Let’s face it: Investing can seem intimidating. All the numbers, charts, jargon and acronyms—it’s enough to make any casual observer dizzy.
But there are serious consequences to being so scared of getting your feet wet that you stay out of the game entirely. “If you do not invest, you are risking your future financial security,” says Certified Financial Planner Stacy Francis, CEO of New York-based Francis Financial.
That could mean the difference between retiring one day on your own terms or having to work throughout your golden years, paying for your kids’ college tuition or having them take out student loans, affording the life you want or always playing catchup.
The good news is that it isn’t as hard as you think to get started investing. Let’s brush up on the basics of stocks, one of the fundamental aspects of investing: what they are, how they get their value and how people use them to grow their wealth.
What is a stock?
When you purchase a stock, you’re purchasing a fraction of the overall value of a company that represents a proportional piece of ownership. Certified Financial Planner Vid Ponnapalli, founder of Holmdel, N.J.-based Unique Financial Advisors, puts it this way: “A stock is nothing but [a share in] a company.”
Because your share is inherently tied to the rest of the company’s shares and the company’s performance, the value of your share goes up and down with the company’s financial well-being—or, rather, with investors’ perception of that company’s well-being. So your stock has the chance to either give you returns or losses depending on how the company performs over time.
Why do companies go public and sell stock?
Going public is one way for a private company to raise money and expand its business. The process is usually launched with an initial public offering, or IPO. An IPO is when a company issues shares to the public through the stock market for the first time. New shareholders then own a stake of the business, and the company (hopefully) gets an influx of cash to (hopefully) grow.
How does a company decide how many shares to sell?
Before the IPO, a company enlists the help of an investment bank to help determine its value, using a lot of assessment techniques and formulas to consider historic and projected revenues, profits and costs, as well as potential plans for new products, whether marketing can drum up more interest in the company and how similar companies are valued.
After that, the bank will advise the company’s board about how many shares to sell. Then the board makes the final decision. Typically, owners want to keep more than half of the shares to maintain control.
Who decides a company’s stock price when it first goes public?
You do—kind of. The investment bank can calculate an appropriate price given the number of shares it recommends. But part of the valuation process is determining public demand for a company’s IPO.
If demand for the stock is high—i.e. if you, your friends and everyone else are in love with a company’s products or services—the price of the stock may also be high. If demand is low, the price will follow suit, and the company may even hold off on going public.
What should you look for when deciding whether a stock is a good buy?
For most people, buying individual stocks isn’t a good idea. “People often choose stocks by what their friends recommend, what stock is ‘hot’ or what is currently going on in the market, which is the opposite of what you should do,” says Oklahoma-based Certified Financial Planner Shanda Sullivan. “You make emotional decisions rather than rational ones.” Instead, she recommends mitigating your risk down by sticking with low-cost index funds, target-date funds or ETFs (a.k.a. exchange-traded funds like those you can invest in with Acorns, which can include shares from many different companies to help minimize risk).
Why does the stock market fluctuate so much every day?
Ups and downs are totally normal. A lot of factors can influence fluctuations—from oil prices to economic reports to the weather. The best thing you can do as an investor is to ignore it and focus on the big picture of reaching your goals.
Okay, but how can you tell the difference between regular market fluctuations and a serious problem with a stock?
Comparing stock performance to an appropriate benchmark is a good way to gauge how it’s doing. For example, on a day when Standard & Poor’s 500-stock index drops, a drop in the price of a large-company stock you own can be expected.
But remember: “When you start investing, you are not investing for daily movements,” says Ponnapalli. “All people who invest in the stock market should do it for the long term.”
How do you know how long to hold onto your stocks?
Ideally, you’ll keep them until you need the money, and your decision will have little to do with what’s been happening with the stock on a daily basis.
But if you’re concerned about holding onto a stock whose price is sinking, Ponnapalli says to go back to square one. “The decision-making [process] is exactly like when you’re buying a stock,” he says, recommending you focus on whether the company is making a profit and how the leadership is running it. “After your analysis, if you still believe that the fundamentals you liked when you bought the stock are the same, you don’t have to sell.”
In fact, when the price is down, it might be a good time to buy more at a discount, he says.
What are dividends, and why do some companies have them while others don’t?
Dividends are periodic payouts of earnings that companies give to certain shareholders. Most companies that pay them are big and stable—and they can afford to spread the wealth. In fact, a steady history of paying dividends indicates to investors that a company is financially healthy, making it a good way for companies to attract more investors.
That’s not to say that companies that don’t pay dividends can’t be financially healthy or attractive. They may be using their earnings to expand their businesses or reinvest in the company in other ways. That’s why most startups or other companies aiming for speedy growth don’t pay dividends.
What’s the difference between the NYSE, Nasdaq and the Chicago Mercantile Exchange?
The New York Stock Exchange (NYSE) and Nasdaq are the two main U.S. stock exchanges. When you picture a mass of investors on the exchange floor shouting out trades and waving pieces of paper in the air, that’s typically the NYSE. The Nasdaq, on the other hand, operates electronically with no physical trading floor.
