Introduction to Stocks
When it comes to investing, there are four primary asset classes that securities fall under: equity, debt, cash and cash equivalents, and real estate and commodities. Stocks are a type of equity security, and they represent ownership. If you own a company's shares, you are a part-owner of the company, and you have the right to vote on members of the board of directors and other important business matters. For example, if Company ABC has 100,000 shares and you buy 10,000, you own 10% of the company.
Type of Stocks
Stocks can either be classified as common or preferred, with the former representing the majority of stock held by the public. Owners of common stock have voting rights and the right to dividend payouts, but there is one major drawback: If a company is forced to liquidate or go bankrupt, common shareholders are at the bottom of the totem pole when it comes to payouts. Preferred shareholders and bondholders must be paid out in full before common shareholders can begin receiving payments.
Preferred stockholders have fewer rights than common stockholders, except when it comes to dividends. Companies that issue preferred stocks usually pay consistent dividends, and preferred stockholders have priority on dividends over common stockholders. Investors buy preferred stock for its current income from dividends, so look for companies that make big profits to use preferred stock to return some of those profits via dividends.
A company's earnings per share (EPS) is its profits divided by the number of outstanding common shares and is an important measurement to look at before deciding to invest in a particular company. For example, if a company makes $1 million in profits and has 100,000 common shares outstanding, its EPS is $10. The company's management may decide to reinvest $7 back into the company and payout $3 to investors in the form of a dividend. Dividends, which are paid quarterly, represent the money companies payout to shareholders and serves as an extra incentive for investors to invest in particular companies.
While older, more established companies—often referred to as blue-chip stocks—tend to pay a higher dividend, newer companies typically don't pay dividends, as they're better off reinvesting the profits into the business for growth. A company paying too high of a dividend is a red flag for investors and may indicate a management team that isn't prioritizing the company's growth and long-term success.
When analyzing a company's EPS, it's important to compare it with other companies within the same sector to give a better perspective. A technology startup's EPS should not be compared with an energy company's EPS, as their businesses are fundamentally different.
Advantages and Disadvantages
The primary advantage of investing in stocks is the potential for high returns. Even though stock prices fluctuate daily, over time, they have consistently increased in value and provided stable returns. While your portfolio should not be all stocks, they do help provide diversification that ensures you can take advantage of increases in the market, while not entirely falling victim to dramatic market changes or collapses.
All investments come with a risk element, but stocks are the riskiest type of investments because factors outside of the investor's control influence their price and performance. If too much of a person's portfolio is tied up in stocks, a market decline could be the difference between retiring comfortably and having to work extra years to make up for losses. The younger a person is, the more risk they can take with their portfolio because they have time to make up for market declines. As one nears retirement, their portfolio should become more conservative and start transitioning into safer, more stable investments such as bonds.
Compound Interest and Time
Compound interest—which Albert Einstein famously called the "8th wonder of the world"—is the greatest tool when it comes to taking advantage of stocks. Compound interest is the process of earning interest on your interest, and its effect can't be overstated. For example, let's assume you make an initial investment of $1,000 into a stock that grows 8% annually. If you contribute $100 at the end of each month for 20 years, that investment will be worth $58,902—even though you only personally contributed $24,000. Even if you were to contribute a lump sum of $1,000 and never contribute another penny, your investment would grow to $4,661 in 20 years. Time and compound interest are some of your greatest tools when it comes to investing.
The Bottom Line
Although stocks offer good return potential, they should not make up all of your investment portfolio. Use other asset classes to help diversify your portfolio and decrease your risks.