Fear of stock market volatility often holds investors back. However, historically, investing in stocks has been an important tool in building wealth and can serve as an important part of a diversified portfolio. Today we're exploring why investing in the stock market matters.
Related post: What to Know About Stocks Before Investing
A stock represents ownership in a company. Your portion of ownership will depend on how many shares you hold compared to the total number of shares issued by the company.
Investors who purchase stock are known as the company's stockholders or shareholders. The price of a stock reflects the public's level of interest in owning the shares. If a lot of investors want to buy shares, they bid against one another, increasing the price. If interest is low, there are fewer competing bids and the price of shares is likely to decline.
You may hold the stock in the form of a stock certificate, which identifies you as the owner and the number of shares you own. Alternatively, and more commonly nowadays, shares can be held in an account with a brokerage firm.
Your percentage of ownership in a company represents your share of the risks taken and profits generated by the company. If the company does well, your share of the earnings will be proportionate to how much of the company's stock you own. The reverse is also true. Your share of any loss will be similarly proportionate to your percentage of ownership. However, you are not personally financially responsible for any share of the liabilities In addition, depending on the company and the types of shares you have, stock ownership could carry other benefits. For example, you may be entitled to dividend payments, capital gains payouts, voting rights, and other corporate privileges.
From the standpoint of the company, issuing and selling stock enables it to raise funds needed to expand, conduct research, modernize, pay off creditors, and meet other corporate expenses. When you provide a company with capital by buying its stock, you acquire equity in that company. It's similar to the way in which equity in a home represents the portion that you own relative to the amount owed on the mortgage. Equity in a company represents your ownership stake. That's why stocks are sometimes referred to as equities.
Fear of investing has kept many on the sidelines, especially after the 2008-2009 recession. In fact, many investors never venture beyond the world of cash alternatives (e.g., bank accounts, CDs, and money market accounts). They take comfort in knowing that these investment vehicles provide relative safety coupled with liquidity that allows them to access their money easily if they need it.
While these investments may not be very volatile, they do hold a different type of risk. They generally yield minimal returns and may not even keep pace with inflation. That means that over time, the investor has less buying power. At some point, most investors want the potential for higher returns, which is where stocks enter the picture.
A variety of factors motivate people to invest in stocks. Many view stocks as an opportunity to accumulate wealth or to prevent inflation from eventually reducing their purchasing power. They generally take a long-term view, hoping their stocks will increase in value over time.
Investors may also be interested in income through the dividends that some stocks pay, which shareholders may accept in cash or (in some cases) reinvest in additional shares of the company. Dividends and any increases or drops in the stock's price combine to produce the stock's total return.
The thrill of playing the market may attract investors with a gambler mentality. They may trade actively, sometimes buying and selling the same issue within a few days or a few hours. These day traders try to take advantage of small, intra-day price movements in volatile stocks or indexes.
Investors who purchase stock hope to make money in one of two ways — through dividend payments and/or capital gains.
Some investors buy stocks because they seek regular income from dividends. Dividends represent distributions of corporate earnings to shareholders. The company's board of directors decides whether to distribute a dividend to shareholders; payment of a dividend is by no means mandatory. Dividends, if distributed, are usually paid out to investors in cash. Some companies allow investors to buy stock through an automatic dividend reinvestment plan.
Capital gains represent increases in stock prices. Investors looking for capital gains hope to buy a company's stock at a low price and sell it when the price has risen. Stock prices can increase for many reasons, including company profitability, a good economic environment, or rumors of a takeover. Conversely, stock prices may decline for many reasons, including weak earnings reports, poor management, lawsuits, faulty or out-of-date products, competition, bad publicity, or an overall weak economy. Prices also can be affected simply by the investment community's view of the stock market as a whole.
Capital gains from selling stock result in taxable income; however, such gains, if long term, will generally be taxed at a lower rate than ordinary income tax rates.
Other related posts in our series about facing your investment fears:
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