Stocks

Stocks serve as an important foundation for long term investing, as well as presenting a useful tool for shorter term capital accumulation through trading. The shorter the time frame with stocks, the higher the risk and the more skill needed. Even long-term stock market investing requires quite a bit of skill and understanding.

The Two Main Types of Stock

Stocks are a type of investment where one buys shares in a corporation. In a way, you are buying a part of the company who initially issued the shares, which gets you a piece of their profits, often involves voting rights at shareholders meetings, and potentially gives you a claim on their assets should they go out of business and need to liquidate.

Companies often distribute their profits by way of dividends, paying a certain amount per share to their shareholders, and this is one of the ways that investors make money holding stock. The other way is by capital appreciation, seeing the value of the stock go up over time, where it may be sold at a profit later.

There are two main classifications of stocks, common stock and preferred stock. Common stock is by far the most traded of the two, and traded here means seeing the stock change hands on secondary markets, such as a stock exchange. Stock exchanges bring together parties who wish to buy and sell stocks and facilitate these transactions, as well as providing regulatory oversight, to look to reduce the risk of investors.

Preferred stock is also traded, although it tends to be bought more by larger, institutional investors, and also tends to be held more and therefore traded less than common stock. Preferred stock typically does not convey voting rights, but it is given preferential treatment when dividends are paid, as well as when the assets of companies are dissolved, thus the name preferred.

StocksThe lack of voting rights should not concern individual investors, as unless one owns a huge number of shares, like a fund may, or someone like Warren Buffett for instance, one really doesn’t have any meaningful influence over the company, and individual investors vote instead with their feet, by buying or selling the stock according to their wishes.

Preferred shares do have the advantage of providing more reliable income though, if that happens to be a big part of one’s stock buying strategy. They also tend to be considerably less volatile than common stock, behaving more similar to bonds than stocks actually, where the traded price does go up and down but not as much as you see with common stock, due to their being less speculative.

This is because the main objective of common stock is speculating that the price of the stock will rise, and this can lead to a bandwagon effect, with people jumping on more as the speculation of a price increase rises, as well as selling more as people speculate that the price will go down.

So the performance of a common stock can itself drive the price in either direction, and much of the pricing of stocks is driven this way, especially in the shorter term. Ultimately, dividends do influence stock prices as well, but only to the extent that this affects supply and demand, which ultimately influences the pricing of common stock completely.

Preferred stock, on the other hand, is primarily driven by the income they generate, because this is the main reason people purchase this type of stock. Preferred stockholders get paid out their dividends before common stockholders do, and if there is not sufficient profit to pay this expected dividend to preferred shareholders, it often is kept on account and paid in arrears later.

With common stock, dividend disbursements are more like a bonus, even though some stocks pay out dividends quite reliably. For the most part though people hold them with the expectation of capital appreciation, that the demand for them will increase, and over the long term this has proven to be the case with common stock generally.

The Importance of Time Horizon In A Stock Investment Strategy

So most individual investors are going to be seeking out long term increases in the price of the stock held, with the expectation of selling it later. One’s time horizon is extremely important though and must be properly accounted for.

Due to the typical volatility of stocks, the longer that a stock is held, the less risky it becomes, because time serves to flatten out this short term volatility provided a stock ends up being a solid investment over time.

Put another way, the longer the time horizon, the more relevant a company’s business results will be, and companies tend to appreciate in value over time generally. This is not always the case though of course and it’s not just a matter of buying and holding just any stock, one must still be quite selective in the stocks one chooses to look to maximize their investment.

This does not mean that one requires a long time horizon to invest in stocks, and that one should always seek to hold stocks over the long term to minimize risk and realize the long term gains that we often see here. However in many cases, for many investors, this will be the wise choice.

Paradoxically, risk can also be limited through very short term holding of stock as well, which is classified as trading and not investing in stock, although trading is still an investment of sorts, but one of a shorter and often much shorter duration.

The extreme version of this is with the computerized trading that we’re seeing a lot more of in the market these days, where trades often only last a few seconds, being executed by computer programs. This limits the risk per trade to extreme degrees, one can only lose a tiny amount for instance with trades like this.

However, this will only work when one’s strategy is sound, and this applies to all forms of trading. It can be quite sound though, and there are a lot of private investors who trade successfully, as well as institutions who have huge teams of traders on hand who do this all day. Trading successfully over time does require quite a bit of skill though.

So time horizons differ greatly when it comes to buying and selling stock, and individual investors may plan on holding a stock from anywhere from a few minutes to a lifetime, perhaps never planning on selling. A lot of this depends on what your objectives are, whether you are looking to make a quick buck for instance, or are looking to build up your portfolio over several decades, with minimal involvement.

Stock Investing Strategies

You do need to be sure that your time horizon matches your objectives though, and this is the first thing a financial advisor will look to determine, because otherwise you may be exposing yourself to excessive risk.

The longer your time horizon, the more appealing stock investing becomes generally, and this is because as time goes on, stock investments are less risky and more reliable. The ups and downs of stocks that you often see don’t even matter much provided the strategy is not to sell it for a long while.

A lot of people tend to value their portfolios by the present value of what it would trade at, in other words if you sold it now, but that’s not a particularly good way to value these things and can lead to confusion and mistakes.

