How do stocks work?
From building wealth to planning for the future, stocks can play a role in many financial strategies. Understanding how stocks work is the first step in using them to reach your goals.
What are stocks?
A stock is fractional ownership of a company. When you buy stock, you become part owner of the business, along with all the other shareholders.
When a privately held company needs money for expansion or operations, it has several options. It can borrow the money, but that involves taking on debt and paying it back with interest. Or it can issue shares on a stock exchange or in the private markets.
By selling stock, the company gets the funding it needs. By buying stock, shareholders may get a say in how the company runs and own a piece of all future cash flows from the business.
Often, when you own common stock in a business, you get a say in major decisions. For example, you can vote on who sits on the board of directors and whether the company should take part in a merger.
Stocks are bought and sold on a stock exchange such as the New York Stock Exchange (NYSE) and in the private market, where individual and institutional investors can negotiate purchases and sales of company ownership. The “stock market” includes stock exchanges and marketplaces where other investments are traded.
Why do stock prices fluctuate so much?
If you’ve ever watched financial reports, you might have noticed stock prices can rise and fall dramatically, even in a single day. That’s because stock exchanges work a lot like an auction.
When demand for a company’s stock is high but the number of available shares is low, the price goes up. When stockholders sell off a lot of shares, the exchange is flooded with more supply than demand. That causes the price to fall. In the long run, however, the performance of a company’s shares relates to the individual performance of the company. If the company can grow its sales and bottom line, the stock price will typically rise.
Several things can fuel demand:
- What’s happening in the company. When a company launches a popular new product, investors may want a piece of the pie. Demand rises and the stock price goes up. If a business is rocked by scandal, investors may distance themselves. They sell their shares, and the stock price falls.
- What’s happening in the industry. In 2020, a surge in online meetings because of COVID-19 drove up the price of Zoom stock by about 700%1. The same year, shelter-in-place orders dropped demand for gasoline, driving the price of ExxonMobil stock down 42%2.
- What’s happening in the world. Wars, interest rate hikes and natural disasters are a few of the global events that may impact stock prices.
- Economic conditions. General economic fluctuation maintains influence on the demand (sales) and expenses for companies, ultimately influencing the trend in profits— a strong driver of stock price performance over time.
2 From " Should You Invest in Exxon Mobil Stock After It’s Been Cancelled?" Yahoo, Sept. 2, 2020
How do you make money from stocks?
The reason to buy shares in a company is so you can profit from that company’s performance. There are two ways your shares can make you money.
Capital gains are the profits you make from price appreciation. Ideally, your stock will go up in value while you own it, allowing you to sell it for more than you paid.
Some companies pay out dividends. A dividend is a share of the company’s profits. Essentially, a company sets aside a portion of its cashflow and divides it up among the shareholders.
Companies aren’t required to pay dividends. Some do and some don’t. And even if a company has paid out dividends in the past, there is no guarantee it will keep doing so.
Expect to pay taxes on your investment income, no matter which form it takes. A lot of factors go into determining the tax rate on capital gains; for most people, it will be 15% or less. Dividends are taxed at your normal income tax rate.
Buy low, sell high
Maybe you’ve read about some stock market whiz kid who made millions overnight. While it is possible to buy low-priced stock and quickly sell it at a profit, it doesn’t happen often. We think the market is generally efficient and correctly prices stocks as new information about a company comes to light. Therefore, a long-term outlook and holding your stock for a long period of time is generally a better strategy to generate returns than “day-trading,” in our view.
Your Edward Jones advisor will help you build a big-picture plan. We focus on long-term investments in companies with a solid track record, strong financial health, and management depth.
We invest systematically, growing the value of your stock portfolio over time. If you don’t need the income from your stock dividends immediately, we’ll help you use it to buy new investments.
Who should invest in stocks?
Stocks have the potential for appreciation, which historically has produced higher average returns relative to lower-risk investments such as bonds or cash, so stocks are generally considered a good investment. But they’re not right for everyone.
Remember that stock prices can fluctuate drastically from day to day. Stocks are most appropriate for investors who seek higher returns and have the tolerance for short-term losses.
