Advantages and Disadvantages of Common Stocks

by Chirantan Basu

    Common stocks represent part ownership of publicly traded companies. Stocks trade on regulated and over-the-counter stock exchanges worldwide. Common stocks are a key component of retirement portfolios, along with bonds and short-term money market instruments. You can buy stocks through your broker or hold stocks indirectly through mutual funds. The proportion of stocks relative to other assets would depend on your financial objectives and tolerance for risk.

    As part owners, common stockholders have some say in company operations. For example, they elect directors and vote on resolutions, such as the approval of auditors' reports and mergers and takeovers. Companies that meet or beat profit expectations usually see their share prices rise over time. Some companies pay regular quarterly dividends to common shareholders from after-tax earnings. Common stocks of mid-cap and large-cap companies usually trade in large volumes, which means narrow bid-ask spreads and rapid trade execution. Online brokers make it easy and inexpensive to trade stocks on major exchanges. Brokers allow margin trading and short-selling for eligible stocks. Margin trading is the use of borrowed funds to buy stocks. Short-selling is the sale of borrowed securities in the expectation of buying them back later at lower prices. You can also use options on certain stocks to hedge against market volatility or speculate on price moves.

    The stock markets can be volatile with frequent price swings of several percentage points in a single trading session. Your portfolio could lose substantial value in a short period. If you are trading on margin, this could mean margin calls and the forced liquidation of stocks at significant losses. Companies are not required to pay dividends to their common shareholders, who are also last in line behind other creditors in bankruptcy proceedings. Investors run the risk of locking in losses for thinly traded stocks, especially in fast-moving markets. Diversification and hedging are two ways to protect stock portfolios from downside risks. Diversification involves investing in several companies and industries, either directly or through mutual funds, so that losses in one stock offset gains in another. You can use options to hedge a stock portfolio against price declines.

    Some companies issue multiple classes of common shares, such as Class A and Class B shares. The main advantage of this type of share structure is that owners get access to the capital markets, while retaining effective control and potentially warding off hostile takeovers. The disadvantage for investors is lower voting rights and trading volumes in some of these share classes.

    Companies issue common stock to raise money for strategic and operational reasons. Owners and employees can monetize their ownership stakes and companies can use shares as currency in mergers and acquisitions. The disadvantages include loss of control to external shareholders and additional costs related to regulatory filings and shareholder communications.

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    About the Author

    Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.

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