Stocks
What they are?
A share of common stock gives an investor a portion of ownership in a company.
The company initially sells shares of stock to the public, and investors can then
trade shares in the secondary markets (on stock exchanges or on the over-the-counter
market). Investors purchasing shares of stock either expect to receive a portion
of the company's profits in dividends, expect the price of the stock to go up,
or both. In seeking dividends and price appreciation, investors are taking on
inherent risks. If the company, the market, or both weakens, then the investor
risks losing all or a portion of his investment. Stockholders are not responsible
for a company's debt, and therefore cannot lose more than their initial investment.
In addition to giving an investor a portion of ownership in a company, a share
of common stock also includes the right to vote for members of the board of directors
as well as the right to vote on important management issues. In most situations,
individual investors are not able to accumulate enough stock in a company to be
able to influence voting decisions. This is usually done by large institutional
shareholders and company insiders.
What they can do for your portfolio
Stocks offer no guarantees to investors, but over long periods of time they have
performed better than any other type of investment. Stocks have historically returned
an average of about 11% per year. Over the long-term, stocks are the best vehicle
for overcoming inflation and building wealth.
Types of stock
Common Stock -
Common stock is the most commonly issued type of stock. It gives the investor
a portion of ownership in the company, as well as voting rights.
Preferred Stock -
Preferred stock also gives the investor ownership in the company; however, preferred
stockholders do not have voting rights. In addition, the dividends on preferred
shares must be paid before dividends on common shares, and the stockholders also
have a greater chance of getting a portion of their investment back if the company
fails. In exchange for this additional security, preferred stockholders generally
experience less price appreciation than common stockholders of the same company.
Classes of Stock
Some corporations also issue different classes of stock. Different classes sell
at different prices, have different dividends or restrictions, or represent ownership
in different portions of the company.
Valuing stocks
The price of a stock in the market changes constantly. Changes can be due to market
conditions, company and industry announcements, investor perceptions, and many
other factors.
Company sizes - Large, Mid, Small and Micro Caps
Company size is usually classified based on market capitalization. Market capitalization
is the total value of the company's shares in the marketplace and is defined as
current price per share times number of shares outstanding. If a company has 10
million shares outstanding and is trading at a price of $10 per share, then it
has a market capitalization (market cap) of $100 million. Stocks are usually classified
as large, mid, small or micro cap. Large cap stocks are generally stable, mature
companies. They tend not to be as volatile as their small cap counterparts. Small
cap companies tend to fluctuate more in price but have historically offered higher
returns.
The approximate sizes of these categories is as follows:
Large Cap: Over 10 Billion dollars
Mid Cap: 1 Billion - 10 Billion dollars
Small Cap: $100 million - $1 Billion
Micro Cap: Less than $100 million
Foreign stocks
Many investors choose to diversify by investing a portion of their portfolio in
foreign stocks. Foreign stocks may offer investors higher potential for price
appreciation than domestic stocks. Companies in developing countries have the
advantage of higher population growth, as well as expanding markets and industries.
This potential doesn't come without a price; foreign stocks tend to be more risky
than US stocks. The recent Asian crisis is just one example of how volatile foreign
stocks can be. In addition to increased volatility, investors have to worry about
fluctuations in currencies. If a country's currency is devalued, US investors
can lose money whether or not the stock price drops.
Investing in individual foreign stocks is difficult and would not be advised for
most small investors. The best way for an individual investor to get exposure
to foreign markets is to purchase an overseas mutual fund or to purchase ADRs
(American Depository Receipts). An ADR is an investment vehicle that represents
shares of foreign stock. The shares of stock are held in a bank as collateral,
and the bank issues shares of the ADR. The shares then trade in US markets, just
as a normal stock would trade.
Buying and selling stocks
In order to buy or sell stocks, you need to go through a brokerage house. A brokerage
house is a company that is a member of one or more stock exchanges. The broker
acts as an agent to execute the orders. A broker charges a commission for this
service. The commission fee can vary from as low as $5 per trade up to hundreds
and even thousands of dollars. The cost depends on the type of broker, the number
of shares, the price of the stock, and the type of order.
Buying on Margin
Investors with a high-risk tolerance don't always have to pay the full price for
investments. They have the option to open a margin account, which allows them
to leverage their purchases by borrowing up to 50% of the price of a stock from
their broker. The stock in the margin account is used as collateral for the loan.
The investor then has to pay interest on the loan, but isn't required to pay the
loan back until he sells the stock. Buying on margin increases the potential return
from a stock - any profit made on borrowed money (less interest fees) is kept
by the investor. For example, if an investor wants to purchase 100 shares of a
stock that is trading at $50, he can either pay the full purchase price of $5000,
or pay $2500 and borrow the other $2500. If the stock then rises to $75, his position
is worth $7500, a $2500 gain. If the investor bought the stock with all cash,
the investor has made a 50% profit ($2500 on $5000 invested), but if the investor
bought on margin, he only invested $2500 and made $2500, a 100% return! (less
commissions and interest payments).
Buying on margin gives investors additional financial power, but also carries
additional risks. If the stock falls, the investor will watch his equity erode
faster than with a cash purchase. To help prevent disasters, brokers will issue
a margin call to investors when the value of their investment drops below a certain
level (this varies depending on the broker and the security, but it is around
a 20-25% drop for most stocks). A margin call requires the investor to either
deposit more money in his account, or sell some stock.
The minimum amount of cash required to open a margin account is $2000.
Shorting Stocks
Investors with margin accounts also have the ability to short sell stocks. Short
selling is not recommended for the novice investor, since potential losses are
much higher than with buying a stock. In a short sale, an investor bets that the
stock price is going to drop. He borrows stock from the brokerage house and sells
it on the open market. He then gets to keep the proceeds of the sale, with the
obligation to buy the stock back at a later date and deliver it to the broker.
The investor hopes that the stock will drop and he will be able to purchase it
at a lower price in the open market, deliver it to the broker, and pocket the
difference in price. If the stock does the opposite and begins rising quickly,
the investor can lose his initial investment and more. As the stock rises, the
broker may issue a margin call, requiring the investor to deposit more equity
in his account.
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