The Chicago Mercantile Exchange is the largest exchange in the U.S. for futures. Futures are agreements to buy or sell an asset like a commodity (which is a basic good, such as orange juice, oil or gold) or a financial instrument like interest rates at a set price on some future date.
Why would a company buy some of its stock back? How does that affect my shares?
A buyback, like a dividend, is another way a company can spread the wealth and return excess cash to shareholders. Isn’t that nice of them? But hold on— it’s not simply an act of generosity.
Typically, this move will push up share prices because it decreases the amount of outstanding shares in the market. So, in a best-case scenario, a company might buy back its stock because it feels the market has undervalued its worth and wants to give itself a boost. But it might also use the strategy to goose its numbers and give the appearance of being worth more than it is.
What’s a “stock split”?
When a company splits its stock, it’s dividing its outstanding shares into more outstanding shares. Since the actual value of the company doesn’t change, the share prices drop. For example, if a company’s stock is priced at $100 a share, and the company executes a 2-for-1 stock split, the number of outstanding shares doubles and the stock price drops to $50 a share. For every one share you owned, now you’ll own two. (But, of course, each share will be worth less.)
A company might do this to make its stock accessible to more investors. (Presumably, more people would be able to afford that $50 stock price than $100.) And if more people buy it at the cheaper price, the stock will soar even higher.
Is it safer to buy a company’s stock or bonds?
A company’s stock price has the potential to increase significantly. But it can also go down. When you buy a company’s bonds, you’re essentially giving it a loan, and it’s promising to pay you back with interest. Unless the company goes belly up, you’re making a relatively safe bet you’ll get your money back and then some.
Of course, some bonds are riskier than others. You can check out ratings from Moody’s (which rates the riskiest entities as C and the least risky bets as Aaa) and Standard & Poor’s (D to AAA) to get an idea of how risky a company’s bonds are.
What’s the difference between buying an exchange-traded fund and a mutual fund?
Because most ETFs track indexes, and are therefore more passively run, they tend to charge lower fees than mutual funds. The former are also traded like common stocks at varying prices throughout the day. Conversely, shares of mutual funds are priced based on their net asset value (NAV) once at the end of the trading day. (That’s calculated by dividing the total value of all the securities in the fund, based on the closing prices that trading day—minus any debts or obligations the fund has—by the total number of shares outstanding).
Why would someone invest in a fund instead of buying individual stocks?
“Single-stock investing is risky and does not provide diversification,” says Ponnapalli. In other words: If you invest all your money in one stock, and it goes down, you can lose a lot of money (assuming it doesn’t go back up before you need to sell). And putting together a well-diversified portfolio of individual stocks requires a lot of homework.
On the other hand, if you invest in a stock mutual fund or an ETF, the fund managers are doing most of the hard work for you. They can put together a portfolio of possibly hundreds of different stocks, allowing you broad diversification with just one investment.
Target-date funds, on the other hand, are designed to be the only fund you ever have to own. You simply choose the year in which you expect to reach your financial goal—usually it’s your retirement year—and the fund’s managers build a portfolio to suit your time horizon, adjusting it when necessary as the deadline approaches.
“[They’re] the little black dress of the investing world,” says Francis. “The only thing an investor needs to do is to choose the right risk tolerance, then let the fund go to work.”
How much tax do I pay on money I make from selling stocks? What if I lose money?
First off, Ponnapalli says it’s important to remember that the tax hit for stocks only comes when you sell; if you’re holding a stock, you don’t have to worry about taxes.
You will, however, be taxed on dividends paid out on stocks you own. The good news is that qualified dividends (which include many paid on corporate stocks) are taxed at long-term capital gains rates, which are lower than ordinary income tax rates, as long as you hold onto the stock for a specified period of time after the dividend is issued.
When you are ready to sell a stock, understand that if the stock price has gone up since you bought it, you may owe Uncle Sam capital gains taxes. If you owned the stock for less than a year, the tax rate is higher than if you had held it longer. But if you own another stock that has gone down, you can sell it and use that loss to offset your gains. “A little tax planning comes in here,” says Ponnapalli.
For example, if you bought one share of Stock A for $10 and want to sell it at $50, you’d owe taxes on that $40 gain. If you also own one share of Stock B, which you bought for $50 and is now priced at $10, you could sell it in the same year and deduct your $40 loss to wipe away your $40 gain from Stock A on your tax bill. One catch: Once you take the tax benefit of the loss, you cannot buy that stock or a similar one again for 30 days.
Of course, if you’re investing within a 401(k), individual retirement account or similar tax-advantaged plan, this is all moot. You won’t be taxed on gains, and you can’t deduct losses. (Just remember, you can buy and sell holdings in those retirement accounts, but if you actually withdraw money before you turn 59 ½, you may have to pay penalties as well as taxes.)
* Investing involves risk including loss of principal. The forgoing is presented for informational purposes only and is not a recommendation to buy or sell a specific security or invest in a particular strategy.