Lesson 4: Why invest in stocks?

A stock is an investment that represents partial ownership of a company. As a stockholder, you’re entitled to a portion of the company’s profits and assets and you participate in the company’s growth. You’ll benefit if the company grows and becomes more valuable because this growth is usually reflected in a higher stock price.

A stock is created when the original owners of a company decide at one point to sell part of the company to investors. Often it’s because they need money, either to run or grow that business or to replace some of the debt —  borrowed money  — they used to start the business in the first place. Or the founders may decide they want to harvest some of their hard-earned gains from the business they created. This gives investors the chance to benefit from a company’s growth without needing to take the risk of creating a business themselves.

First, there’s the potential for long-term growth. Over time, many companies grow and become more valuable, leading to higher stock prices and potential profits for investors. History has shown that the growth rate of a stock investment has one of the best chances of matching or beating inflation over time. We mentioned in lesson 1 that beating inflation is an important aspect of keeping and growing your net worth. Over a long period of time, stocks have had a better return than almost any other type of investment and that’s part of the reason many investors include stocks in their portfolios.

Second, there’s the potential income from stocks that pay dividends. Dividends are the portion of a company’s profit that’s paid out to shareholders. Some companies pay regular dividends, providing a steady stream of income. This can be a great feature for those looking to live off the returns from their investment portfolios.

Third, there’s the possibility of diversification, since there are many different stocks to choose from. This can help reduce the risk of loss from an investment in any one company. Stocks are also very easy and convenient to buy and sell and don’t require maintenance in the same way as an investment like real estate. There is also usually an abundance of information available about stocks’ past and present performance and company financials over time.

Fourth, with stocks you have the chance to earn capital gains, which is the profit earned on the increased value of an asset. In Canada, capital gains are given preferred tax treatment compared to interest income, like you would earn from bonds. Not only are capital gains often taxed at a lower rate than interest income, but the tax on capital gains doesn’t usually need to be paid until the gain is actually realized — that is, until the investment is sold. Capital losses can also be used to offset capital gains and reduce the tax owing.

One of the trickiest aspects of stock investing is how volatile the stock market can be, especially in the short term. Individual stocks or industry groups can be even more volatile.

There are many factors that can create this volatility: inflation, the economic cycle, political events and changes in investor sentiment can all affect a stock’s price. The prices of international stocks will also be affected by currency exchange rate fluctuations.

If you need income from your investments, stocks that pay dividends can provide that, but those payments aren’t secure in the same way as the interest payments on fixed-income investments. More information about fixed-income investing is coming up in lesson 6.

In the long run, how well the business is doing and how well it’s expected to do in the future are the main things that influence a stock’s price. But in the short term, other things come into play.

Here are some of the things that can influence stock prices day-to-day:

• Economic data releases
• Company-specific news
• Changes in interest rates
• Political events
• The general mood of investors, also known as market sentiment
• Technical factors such as chart patterns or resistance levels

Those are just some of the reasons why stock prices frequently become disconnected from what they “should” be worth — as determined by traditional analysis of a company’s fundamentals — and what they’re going to be worth tomorrow when nothing has really changed.

Because stocks trade on stock exchanges and their prices are visible and constantly fluctuating when the exchanges are open for business, price fluctuations are very obvious. This can make stock investing emotionally challenging for some investors who may be uncomfortable seeing their portfolio value fluctuate dramatically during volatile periods. On the other hand, those price fluctuations can create opportunities to buy or sell and capture shorter-term profits or establish a better base price for your stock holding.

It’s sometimes hard to know if you’re paying too much for a stock or if the bargain you found is a bargain for a well-deserved reason. Both fundamental and technical stock analysis try to determine a fair price for a stock at a given time, and each method looks at the stock in a different way. The ultimate goal is to purchase the stock at a price that’s currently reasonable and fair. You can then benefit from a rising stock price if the company grows and its value increases.