When you invest in stock, you buy ownership shares in a company—also known as equity shares. Your return on investment, or what you get back in relation to what you put in, depends on the success or failure of that company. If the company does well and makes money from the products or services it sells, you expect to benefit from that success.
There are two main ways to make money with stocks:
1. Dividends. When publicly owned companies are profitable, they can choose to distribute some of those earnings to shareholders by paying a dividend. You can either take the dividends in cash or reinvest them to purchase more shares in the company. Many retired investors focus on stocks that generate regular dividend income to replace income they no longer receive from their jobs. Stocks that pay a higher than average dividend are sometimes referred to as “income stocks.”
2. Capital gains. Stocks are bought and sold constantly throughout each trading day, and their prices change all the time. When a stock price goes higher than what you paid to buy it, you can sell your shares at a profit. These profits are known as capital gains. In contrast, if you sell your stock for a lower price than you paid to buy it, you’ve incurred a capital loss.
Both dividends and capital gains depend on the fortunes of the company—dividends as a result of the company’s earnings and capital gains based on investor demand for the stock. Demand normally reflects the prospects for the company’s future performance. Strong demand—the result of many investors wanting to buy a particular stock—tends to result in an increase in the stock’s share price. On the other hand, if the company isn’t profitable or if investors are selling rather than buying its stock, your shares may be worth less than you paid for them.
The performance of an individual stock is also affected by what’s happening in the stock market in general, which is in turn affected by the economy as a whole. For example, if interest rates go up and you think you can make more money with bonds than you can with stock, you might sell off stock and use that money to buy bonds. If many investors feel the same way, the stock market as a whole is likely to drop in value, which in turn may affect the value of the investments you hold. Other factors, such as political uncertainty at home or abroad, energy or weather problems, or soaring corporate profits, also influence market performance.
However—and this is an important element of investing—at a certain point, stock prices will be low enough to attract investors again. If you and others begin to buy, stock prices tend to rise, offering the potential for making a profit. That expectation may breathe new life into the stock market as more people invest.
This cyclical pattern—specifically, the pattern of strength and weakness in the stock market and the majority of stocks that trade in the stock market—recurs continually, though the schedule isn’t predictable. Sometimes, the market moves from strength to weakness and back to strength in only a few months. Other times, this movement, which is known as a full market cycle, takes years.
At the same time that the stock market is experiencing ups and downs, the bond market is fluctuating as well. That’s why asset allocation, or including different types of investments in your portfolio, is such an important strategy: In many cases, the bond market is up when the stock market is down and vice versa. Your goal as an investor is to be invested in several categories of investments at the same time, so that some of your money will be in the category that’s doing well at any given time.
Common and Preferred Stock
You can buy two kinds of stock. All publicly traded companies issue common stock. Some companies also issue preferred stock, which exposes you to somewhat less risk of losing money, but also provides less potential for total return. Your total return includes any income you receive from an investment plus any change in its value.
If you hold common stock you’re in a position to share in the company’s success or feel the lack of it. The share price rises and falls all the time—sometimes by just a few cents and sometimes by several dollars—reflecting investor demand and the state of the markets. There are no price ceilings, so it’s possible for shares to double or triple or more over time—though they could also lose value. The issuing company may pay dividends, but it isn’t required to do so. If it does, the amount of the dividend isn’t guaranteed, and it could be cut or eliminated altogether—though companies may be reluctant to do either if they believe it will send a bad message about the company’s financial health.
Holders of preferred stock, on the other hand, are usually guaranteed a dividend payment and their dividends are always paid out before dividends on common stock. So if you’re investing mostly for income—in this case, dividends—preferred stock may be attractive. But, unlike common stock dividends, which may increase if the company’s profit rises, preferred dividends are fixed. In addition, the price of preferred stock doesn’t move as much as common stock prices. This means that while preferred stock doesn’t lose much value even during a downturn in the stock market, it doesn’t increase much either, even if the price of the common stock soars. So if you’re looking for capital gains, owning preferred stock may limit your potential profit.
Another point of difference between common stock and preferred stock has to do with what happens if the company fails. In that event, there’s a priority list for a company’s obligations, and obligations to preferred stockholders must be met before those to common stockholders. On the other hand, preferred stockholders are lower on the list of investors to be reimbursed than bondholders are.
Classes of Stock
In addition to the choice of common or preferred stock, certain companies may offer a choice of publicly traded share classes, typically designated by letters of the alphabet—often A and B. For example, a company may offer a separate class of stock for one of its divisions which itself was perhaps a well-known, formerly independent company that has been acquired. In other cases, a company may issue different share classes that trade at different prices and have different dividend policies.
When a company has dual share classes, though, it’s more common for one share class to be publicly traded and the other to be nontraded. Nontraded shares are generally reserved for company founders or current management. There are often restrictions on selling these shares, and they tend to have what’s known as super voting power. This makes it possible for insiders to own less than half of the total shares of a company but control or strongly influence the outcome of issues that are put to a shareholder vote, such as a decision to sell the company.
