There are several things to consider before buying stocks.
How do you make money with stocks?
Investors who purchase stock hope to make money in one of two ways--through dividend payments and/or capital gains.
Some investors buy stocks because they seek regular income from dividends. Dividends represent distributions of corporate earnings to shareholders. Dividends, if distributed, are usually paid out to investors in cash. However, a company may also pay dividends in the form of additional stock, known as stock dividends, or in property (this is rare).
Capital gains from sale of stock
Capital gains represent increases in stock prices. Investors looking for capital gains hope to buy a company's stock at a low price and sell it when the price has risen. Stock prices can increase for many reasons, including company profitability, a good economic environment, or rumors of a takeover. Conversely, stock prices may decline for many reasons, including poor earnings reports, poor management, lawsuits, faulty or out-of-date products, competition, bad publicity, or an overall poor economy. Prices also can be affected simply by the investment community’s view of the stock market as a whole.
What are some things you should consider before buying stock?
The decision to invest in stocks is a personal one that should depend on your individual situation. Before taking this step, and before selecting specific types of stocks to add to your portfolio, there are some issues you should take into account.
Your temperament for risk
One of the main factors to consider before buying stock is your attitude toward risk. How much financial risk, if any, are you willing to accept? If the thought of even a small amount of risk makes you anxious, you probably would be considered risk averse, in which case stocks might not be an appropriate investment for you. If you can handle some risk, you still need to tailor the stock portion of your portfolio to your particular level of risk tolerance.
Because of the potential reward for long-term price appreciation, stocks generally have a higher level of risk compared to other investments. You can lose a portion of your investment in stocks--or even your entire investment. Among the factors that affect the level of risk you face with stocks are:
- Competitive risk--Competitor actions may cause lower profitability, business losses, or bankruptcy.
- General business risk--Poor managerial decisions cause business losses or bankruptcy.
- General systematic risk--The state of the economy prevents the corporation from achieving the profit levels it is seeking.
- Political or social risk--Groups within a society may object to the nature of a particular company's business, or to how it conducts its business. Bad publicity could cause prices to decline.
Different kinds of stocks carry different degrees and types of risk and are therefore suited to different types of investors. For example, if you are fairly conservative and prefer minimal risk, you might think about stable, relatively safe blue-chip stocks. If you are very aggressive, however, you may want to consider riskier investments like aggressive growth and microcap stocks.
Although an investor can screen for potential risks before making an investment, it is virtually impossible to plan for every conceivable contingency that could affect a business. For this reason, stock investors must be prepared for some degree of risk.
Your holding period
Stocks are typically a long-term investment. The reason is that stocks can be volatile. If you're counting on a stock's price going up, it may take several years of ups and downs to reach your desired selling point--if indeed it ever does. But there is another reason. The sale of stock held for one year or less results in short-term capital gain or loss, and short-term capital gains are taxed at ordinary income tax rates. By comparison, the sale of stock held more than one year results in long-term capital gains, and long-term capital gains generally are taxed at lower rates than ordinary income. For example, if you are in the 28 percent tax bracket for ordinary income, your long-term capital gains are generally taxed at 15 percent.