Stock overview

Stocks represent ownership of shares in a company and are called Equity. The stockholder is generally looking for long-term gain appreciation- and is differentiated from a bondholder who invests in debt and is primarily seeking income. Income, as dividends, may also be paid to stockholders but only after the bondholders have received their payments and only if the company Directors vote accordingly. Since the stockholders ability to receive income is limited, he must look to an increase in the value of the shares as his potential reward. The value of stock is subject to far more variable economic factors and there therefore is a much greater risk than that of owning bonds. However, historically, the overall returns are significantly greater than that of holding cash or bonds.

A significant difficulty in the purchase of stock is trying to recognize not only that the company has a potentially bright future, but that the industry and the national and international economics in general do as well. It is also noteworthy to address that the purchase of just one company comprises considerably more risk vs. that of a diversified portfolio. For these reasons, an investor or his broker must normally commit to extensive homework on many different industries.

Most Investors who own publicly traded stock that trade on an exchange may, in most cases, buy and sell as little or as many of the shares as they may desire and at anytime. Such trades normally occur through a brokerage firm on which the individual will pay a commission (though direct trading through the Internet now plays a key role). The amount of commission is generally greater when using what is referred to a full service broker- those that provide a substantial amount of research and advice for the consumer. Lower commissions are available through discount firms or through Internet trading where limited, if any, advice is provided.

Please note however, that there are many types of stock and stock ownership and that this brief overview in no way identifies the complexity of the issues an investor should consider.

The stock exchange

As stated, stock is generally traded on the exchanges such as the New York Stock Exchange, American Stock Exchange and many others. These handle the larger public companies. Smaller, and less active companies may be traded over-the-counter on the NASDAQ market.

Stock indexes

A single company cannot be a gauge to the entire stock market. Over the years therefore, certain indexes have been devised to indicate the movement of the stock market overall. The two most common indexes are the Dow Jones industrial average and the Standard & Poor's 500 index, though there are many others in use such as the NASDAQ and Russell indexes.

The Dow Jones tracks 30 large companies that are traded on the New York Stock Exchange. These blue-chip companies are leaders in their industry with well regarded reputations. However, most analysts have limited the DJIA as a good gauge of the market due to the limited number of stocks being reviewed.

The S&P 500 covers stocks traded on the New York Stock Exchange, American Stock Exchange and the over the counter market. While there are various interpretations as to which index a consumer might use to gauge the movement of their own portfolio, the general tendency is to use the S&P 500 due to his larger broad-based diversification.

An important item is portfolio diversification. Owning one stock is far more risky that owning a portfolio of stocks made up of the S&P 500 index. By the same token, such risk can actually be reduced to the same effective rate of the S&P 500 index by just buying a relatively small number of stock- approximately 10 to 15. Please note however, that the, say, 13 stocks must still be in different industries. For example, buying Chrysler, Ford, General Motors, a steel stock, etc. would all be focused in one industry and provides little overall diversification.

Share prices

The market value of a share of stock is the same regardless of whether not you are buyer or a seller, save for the fact there is a minor difference for compensating a specialist or market marker an exchange who is required to provide an orderly market. For example, it may cost 25 dollars to purchase a share, but you might only receive $24.75 if you sold that same share at the same time.

If the share prices of the market are effectively all going up that the same time and for an extended period of time, this is called a bull market. Investors would normally be buying more shares during this time. Conversely, a market that is declining is called a bear market. In this case, investors are normally selling shares.

Why invest in stocks

1. While the ownership of stocks contains a greater risk, statistically the returns over long periods of time are considerably higher than owning cash or bonds.

2. Since the returns are generally higher than other investments, stocks may be used to offset inflation. For example, if your portfolio returns 10 percent and inflation is three percent, you have a seven percent gross return. Obviously however, any taxes must be deducted against this return.

Stock value and return

The primary reason that investors consider stock is the capital appreciation due to the capabilities of management of the company, the economics of the industry and the general economic overall. In addition, and not to be dismissed, is the amount of dividends paid by the company. As stated, dividends must be voted upon by the Board of Directors and are not guaranteed. However, there are many companies that almost always try to pay dividends. These are normally paid on a quarterly basis.

In measuring the amount of return from this type of an investment, the issue of both dividends and appreciation must be considered. This is call the total return on the investment.

For example, let's consider the purchase of a stock one year ago for 15 dollars share. During that year it paid 50 cents per share in dividends. Additionally, at the end of the year, the share had increased to 18 dollars per share. Therefore, your total return on the investment was the 50 cents of dividends and the $3.00 of capital appreciation or $3.50. To determine your total return, you divide this amount by your original investment-in this case the $15.00. That amounts to a 23.33% return for that year. However, that does not mean that you'll be taxed on this increase this year. In a standard account, you are taxed only on any value received. In this case, the only monies received during the year, was the $.50 of dividends. You will pay ordinary income tax on dividends. The $3.00 of appreciation will not be taxed since we'll assume you did not sell the share(s). You would also be taxed on the additional $3.00 increase if you had sold the shares at the end of the year (we are excluding tax deferred accounts for this exercise). Assuming you still retained the shares at the end of the year, the gain is simply known as unrealized appreciation.

Capital gains and losses

If however the stock was sold, the three dollars above the original price is considered a short term capital gain if the stock was held less than one year or long-term capital gain if held one year or longer (various tax rates apply depending on the time the assets are held).

Basic risks involved with stocks

Market risk-the risk that the price of a stock will be lower when you sell it than when your purchased it. The stock market is volatile. The stock you purchase today for thirty dollars could be worth less tomorrow.

Financial risk-the risk that the company may not be financially stable. The company may take on too much debt, lose sales, face increased competition from abroad and a host of other problems. Such factors would almost undoubtedly cause the stock to drop in value.

Social risk-the risk that the stock may be out of favor with the market because of social concerns by the public. Such problems could include those companies their cause environmental pollution, provide tobacco products, unsound drugs and so forth.

Industry risk-the risk of a decline in a specific industry as a whole. A specific industry is a group of companies that produces same category of products and/or services. Examples of these industries would include the automobile, hotel, utility, health care and computer industries.