If someone was only planning on investing for a couple of years, putting all their money into the stock market would not typically be a good idea, because the risk of having to sell at a loss at the end of this period would be unacceptably high, and they would usually be better served going with a less volatile form of investment, with a smaller potential for returns but with less risk of loss.

However, if one intends to keep the stock for a number of years, the fact that there would be a loss if sold at any given point in time may not even be significant. Since there is not an intention to sell now, the current price does not really matter, and it only matters when you sell actually.

However, we still want to monitor the performance of a long term stock holding, but we need to look to filter out the noise so to speak, the usual ups and downs that you very often see with stocks, especially the ups and downs of stock markets in general, to the extent that they influence things in the short term but even out more over the long term.

For this to even out though requires a longer time horizon, and if you have this strategy and tend to trade too much you can hurt yourself, like all the people who sell off during recessions, only to see the stocks come back when things improve. If anything, recessions are a time to buy, not sell, if you’re after a long term profit that is.

As a general rule, the longer you plan on holding something, the less skill plays a role, and vice versa. There is always skill involved though in investing, especially with stocks.

Many individual investors fancy themselves as more skilled than they actually are, and can get themselves into trouble if they allocate too much of their portfolio to speculation. Speculating can really be a learning experience as well as a lot of fun, and it can be plenty rewarding as well if you get it right, but one should not overly risk one’s assets on this, which is to a large degree dependent upon your level of skill.

For the most part, a lot of people don’t know how much they don’t know, and for those who wish to know more, we will be providing quite a bit of information for you on this site on how you can become better at investing in stocks, regardless of your appetite for risk and your time horizon.

Stocks FAQs

  • How do you buy stocks?
    Stocks are bought and sold through stock brokers. To buy stocks, you open an account with an accredited broker and make a deposit. You then can place orders with your broker to buy and sell stocks, where you will pay them a commission to conduct the transaction for you. Orders can either be placed over the phone, or more commonly these days, online.
  • What are the different types of stocks?
    There are two main categories of stocks, which are common stock and preferred stock. Common stock is the type that we normally associate with stocks, the ones that go up and down in value a lot, and the ones that the vast majority of stock transactions occur with. Preferred stock doesn’t move much in value and people invest in them for their dividends only.
  • How can I make money in the stock market?
    Making money in the stock market involves your investing money in a certain position and closing your position later at a profit. For most people this means buying stock at a certain price and selling it for a higher one, which is called going long a stock. You can also go short and make money if the price of your stock goes down.
  • How can I invest $100?
    $100 isn’t very much at all to invest in stocks, as they are almost always bought and sold in lots of 100 shares, and this would limit you to stocks under $1 per share. Odd lot trades are allowed though even though they come with higher trading costs, so you could just buy one share, but the commission involved would make this a lot more difficult to make a profit with.
  • How do I begin to invest in the stock market?
    Most people invest in the stock market without much of an idea about what they are doing although being more informed is certainly a good thing. If you are trying to pick your own stocks though, doing so without the proper knowledge is pretty challenging, so people generally will just buy indexes to simplify the matter by taking selection out of the equation.
  • How much should I invest in stocks?
    Whenever we invest in anything, we need to take risk into account, and stock investing does come with some significant risks. How much you should invest in stocks will depend a lot on how much risk that you can take with your money, in addition to how well you know how to manage your risks. You shouldn’t risk amounts that you cannot afford to lose though.
  • What is the tax rate on stock gains?
    Stock gains typically are treated as capital gains, although if you are a frequent enough trader this will be assessed as ordinary income. Those who hold on to their stock positions, as the great majority of stock investors do, will hold them plenty long enough typically to qualify for the lower tax rate that capital gains involve.
  • Do you pay taxes on dividends?
    In the United States, dividend income is provided preferential tax treatment as long as the dividends are qualified, which involves the dividend being paid out by a U.S. company and your holding the stock for a long enough period. How much tax you pay on qualified dividends depends on your tax bracket, ranging from 0% on the lowest two to 20% in the highest bracket.
  • How do beginners invest in stocks with little money?
    The best way for either beginners or those with little money to invest in stocks is to buy shares in either an index mutual fund or an index ETF. If you have little money, a mutual fund would be best, since ETFs involve paying commissions and require a certain size to justify this extra expense. There are many no-load index mutual funds that you can invest in though.
  • How can stock market risk be reduced?
    Whenever we invest in a stock, we do so with the positive expectation that its price will rise. The risk with stocks is that the price will go down instead, and the more of a loss that you are willing to take prior to selling, the more risk you take on. Setting your threshold of pain lower will lower your risk of losses. Reducing risk here means being out when things get riskier.
  • How do you develop a stock trading strategy?
    The best way to develop a good stock trading strategy is to observe the way that stock prices move and come up with ideas based upon this observation to trade upon. This does require actual practice though which is why simulated trading is so helpful. We want to look back at what would have worked more often than not and discover profitable patterns.
  • What are the best stocks to buy for beginners?
    Beginners should not be selecting their own stocks to trade or invest in, with real money at least. Once we have sufficiently demonstrated that we can help ourselves by choosing particular stocks, where we can beat the market in other words, then we may try this. Otherwise, it’s better to just simplify things and invest in stock indexes.
John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.