Stocks – What Are They?
To own part of a company, you buy stocks, shares or equity. All these terms represent the same thing: part of a company’s assets or earnings. When you invest in stocks, you become a shareholder. Shareholders are a group of people or organizations that own a company and are entitled to voting rights as stated in the contract of said company.
When you buy stocks or shares, you are issued with a stock certificate which acts as proof of ownership. You can use this document to trade shares. If you use a broker, they will maintain an electronic copy of the stock certificate to simplify trading.
But it’s also important to note that shareholders do not have a say on every activity that goes on in the company. You can have a say in choosing the management but not on daily operations of the business. But larger investors and entrepreneurs who own a huge part of the company have more power to make decisions.
A company issues stocks for several reasons. The main reason is that it helps the company to raise money. They will borrow from several people and then when they use the money, they will share the profits with all shareholders. Sometimes the company doesn’t want to borrow money from a bank or issue bonds for various reasons and so it decides to seek equity financing because it doesn’t have to pay back the money or make interest payments along the way.
When a company issues the first sale of a stock, it is regarded as an initial public offering, which is also known as an IPO. Buying stocks does carry certain levels of risks which you must understand before you buy. I do cover this in another article on the risks in buying stocks. You also need to know the difference between buying a debt investment and an equity investment. Stocks are an equity investment which means that you are not guaranteed the return of your money together with the interest payments.
It’s also worth noting that when a company goes bankrupt, it may be impossible to recover your investments. Bond holders are usually given more priority than shareholders. Some companies may pay dividends while others may not. The ones that don’t pay dividend allow investors to make money in the open market when their money appreciates over time.
Although investing in stocks might sound very risky, people have made lots of money out of this form of investing. History has shown stocks have outperformed all other forms of investment like bonds and savings accounts because they usually present higher interest rates. Stocks can have an average return of 10-12% whereas bonds can have a much lower average return of 4-6%.
Investing in Stocks – The Basics
So you’ve decided to invest in stocks. What next? First, know that you’ve made a sound investment decision. Historically, stocks have been shown to outperform all other forms of investments. But the way you choose to invest in the stock market will determine your chances of success.
There are basically different forms of stock investing such as individual stocks, EFTs, domestic stocks, foreign stocks and index funds. Don’t feel intimidated if you are not familiar with any of these terms. You’ll learn about each one of them as time goes on.
For now, you need to know how to choose the form of stock investing that is right for you. To do this, you might want to consider the following.
First, the kind of stocks you will invest in will be largely dependent on the kind of person you are. Are you a risk taker? Are you the kind of person who prefers to play it safe? There are cases where you will be presented with an opportunity to invest a lot of money and make a killing or potentially lose everything. In many cases, it’s those risky investments that pay out more than the safe ones. That’s why even long-term bonds have higher interest rates than short-term bonds.
Secondly, understand that the prices of stocks fluctuate depending on several factors. The economic fluctuations may significantly affect the prices of stocks. When bonds are not performing very well, there’s a high chance that the stocks will be doing immensely well.
You also need to understand what actively managed funds are. Actively managed funds are simply stocks which are chosen with a goal in mind, usually to beat a specific index or to achieve a certain return. This type of funds tends to have higher taxes.
Understand also how stocks work. Stocks trade in exchanges. In the US, there are a variety of exchanges and the major ones are the New York Stock Exchange and American Stock Exchange. These exchanges handle their stocks in different ways, but the rules of buying and selling are more or less the same.
The purpose of stock exchanges is to bring together buyers and sellers. The buyer will set a bid, which is a price which they are willing to pay to acquire stocks and the sellers will have an ask price which is what they are willing to accept. The difference between the two is known as the spread and it usually goes into the broker or professional handling the exchange.
How To Purchase Stocks
You have two main options when it comes to buying stocks. You can decide to buy stock with the help of a broker or directly from the company. A good thing with using a brokerage firm is that they can manage your portfolio and ensure everything goes according to your investment goals. But before you decide to buy stocks, you need to understand the difference between mutual funds and individual stocks and decide which of the two you should buy.
Mutual funds are stocks which are bundled together and represent different companies. When you choose to buy mutual funds, you are investing in a small portion of different companies at the same time. If the value of one company in the fund increases then your portfolio will not be significantly affected because you have to consider the performance of other companies.
On the other hand, individual stocks are the ones you buy when investing in a single company. This kind of stock has a much higher risk than mutual funds because there’s no diversification of your investment portfolio. You are basically relying on a single company’s performance. But if the value of the stock increases then you’ll make more money than what you would have made in a mutual fund.
