Stocks or shares represent a certain share of a company’s equity capital and the right to participate in the company’s profits. Return on investment for stocks depends on the dividend rate and market price changes of the stocks.
Although any company wants to earn profit and make the price of its stocks go up, it has no legal obligations to its stockholders to maintain the market price of the stocks on a certain level.
Likewise, a company is under no obligation to pay dividends — whether to do it or not is subject to decision by shareholders’ council depending on the company’s financial standing. Therefore stocks are a less predictable and a more risky instrument than fixed-income securities.
At the same time, unlike fixed-income securities whose yield potential is limited investments in stocks have a much greater profit earning capacity.
Why do companies issue shares?
Shares are issued to attract capital from investors for further development of business.
Companies can issue various types of stocks, but the basic ones are ordinary shares (common stock), which entitle the owner to a share of the corporation’s profit in form of dividends and a share of the voting power in shareholders’ meetings.
Why do investors buy shares?
In case of favourable trends stocks can offer great earning potential. For example, the Dow Jones index – one of the principal indicators of US stock market’s performance, which reflects the share values of largest US companies, went up 42.52% from the beginning of 1997 to the end of 1998.
This being said one has to bear in mind that during that period the world’s markets were twice hit by financial crisis (October 1997 and August 1998). The convincing performance of the stock market can be explained by a favourable economic situation in the USA, stable economic growth and low inflation.
Risks associated with investments in stocks
The main risk is the possibility that the price of your stocks may go down in comparison with the price you bought them at.
Stock prices can be strongly influenced by financial performance indicators, which determine the size of dividends and reflect the future prospects of the company or industry: change of top management and lots of other factors, which quite often come as a surprise to investors.
Besides, stock prices are much affected by economic climate. That is why stocks are the most unpredictable investment instrument. An investor can either gain a huge profit or suffer substantial loss within a certain period of time.
How to become a stockholder?
The easiest way is to buy stocks on the stock market through investment brokerage companies or banks.
If an investor does not have enough money for portfolio diversification it is preferable to buy shares in one or several mutual funds.
Apart from that there are other ways of acquiring stocks, for example, Initial Public Offering (IPO) or a company’s first issue of stock to the general public when companies offer subscription for a certain number of their stocks in advance.
Information about such offerings is normally obtained from mass media or one’s broker.
Today almost all stocks are registered electronically, therefore your being the owner of a certain number of stocks will normally be confirmed by your securities account statement provided by your broker — it will show the amount of your investments, the quantity and name of stocks, etc.
How to hedge risks when investing in stocks?
On advanced and reliable stock markets, for example, in the USA, investors who own stocks can hedge (insure) their positions against heavy price declines.
However, before making such deals an investor should consult his broker or investment manager to verify that this strategy is acceptable.
Some tips for potential investors
Before investing in stocks an investor should determine the level of exposure he can afford and formulate the objective of his investments — be it a long-term investment for fixed income, capital appreciation or speculative trading.
The investment strategy you will choose will determine the list of companies whose stocks can be used to build your investment portfolio, as well as what share of your portfolio will be invested in stocks.
Another highly important consideration apart from investment strategy is portfolio diversification, i.e. reducing the overall risk by spreading your investment among a wide variety of stocks of different companies — poor performance of one type of stocks can be compensated by good performance of other stocks.
Unfortunately, achieving good diversification is not always realistic for an individual investor because of limited financial resources, therefore the most popular form of investing in stocks is doing it through mutual funds — collective investment schemes managed by professional managers.
This type of investment enables broad portfolio diversification not only among stocks of different companies within one industry or country but also among different regions of the world. Very popular are mutual funds that mirror stock market indices such as Dow Jones Average, S&P 500 and others.
Whatever the case may be an investor should be fully aware of the risks he exposes himself to by investing in stocks and soberly evaluate his financial capacity.