents a unit of ownership, or equity, in the issuing corporation. Each share of common stock usually has a par value, which is a more or less arbitrary value established in the corporation's charter and which bears little relation to the stock's actual market value. The market value is influenced by many factors, including the corporation's potential earning power, its financial condition, its earnings record, its record for paying dividends, and general business conditions.
Ownership of a share of common stock carries certain privileges:
- A share in earnings. Each year, the board of directors of the corporation meets to determine the amount of the corporation's earnings that will be distributed to stockholders. This distribution, known as the dividend, will vary depending on the company's current profitability. It may be omitted altogether if the company is earning no current profits or if the board elects to plow back profits into growth.
- A share in control. Holders of common stock have the right to vote on matters of corporate policy on the basis of one vote per share held. However, the small investor with only a few shares of stock has little or no practical influence on corporate decisions.
- A claim on assets. In the event of the company's liquidation, holders of common stock have the right to share in the firm's assets after all debts and prior claims have been satisfied.
There are four main categories of common stock, each of which is best for a particular investment strategy and purpose.
- Blue-chip stocks. High-grade, or blue-chip, stocks are issued by well-established corporations with many years of proven success, earnings growth, and consistent dividend payments. Blue-chip stocks tend to be relatively high priced and offer a relatively low-income yield. They are a relatively safe investment.
- Income stocks. Income stocks pay a higher-than-average return on investment. They are generally issued by firms in stable businesses that have no need to reinvest a large percentage of profits each year.
- Growth stocks. Issued by firms expected to grow rapidly during the years to come, growth stocks have a current income that is often low, since the company plows back most of its earnings into research and expansion. However, the value of the stock may rise quickly if the company performs up to expectations.
- Speculative stocks. Speculative stocks are backed by no proven corporate track record or lengthy dividend history. Stocks issued by little-known companies or newly formed corporations, high-flying "glamour" stocks issued by companies in new business areas, and low-priced "penny stocks" may all be considered speculative stocks. As with any speculative investment, there is a possibility of tremendous profit—but a substantial risk of losing all as well.
Preferred Stock Preferred stock, like common stock, represents ownership of a share in a corporation. However, holders of preferred stock have a prior claim on the company's earnings as compared with holders of common stock; hence the name preferred stock. Similarly, holders of preferred stock have a prior claim in the company's assets in the event of a liquidation, but they have no voting privileges.
Preferred stock also has certain distinctive features related to dividend payments. A fixed, prespecified annual dividend is usually paid for each share of preferred stock. This fixed dividend may be expressed in dollars (for example, $10 per share) or as a percentage of the stock's par value. It must be paid before dividends are issued to holders of common stock.
However, preferred stock dividends are not considered a debt of the corporation—unlike, for example, the interest due on corporate bonds—because the firm is not obligated to meet its dividend payments. If the corporation is losing money, the board of directors may decide to withhold the dividend payment for a given year. To protect stockholders against undue losses, most preferred stock is issued with a cumulative feature. If a dividend is not paid on cumulative preferred stock, the amount is carried over to the following period, and both current and past un-paid dividends must be paid before holders of common stock can receive any dividend.
What Are the Advantages and Disadvantages of Stocks?
Like any investment, stocks have distinct advantages and disadvantages.
Advantages:
- Growth potential. When a company has the potential for growth in value and earnings, so does its stock. If you pick the right stock or group of stocks, you can profit significantly and relatively quickly. History shows that, as a whole, the stock market has had an upward trend in values, with years of gain outnumbering those of decline by better than three to one.
- Liquidity. Stocks traded on the major exchanges can be bought and sold quickly and easily at readily ascertainable prices.
- Possible tax benefits. Growth stocks, which pay low or no dividends so that company profits can be reinvested, provide an effective tax shelter. As the corporation's value grows, so does the value of the stock, which is a form of tax-deferred income, since no taxes need be paid on these gains until the stock is sold.
Disadvantages
- Risk. There can be no guarantee of making money by investing in stocks. Companies may fail, stock prices may drop, and you may lose your investment. Remember the saying of one concerned investor: "I am not so concerned with the return on my investment as I am with the return of my investment."
- Brokerage commissions. Most investors need the help and advice of a stockbroker when they become involved in the market. However, high broker commissions can largely erode profits. Since one fee is charged when you buy the stocks and another when you sell them, you are, in effect, forced to pay twice. Unusually well-informed investors should look into the use of a discount broker, who provides little or no investment counseling but charges greatly reduced commissions when trading stocks.
- Complexity. The stock market is complicated, and the amount of knowledge needed to be consistently successful is tremendous. Investors who lack the patience, time, or skill to inform themselves about the market often buy and sell on impulse, thereby minimizing their profits and maximizing their losses.
Summary
Never forget that whenever you buy a stock, there is someone selling it. You may buy the stock because you believe that the investment is good and the price will rise. However, the person selling that same stock believes the opposite, so only one of you will be correct. Think of it in these terms, and you will become a realistic and conservative player.
(See also: Financial Statements; Securities Acts: Requirements for Accounting; Securities and Exchange Commission)
JOEL LERNER