Before buying stocks, look into the different companies and make a smart decision. Don’t just focus on the stock price and the number of shares because some companies may be overvalued in the sense that the company is considered worth more than what it actually is. So don’t brush off the companies that have a low stock price because many of them are undervalued. Your goal should be to buy low and sell high but try as much as possible to buy undervalued stocks and sell overvalued ones.
If you have an option of buying stocks without a broker then go ahead and do that because it will save you a lot of time and money in the process. Get online and look for companies whose stocks you would wish to buy and find out if they have direct stock purchase plans or DSPPs.
If you choose to work with a broker, make sure you find a reliable one who can even help you to make sound investment decisions. Understand when their commission rates apply and ask all the questions before signing any agreement with a brokerage firm. Pay close attention to the rates offered regarding the types of stocks you plan to trade often.
The Various Types of Stocks Available
Stocks can be categorized into two broad terms, common stocks and preferred stocks. The majority of stocks are common stocks which represent a part of a company and the ability to claim dividends on a portion of their earnings. Individuals are given common shares and they get one vote per share to elect board members of the company. Common stocks usually have the highest risks but yield higher returns than almost any other form of investment. If the company goes bankrupt then the common shareholders will not receive any money until the bond holders, preferred shareholders and creditors are paid.
Preferred stocks are the ones that present a lower level of risk and the shareholder have more voting rights. An investor who has preferred shares can be assured of a fixed dividend forever. The advantage of being a preferred shareholder is that, first you will be paid off before common shareholders in the event of bankruptcy when the company is liquidated. Secondly, the company can decide to buy the preferred stock at any time for any reason so it’s easy to liquidate your stocks.
Companies usually have their own classifications of stocks depending on how they want to differentiate their shareholders. For instance, if the company wants the voting power to remain within a certain group of people or individuals then they will have different classes of stocks with different voting rights. You can find one class of shares which has investors who have 10 votes per share whereas another has only a single vote per share. Most companies have class A and Class B Shares
Class A shares are the ones given to people so that they can have an extra voting ability. Shareholders belonging to this class may have 10 votes per share they own. This is a class that is usually reserved for the insiders, founders and family members of the organization. That is, the people who want the control of the company to remain internally even if they don’t own a majority of the stock.
Class B shares on the other hand are the ones reserved for the majority. Shareholders belonging to this class usually have one vote per share they own. The difference between the two classes is usually noted by a symbol at the end. Companies can have many other different share classes in order to separate voting rights among its shareholders.
Many people consider penny stocks to be stocks that trade for under $5. Others consider the term penny stock to mean stocks that trade off the major market exchanges. However, it’s important to note that there are large companies with stocks that are trading below $5 per share whereas some small companies are trading for more than $5 per share.
So it would be best to define penny stock as a stock offered by a very small company and comes with high risk because of their lack of liquidity and limited disclosure. Companies that offer penny stocks are usually given limited regulatory standards to comply with. There are also fewer requirements for investors who want to buy penny stocks.
Instead of defining penny stocks based on the pricing, this type of stock can be defined based on where it is trading. These stocks can refer to any stock that is trading on over the counter bulletin boards or pink sheets. Generally, these stocks are much riskier than the regular stocks. There are 4 main reasons why penny stocks are risky.
Why penny stocks are considered risky
For a start, information about companies that are listed in pink sheets is much more difficult to find. These companies are not required to file with the Securities and Exchange Commission so they tend to get away with so many things which present a high risk to you as an investor. Sometimes even the information that is available about the penny stocks doesn’t come from credible sources.
Secondly, penny stocks don’t have to fulfill minimum standards in order to trade on the pink sheets or OTCBB. These smaller exchanges usually do not impose strict standards compared to major exchanges like the NYSE.
The other risk of investing in penny stocks is that some companies which offer penny stocks have obtained false recommendations from media houses like radio and TV shows. They pay these sources to recommend their company in order to persuade investors to buy their stocks.
Penny stocks also don’t have much liquidity. Once you invest in them, there’s a high chance that you wouldn’t be able to sell it fast. This low level of liquidity means that it’s hard to find a buyer of penny stocks so you may be required to lower your asking price until it is considered attractive to another buyer. Furthermore, companies that offer penny stocks are usually newly formed and don’t have a history so it’s hard to determine the stock’s potential.