Stock Investments

What is a stock investment?  Simply defined, a share of stock represents a share of ownership in a publicly-traded company.  According to the Investment Company Institute, the national trade association representing investment companies, 36% of U.S. households owned stock during 2008, making them one of the most common investments made by Americans.

Classes of Stock

There are two primary classes of stock investments, preferred and common stock.  While there are few hard and fast rules that apply to all preferred or all common shares, here are some of the basics:

• If you own preferred stock, you will usually be paid a dividend before holders of common stock are paid.  Preferred stockholders also get paid before common stockholders in the event of a bankruptcy.  Preferred stock can also carry other privileges, such as the right to vote on certain company decisions.  While a preferred share price doesn't usually change with the stock market, it's value can go up or down depending on interest rates.

• Common stock, on the other hand, while much more prevalent than preferred stock, is lower in the pecking order.  It is last to get dividends and can lose all its value in the event of a bankruptcy.  A perfect example is General Motors, whose common shares became worthless when the company went belly-up.  Shares of common stock can earn dividends, but preferred stockholders get their dividend money first.  The value of a share of common stock goes up and down with the stock market.

The Rewards

There are two primary ways a stock investment earns you a return:  An increase in the share price and the payment of dividends. 

• Conventional wisdom holds that stock investments will, over the long haul, yield returns in the area of 10% per year, while other investments such as real estate or bonds will have returns over the same time frame of 5% to 7%.  Generally, the longer you hold common stock, the more it will increase in value.  But day-to-day, the price of common stock can swing up and down wildly.

• Some companies pay a dividend (a share of the company's earnings) to owners of their stocks. Preferred stock normally earns a predetermined dividend, while common stock earns a dividend when the board of directors declares one. 

The Risks

This part is simple.  There is never a guarantee that a stock will go up in price.  And there is absolutely no way to know which stocks will go up in price and which will go down.  It is always possible for you to lose everything you have invested in a particular stock.  Who would have predicted, even five years ago, that General Motors, once the largest automaker in the world and one of the most commonly owned stocks, would go bankrupt? 

Uncle Sam Gets His Share

Also keep in mind that you have to pay taxes on dividends.  And, if you sell your shares of stock for more than you paid, you will also have to pay a capital gains tax.

How To Buy Stock

Most stock is purchased through stockbrokers.  A stockbroker is a specially trained and licensed professional who has the ability to buy and sell stocks on your behalf.  In addition to doing the actual buying and selling, brokers often provide other services:

• Investment advice, suggestions and recommendations
• Market research – many brokers have staffs of analysts who do nothing but follow the markets and suggest which stocks they think will go up or go down in price
• Financing – some brokers will --  after credit approval -- finance your stock purchases
• Record-keeping – a broker should keep detailed records of everything you buy and sell, information that will be critical when you pay taxes and to track your profits (or losses).

In exchange for these services, brokers charge a commission or fee, typically for each transaction.  But the advent of the Internet has increased competition and driven down prices considerably.

You can also buy some stocks directly from many companies in what is called a DRIP – a Dividend Re-Investment Plan, in which you complete the purchase through a bank or other institution, which then holds the stock in your name.

In Summary

Stocks can provide a higher return than other forms of investment, but they are not without risk.  Work with a professional to determine what types of stock investments are best for you, based on your own personal financial circumstances and your tolerance of risk.