Types of Investments: Stocks

How do stocks work?

When you buy a company's stock, you're purchasing a share of ownership in that business. You become one of the company's stockholders or shareholders. Your percentage of ownership in a company also represents your share of the risks taken and profits generated by the company. If the company does well, your share of its earnings will be proportionate to how much of the company's stock you own. The flip side, of course, is that your share of any loss will be similarly proportionate to your percentage of ownership.

If you purchase stock, you can make money in one of two ways. The company's board of directors can decide to distribute a portion of the company's profits to its shareholders as dividends, which can provide you with income. Also, if the value of the stock rises, you may be able to sell your stock for more than you paid for it. Of course, if the value of the stock has declined, you'll lose money.

The role of stocks in your portfolio

Though past performance is no guarantee of future results, stocks historically have provided higher long-term total returns than cash equivalents or bonds. However, that potential for greater returns comes with greater risk of volatility and potential for loss. You can lose part or all of the money you invest in a stock. Because of that volatility, stock investments may not be appropriate for money you count on to be available in the short term. You'll need to think about whether you have the financial and emotional ability to ride out those ups and downs as you try for greater returns.

The universe of stocks offers enormous flexibility to construct a stock portfolio that is tailored to your needs. There are many different types of stock, and many different ways to diversify your stock holdings. For example, you can sort through stocks by industry, by company size, by location, and by growth prospects or income.

Growth stocks are usually characterized by corporate earnings that are increasing at a faster rate than their industry average or the overall market. Income stocks (for example, utilities or financial companies) generally offer higher dividend yields than market averages. Value stocks are typically characterized by selling at a low price relative to a company's sales, earnings, or book value.

These are only some of the many ways in which stocks can be identified, and your financial professional can help you decide which might be more appropriate for you than others. With stocks, it's especially important to diversify your holdings. That way, if one company is in trouble, it won't have as much impact on your overall return as it would if it represented your entire portfolio.

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