Safe Investing in Stocks
Know What You're Buying

Investing in stocks is the most widely publicized way to "invest" your money. Unfortunately, that is where the consensus ends, and you are left to fend for yourself.

Large cap vs. small cap, blue chip vs. high tech, penny stocks vs. value plays...the list goes on and on. And guess what...all of them fall under the stock investing umbrella!

Unfortunately, there is a lot of BAD information out there and in the end, you're the one that is held responsible. To highlight my point, think about this:

On June 1, 2009:

  • General Motors filed for bankruptcy protection
    • GM could no longer pay its creditors (debt holders)
    • Shares of GM stock had a value of $0.00

On July 10, 2009:

  • ~74.8 million shares of GM stock had been traded since June 1
    • GM shares INCREASED in price from $0.837 to $1.14.
    • Shares of GM stock STILL had a value of $0.00

There is no need to speculate on the "what" or the "why" involved in buying and selling shares of the "old" GM (after GM declared bankruptcy and before the new initial public offering in November 2010).

The fact remains that many people lost money, because shares of the "old" GM were purchased for something other than $0.00.

What are Stocks?

Stocks are financial assets that allow investors to purchase a share of a corporation’s equity.

As you know from my page on personal balance sheets, stockholders' equity is a company's assets minus its liabilities.

Basically, an investor purchases a share of the financial value remaining after all of the debts are paid.

This is the reason that you hear the terms "equities" and "stocks" used interchangeably.

Investing in stocks provides a shareholder (you) with two aspects of corporate ownership: residual claim and limited liability.

Residual claim

This means that during a bankruptcy, shareholders of preferred and common stock get reimbursed, respectively, ONLY if money (equity) is left over after all corporate liabilities are paid.

Going back to the GM example, there was not enough money to pay creditors in full (i.e. people who hold corporate debt, bonds, etc.). Since no equity remained, the stock was worth $0.00.

Limited liability

This means that shareholders are not personally liable for the corporation’s losses. In the event of a bankruptcy, shareholders can only lose the value associated with their shares.

A shareholder of GM stock cannot lose more than the amount they invested in GM. Even though investors that owned GM debt were not fully repaid, they could not get any money from the shareholders.

Why Try Investing in Stocks?

Investors are looking to trade the money they have now for a fair rate of return over the length of their investment, and then access their money (plus the added return) at some point in the future.

Investing in stocks can provide returns in two ways: capital gains and dividends.

Capital Gains

These are the result of "buy low, sell high"; you purchase a stock, the price increases, and then you sell the stock.

Or, you short the stock (sell shares and create a "negative" position), the price decreases, and then you buy the stock at a lower price and pocket the difference.

When investing in stocks for capital gains (i.e. a growth investing strategy), the length of time between your buy and sell trades (how long you "own" the stock) will determine how you are taxed (long term verses short term capital gains).

  • Holding period of < 1 year = Short Term Capital Gains Tax
  • Holding period of > 1 year = Long Term Capital Gains Tax

Dividends

Divndends are cash distributions of a corporation's earnings. Regular cash dividends occur at set intervals, usually once per quarter.

Some companies pay out extra cash dividends toward the end of their fiscal years to improve their financial statements.

If you're investing in stocks for dividends (i.e. an income investing strategy, it is important for you to know how your trading account and/or investment broker handles dividends.

You will usually have the choice of adding the cash to your account balance, or signing-up for a dividend reinvestment plan (called a DRIP) to purchase additional shares of the dividend paying stock automatically.

Invest Safely Dollar Sign Callout

Safe Investing Tip:
DRIPs are a great way to keep expenses low and preserve capital (See my method for better investing). Any dividend you receive will be automatically reinvested without charging you any commissions or fees.

Investment Choices

You have two choices when it comes to investing in stocks: Common and Preferred

Common stock

The type that you usually hear about on the TV or internet.

As stated earlier, common stock represents an ownership stake in the equity of a corporation. It normally provides investors with voting rights, dividends, limited liability, and residual claim.

  • Advantages
    • Dividends can increase with improving financial performance
    • Shareholders are granted voting rights
  • Disadvantages
    • Dividends can decrease if financial performance declines
    • Last stakeholders to be reimbursed in the event of a bankruptcy

Preferred stock

Similar to common stock, with a few important differences.

Unlike common stock, it is typically issued without voting rights ("non-voting" - see below), and pays dividends at constant, contractually specified rates.

The reason some equities are called "preferred" is because dividend payments are made to shareholders of preferred stock before shareholders of common stock.

If preferred dividends are paid and there is no more money left for dividends, owners of common stock will not get dividend payments.

  • Advantages
    • Dividend will not decrease
    • Dividend is typically higher than a common stock dividend
    • Reimbursed before common stock in the event of a bankruptcy
  • Disadvantages
    • No voting rights
    • Dividend cannot increase with improved corporate performance

Sometimes, people will say that investing in preferred stock is like bond investments (debt), because shareholders receive a fixed dividend and are ahead of common stock shareholders in the event of bankruptcy.

In the end, preferred stock derives its value from a corporation's equity, and should not be considered a debt instrument.

Voting vs Non-Voting Stock

Being eligible to vote on corporate matters is another benefit of investing in stock. The class of share you purchase determines the level of your voting abilities.

A company can issue different classes of stock, and each class usually has different voting rights. Each share of voting stock entitles the owner to one vote (or some percentage of one vote) in decisions addressed at the corporation's annual meetings.

Non-voting stock only gives shareholders a share of the financial success of a company (similar to a silent partner). Preferred stock does not usually have voting privileges.

Physical vs Virtual Shares

These days, it is common to buy and sell shares of a company without touching anything physically.

Your broker keeps track of the number of shares you buy and sell (similar to using a ledger). This is one way brokers keep costs low.

However, you can also receive paper copies for the shares that you own.

Google Stock Certificate

But stock certificates do make a very unique gift, and look great framed above a desk.