What are Stocks and Why Should You Care?

Dividends + Capital Appreciation = Your Total Return.
Dividends are one way a company can distribute earnings. But after paying a dividend, the value of a stock actually declines to reflect the reduction in earnings. If a stock is trading at $50 per share, and the company declares a $5 dividend, the price per share falls to roughly $45 after the dividend payment is made. If instead, the company decided to retain the $5 in earnings per share, the value of the stock would remain $50.

Remember to focus on the total return of your investment. You can always sell shares to generate income if that is what you desire.

2) The right to vote in shareholder meetings

As a shareholder, you are entitled to receive (quarterly/annual) reports which discuss the financial health of the company.

Corporations are usually required by law to hold annual shareholder meetings, during which the shareholders elect the corporation’s board of directors. If you are a shareholder, you can attend the annual meeting and vote. If you cannot attend the annual shareholder’s meeting, you can request an absentee ballot to voice your opinion.

Shareholders control the direction of a company by appointing the board of directors. The board of directors is responsible for increasing the value of the corporation while protecting shareholder interest, and does so by appointing professional managers and officers in the corporation, such as the Chief Executive Officer (CEO). Managers are responsible for running the company on a daily basis, improving productivity, and ultimately increasing revenue, which increases the value of outstanding shares (stock).

This distribution of power is known as corporate governance. For the most part, corporate governance is highly effective in protecting shareholder interest. The biggest problem is that shareholders need to own a large percentage a company’s stock to influence important votes or decisions. Most investors do not have adequate ownership interest because many large firms issue millions or billions of outstanding stock shares.

As a result, few individuals attend shareholder meetings on a regular basis.

Are Stocks Risky?

There are significant risks associated with stock ownership. These include:

1) Price Fluctuations:

Above, I described the importance of capital appreciation in stock ownership. But stocks don’t always increase in value. Take a look at this chart showing U.S. stock market performance over a recent 15-year period:

what are stocks

What are stocks?

Performance represented by Vanguard U.S. Total Stock Market Index (VTI)
As you can see, the overall trend is positive, and stocks have provided an average return of approximately 10% each year over the last century.

However, there are times when the stock market delivers extreme losses. In these years, the economic environment takes a downward turn and companies experience a significant reduction in earnings. In reaction, many investors get scared and sell their shares of stock. When most stock market participants are trying to sell, and very few are trying to buy, a company’s stock price will continue declining until sentiment reverses and investors return to purchasing.

If a stock falls in value after you purchase it, you can continue holding the stock and hope the stock price will rebound (which is usually the case unless the firm is going bankrupt). Or, you can sell your shares and realize a capital loss.

2) Residual Claim in Bankruptcy:

If a publicly traded company goes bankrupt, the company’s assets are usually liquidated and sold. The common shareholders are the last in line to share in the proceeds and will receive nothing until the other claimants have been paid (including the tax authorities, employees, suppliers, bondholders, and preferred shareholders).

Thus, if you are a common stockholder, you have what is called a residual claim (which may be nothing). You could lose your entire initial investment in the event of bankruptcy. However, you cannot lose anything more than your initial investment because shareholders have limited liability under the law.

Should You Invest in Stocks?

Over the last 100 years, stocks have provided exceptional growth. There have been years with large gains and years with large losses, but the overall trend has remained positive and many investors have built substantial wealth by staying invested in the stock market.

It’s not a good idea to invest all of your money in the stock of one company because your entire investment portfolio would be tied to the earnings of that particular company. If the company experiences problems, the value of your stock will most likely fall, and you could lose your entire investment if the company goes bankrupt.

To mitigate that risk, you can invest in thousands of different stocks through a diversified fund or robo-advisor. In doing so, you can own the entire U.S. stock market and foreign markets at a very low cost. To determine how much to invest in stocks, you should first consider your financial goals. Stocks are best held for many years, making them an investment most suitable for your long-term goals.