FinEdFriday: What Are Stocks?

Over the next several FinEdFriday’s, we are going to be addressing some common financial questions from the ground up, using the simplest terminology, so that everyone can share an understanding of the basics.  Whether you are just learning for the first time, or using these posts as a refresher, we hope we can set the record straight on some of the most commonly used terms in the finance industry.

A stock is a slice of ownership you can buy in a company.

That’s it. 

Oh, you want more…

You probably hear it all the time, either from friends, family, or on the news...“I invest in stocks.” Or maybe, “the stock market crashed today.” Let’s uncover what these people are talking about:

As stated previously, a stock is a slice (or share) of ownership you can buy in a specific company. You can buy these shares on stock exchanges. Think the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations (NASDAQ). To do this you use a broker (an intermediary).

Companies offer these shares of ownership to raise money. Why would you buy into their shares of ownership?  Two reasons: 

You want to take part in their success, possibly gaining the right to vote as a shareholder. 

And/or they offer extra add-ons, like a monthly variable or fixed dividend payment, that you get to take as income or reinvest.

2 Types of Stock:

Common Stock

Just as the name suggests, this is the most common type of stock. You get to share in the company’s success (or failure), while receiving the right to vote as a shareholder. Some common stock pays a dividend, but it is most likely variable and there is no guarantee behind them. People usually buy common stocks for their growth potential.

Preferred Stock

When you purchase preferred stock, your dividend is most likely fixed, and you are paid before common stockholders regardless of what is happening with the company. However, most of the time you will not have the right to vote. People usually buy preferred stocks for their income-producing potential.

*There is a third type, called convertible preferred stock, but that is another lesson for another day.    

Categories of Stock:

Geography

There are companies inside the U.S. and outside the U.S., which you can imagine function very different from one another.

Examples:  Dollar General – US based stock, Alibaba – China based stock

Sector

Companies vary by their industry.  Stocks that are in the same sector may be correlated (move in a similar direction together).

Examples: Technology Sector, Energy Sector

Company Size

Every company has a different size, or market capitalization (the value of the company). There are generally 3 sizes of companies:

Small-Capitalization – valued between $300 Million and $2 Billion

Mid-Capitalization – valued between $2 Billion and $10 Billion 

Large-Capitalization – valued above $10 billion

Style

Every company is poised for a specific strategy. Some companies are geared to grow as fast as possible. These are called Growth Stocks. Some companies are deemed to be underpriced either because no one is paying attention to them, or because they just suffered a decline of some sort. These are called Value Stocks.

So, you put all of that together and you can see why someone might say:

“30% of my portfolio is made up of Large Cap Domestic Growth Stocks, spread over several different sectors.”  

What everyone wants to know: How do you make money on a stock?

Well, if the stock is paying a dividend, you may get a monthly check or credit to your account. But more often than not, people make money from stocks by SELLING them. If you buy a stock, and the value of that stock rises but you have not sold it yet, you have not actually gained any money. 

The opposite is true too. If you buy a stock, and the value of that stock falls, if you have not sold the stock, you have not actually lost any money. This is why it is so important that you think through why and when you are selling a stock. Everyone is concerned about when to BUY, but they wait until they are emotionally compromised to decide when to SELL. Hence why professional portfolio managers (PM’s) already have a strategy for buying and selling before they ever buy something.

When you sell a stock for a gain, you profit the difference between original buying price and selling price.  

TAXES

If you bought a stock in a taxable investment account, and then you sell it at a higher price than what you paid for it, you will have to pay Capital Gains Tax on that profit. This is different than Ordinary Income Tax.  There are two types of capital gains taxes: Long-Term and Short-Term.

If you held the stock for less than a year, you pay short-term capital gains taxes on the amount of gain. These can be higher than long-term capital gains taxes.

If you held the stock for more than a year, you pay long-term capital gains taxes on the amount of gain. These can be lower than short-term capital gains taxes.

If you sell a stock for a loss (either short-term or long-term), they can offset the gains you may have realized from another stock, bringing your capital gains tax liability down. And you can even use up to $3,000 of net losses to deduct from your ordinary income taxes.   

That is enough for now. Next FinEdFriday we will talk about Bonds, followed by Mutual Funds, and ETF’s. If you would like us to cover a specific term, just let us know and we will add it to the list!    

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Mid-capitalization companies are subject to higher volatility than those of large-capitalized companies.

The prices of small and mid-cap stocks are generally more volatile than large cap stocks.

Because of their narrow focus, investments concentrated in certain sectors or industries will be subject to greater volatility and specific risks compared with investing more broadly across many sectors, industries, and companies.