If you’re uncomfortable with the idea of your investments losing value, even temporarily, you could be more comfortable investing in lower-risk alternatives like cash and bonds.
As a rule of thumb, the longer your investment timeline, the more risk you can afford to take. For example, let’s imagine a 25-year-old and a 55-year-old are both saving for retirement. The younger investor, or someone with a longer investment horizon, can afford to devote a greater percentage of their portfolio to stock. They have time to make up any short-term losses. For the older investor, or one with a shorter time horizon, it may be appropriate to have some money in stocks. But a lower tolerance for risk may make it more appropriate for them to allocate a larger portion of their portfolio toward investments that hold a steadier value.
How to buy stocks
You can buy or sell stocks by opening a brokerage account through a financial services firm. Your financial advisor can help you get started.
How do I know which stocks to buy?
Buying stocks is the easy part. Knowing which stocks to buy—and how to manage them—is more complicated.
Picking stocks is not a magic trick or a lucky break. Understanding what you are investing in—and the kind of return you can expect—takes research and analytical skill. That’s why many investors turn to financial advisors for help. We have deep expertise and experience in the market. Our knowledge can help guide you to make good picks.
You also need to consider how each stock fits into your portfolio. All your investments work together to move you toward your financial goals.
Most investors apply one or more of these investment strategies:
- Value investing. Value investors pick stocks that are trading for less than their intrinsic value and typically focus on stocks with lower valuations. These investors are focused on long-term capital gains. To take this approach, you need a deep understanding of the companies and markets in which you’re investing.
- Growth investing. Growth investors pick young or small companies on the cusp of a major expansion. This is a risky strategy that requires a lot of confidence. You’ll have to keep one eye on your stock picks and another on changes in the marketplace.
- Momentum investing. Momentum investors ride the waves of market trends. For example, if the market is rising, momentum investors will buy stock, and if the market is falling, investors will sell.
- Income investing. The goal of this strategy is to bring in a steady income from dividends. The portfolios of these investors most often focus on large companies with a long history of paying dividends.
How to manage a stock portfolio
Managing your portfolio is all about your goals and your timeline. What are you trying to achieve, and how long do you have to do it?
You’ll often hear financial experts talk about the importance of diversification. This means buying more than one stock, so your risk is spread across multiple industries, geographic regions and market styles. This can help limit losses in your portfolio from the downside in any one industry or sector. There are two important ways to diversify your portfolio.
The first is diversifying your stock picks. When one of your stocks performs well, you’ll naturally want to buy more just like it. But going too heavily into one company or even one sector can dramatically increase your risk. A sudden dip in that industry can be a blow to your entire portfolio.
The second way to diversify your portfolio is to diversify your investments. Your portfolio should balance stocks with other investments, like bonds or real estate. A well-balanced portfolio includes a variety of investment vehicles that rise and fall at different times. This can help keep your overall performance steady.
Each stock is just one piece in the engine driving to your goals. Your Edward Jones advisor can help you identify not just what to buy, but when to buy and sell. We have the expertise to see the big picture. We’ll make sure everything in your portfolio works together. Diversification does not guarantee a profit or protect against loss in declining markets. Investing in equities involves risks. The value of your shares will fluctuate, and you may lose principal.
Common mistakes when investing in stocks
When investing in stocks, avoid these common mistakes:
- Trading too often. Trading stocks through an online platform can feel like a game. It’s so easy, new investors often fall into the trap of trading daily. Remember, you generally get the best return from stocks over the long term. When you buy and sell frequently, your profits can get eaten up by taxes, fees and commissions.
- Emotional investing. Investment decisions should be made in the context of your goals, not in the context of an exciting day on Wall Street. Every day, we see stocks soar when emotional investors get excited. And we see them plummet when those same investors panic. Success comes from keeping a cool head in hot moments.
Are you ready to invest?
The stock market can seem intimidating. But stocks are just one more tool to move you closer to your financial goals. You don’t have to go on your investment journey alone. Wherever you are, there’s an Edward Jones advisor right down the street. You can schedule a free initial meeting to talk about your goals and learn about ways we can help you. Connect with us today.