Stocks are equity investments, which means that when you buy a share of stock you actually own a piece of the company that issued the stock. Each share of stock represents the same amount of ownership as every other share of stock, and it gives you the right to participate in the company's financial fortunes, good or bad. A general rule of thumb when investing in the stock market is that the greater the risk, the greater the potential reward, but the key word here is "potential."
The market price of a share of stock fluctuates up or down based on such factors as the company's performance, positive or adverse news about the company, trends in the company's industry sector, and movements in the economy as a whole. One powerful reason to purchase stocks is their potential to increase in value, resulting in a capital gain. But stock prices don't always rise. One of the major risks of investing in the stock market is a sharp decline in the market price of your stock, which can result in a capital loss.
Although the boards of directors of some companies choose to plow their profits back into the company to fuel growth, the boards of older, more well-established companies might return a portion of the profits to the shareholders in the form of a dividend. Companies that have a long history of paying dividends in both bad and good economic times are called blue-chip companies. Companies that pay regular dividends typically do so on a quarterly basis. This gives you the benefit of a predictable stream of current income. Dividends are not guaranteed, and even blue-chip companies may cut or eliminate dividend payments at any time. Even dividends on preferred stock are not guaranteed, although a company typically must make good on all preferred-stock dividend payments before it can pay any dividends on common stock.
Common-stock ownership gives you a number of rights, including the right to vote in the company's annual shareholder's meeting. Although you get to participate in the company's successes, you are also protected from its worst failures. Your liability is limited to your investment, so if the company is sued or files for bankruptcy, you are not held liable for any of the company's obligations or adverse judgments. The most you can lose is your investment.
Just about everything you own, including stocks, is a capital asset. If you sell your stock at a profit you have a taxable capital gain. But if you owned the stock for more than one year, that gain is taxed at the more advantageous long-term capital gains rate. You are not taxed on the appreciated value of your stocks at all as long as you own them. You incur a tax obligation only when you sell your stocks. This gives you the advantage of being able to choose when you wish to pay your capital gains tax.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.