What to Know About Stocks Before Investing

We continue our series on facing your investing fears. Is a lack of knowledge holding you back from investing in stocks? Here's what you need to know about stocks before investing.

What are stocks?

Companies sell shares of stock to investors as a way to raise money to finance growth, pay off debt, and fund operations. Each share of stock represents a share of ownership in the company. As a shareholder, you share in a portion of any profits and growth of the company. The company pays dividends from earnings to stockholders, and growth is realized by the increase in the stock's value. 

Why should people invest in stocks?

The main reason that investors buy stock is to see an increase in the value of their investment through capital appreciation. Although past performance does not guarantee future results, stocks have historically provided a higher average annual rate of return over long periods than other investments. This includes bonds and cash alternatives. Keep in mind, though, that stocks are generally considered to have more volatility than bonds or cash alternatives.

When you invest in stocks, can you lose money?

Yes, you can lose money when you invest in stocks. Numerous factors can affect the value of your shares:

  • Actions of other investors: If there is a widespread belief amongst investors that the nation is entering a recession, their actions can change the direction of the stock market
  • Business conditions: A pending merger, new patent, an increase in profits, or litigation can affect share prices
  • Economy: Various economic factors such as employment, inflation, inventory, and consumer spending all influence the potential profit of a company and its stock price
  • Government policy: Tax policy, trade policy, and decisions on taxes impact stock prices
  • Global economy: Changes in foreign exchange rates, tariffs, or diplomatic relations can cause stocks to go up or down

All investing involves risks. There can be no assurance that any investing strategy will be successful. Still, understanding the various factors that impact share prices can help you make sound decisions and keep losses to a minimum.

Stocks are often categorized in the following ways:

Growth stocks

These stocks have earnings that are growing at a faster rate than the market average. These are usually in new or fast-growing industries and have the potential to give shareholders returns higher than those offered by the stocks of companies in older, more established industries. Growth stocks are more volatile than other types of stock, however, and can be just as likely to go down in price.

Value stocks

The value category includes shares of companies with good earnings and growth potential that are currently selling at a low price relative to their intrinsic value. Due to some problems that may be only temporary, investors are ignoring these stocks. Since it can take quite some time for their actual value to be reflected by their price, value stocks are usually purchased for the long term.

Income stocks

Income stocks typically pay steady dividends. They are generally not expected to appreciate significantly in share price. Utilities are an example of companies that have historically been considered income-oriented.

Blue-chip stocks

Blue-chip stocks are the stocks of large, well-known companies with excellent reputations and reliable records of profit growth. They also generally pay dividends.

Penny stocks

Penny stocks are the most volatile of the stocks we're discussing. They are very risky speculative stocks issued by companies with short or erratic performance histories. They're called penny stocks because they sell for under $5 per share.

Bottom line

It's usually best to diversify among the different categories and not concentrate your ownership in just one or two companies or industries. Remember, though, that diversification alone cannot guarantee a profit or ensure against a loss.

How do you buy and sell stocks?

Stock is generally purchased through a brokerage account. The buy order you place will be directed to the appropriate stock exchange. When someone who owns the stock is willing to sell at the price you are ready to pay, the sale takes place. A commission or fee is charged on your transaction.

Stock certificates can be transferred from one owner to another. The documents are issued in the buyer's name or held by the brokerage house in street name (i.e., the brokerage firm's name) on behalf of the investor. The advantage of a street-name registration is that if you decide to sell, you don't have to sign and deliver the stock certificates before the sale can be completed. You also don't have to worry about losing the stock certificates.

Who will make the investment decisions? You will — unless you give discretionary power to your broker or agent. Discretionary power allows a broker or agent to make decisions based on what she believes is best for you.

How do you set up a brokerage account?

You will need to complete a new account agreement. Make sure to read the account agreement. Never sign a document without fully understanding it. Early precautions can prevent later misunderstandings.

Keep good records of:

  • Documents you sign
  • Documents outlining the details of an account or investment
  • Periodic account statements
  • Transaction confirmations
  • Documents verifying an account error was corrected
  • Correspondence with your broker or agent

Review these as soon as you receive them. Discuss any discrepancies you find with your advisor at once, and follow up on any actions taken until you are satisfied. 

Be patient

Keep in mind that buy stock is an investment. Some stock investors have made money quickly, but they are the exception rather than the rule. Investing in stocks requires a long-term outlook. 

Other related posts in our series about facing your investment fears:

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