Stocks: Owning a Piece of the Pie

By: Source: AARP.org Date Posted: 2006-04-17 12:49:33.463888-04:00

When privately owned companies want to raise a large amount of money in order to compete at a higher level, they often divide the company into "shares" of stock and sell them to the general public. When you own shares of a company's stock, you own a piece of the company, sharing in its successes or failures along the way. Because stocks represent ownership, they are often called equities.

Why own stocks?
As a shareholder—an owner—you could earn money in two possible ways:

Through distributions of a company ' s profits, called dividends;
From an increase in the share price, called price appreciation.

Larger companies tend to pay dividends quarterly, semiannually or annually. Often, shareholders can choose to receive cash payments or reinvest their dividends in additional shares of the company. Smaller companies tend to reinvest any earnings in order to stay competitive and may be less likely to pay regular dividends. However, smaller companies may offer more potential for price appreciation over time.

Investing for the long haul
Shares of stock are available for trading on a stock exchange every business day. Over the long term, the stock price should generally reflect how well a company is performing. Over the shorter term, though, a stock's price can be affected by all sorts of market factors that may have little to do with a company's long-term prospects. Therefore, investing in stocks should be viewed as a long-term proposition.

When it comes to investing in stocks, most people want to "buy low and sell high." However, it's very difficult to tell when an investment is high-priced and ready for a fall, or low-priced and ready for a rise. This is another reason that investors should take a long-term view and avoid trying to time the market. Investors who are interested in purchasing individual stocks should only consider companies in which they have a clear understanding of the business model, have faith in the company's products and management team and believe that the company has strong prospects for continued success.

Types of stocks
Stocks are often grouped into categories that indicate important characteristics. An individual stock may be identified by one or more of the following categories:

Market cap: (or size) from micro, to small, midsize, and large.
Growth vs. value: growth potential vs. offering an attractive value
Ownership risk: from emerging companies to well established names
Geography: by country, or by region (or foreign and domestic)
Sector: such as natural resources, transportation, or many others
Industry: such as entertainment, biotechnology, and many others

How big is the company
Market capitalization refers to the total value of the company's stock in the marketplace. If you take the share price and multiply it by the total number of shares of stock issued by the company, you get the market capitalization. So a stock with a high price and a lot of shares will be a large cap stock, while a company with a low price and relatively few shares will be a small cap or even a micro cap stock.

Another way to look at this is to think of large, medium, small and micro companies.

Micro-cap: very small companies, sometimes called "penny stocks"
Small-cap: small companies
Mid-cap: established companies with reliable track records
Large-cap: which are the giants of our economy, often called "blue chips"

Growth stocks vs. value stocks
Growth stocks are those that offer the potential for significant price appreciation for any number of reasons. Companies identified as growth companies may have launched a popular and innovative new product, exhibit an unusual degree of market leadership, or be in the process of introducing a new way to solve an old problem.

Value stocks are those that may be undervalued in the marketplace because they have been overlooked by investors. Companies identified as value companies may be experiencing temporary difficulties, suffering from negative publicity, or experiencing some market volatility unrelated to their core business operations. However, they are also companies that may have attractive long-term prospects for success. Because you may be able to buy them at a lower price than they have historically traded at, some investors may think that they represent a good value.

The terms "growth" and "value" may be useful terms for describing stocks during a specific period of time, but keep in mind that labels can change as companies change. A stock that has experienced significant price appreciation or a change in its business operations may stop being a growth stock after a while. And a stock that at one time may have been a good value, may become more expensive over time.

Risk and rewards
All stock ownership involves risk, although the level of risk can vary widely depending on the individual company you are investing in. Smaller companies tend to have a higher level of risk and may experience wider swings in share prices, while larger, more established companies tend have less risk and may experience less volatility in share prices.

Remember, that as an owner of shares in a company, you have the potential to participate in both the success and failure of a company. Any company, large or small, faces the potential of having significant business problems, going bankrupt or even ceasing operations. If a business collapses, which happens at times to even the largest companies, your investment could become worthless. Many financial professionals recommend avoiding having a large position in any one stock or type of stock to help minimize this risk.

Take Action

Investigate stocks using factors that you choose at:

AARP Resources

Learn about stock mutual funds.

Should you convert your paper stocks over to an electronic form? Here are things to consider.

Because your Money Matters, get more tips and action steps on Investing in Stocks (PDF)

Additional Resources

Stay on top of the latest news about stocks at CNN_Money.com and Reuters_Stock_Information.

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