Find out more about this building block of an investment portfolio.
CIBC Investor’s EdgeNov. 16, 2022
Once there was a stock
What is a stock? This investment that almost everyone knows a little, but few outside of Wall Street seem to understand completely. Stocks can be the stuff of legend — sometimes responsible for monster gains or legendary crashes, with more-than-you-can-count Reddit memes, YouTube channels, gurus of the week and a thousand dramatic stories. And you want some of that?
When you buy a stock, you’re buying a piece of a company. A small or a large company, located somewhere on earth — for now. A piece of that company is always what a stock represents. You can hold that stock for 5 seconds or for 10 years, but during the time you own it, you own a part of that business.
Where does a stock come from?
Why did the people who created this company decide to sell part of it to strangers? Well, usually it’s because at some point they needed money, probably 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 maybe the founders decided that they wanted to spend some of those hard-earned gains from the business they created. That’s when investors got the chance to own a piece of something they didn’t have the time or weren’t willing to take the risk to create themselves.
What is a stock worth?
Now, most of us aren’t used to seeing the price of something we own displayed to us every day, much less every minute. If you’re a condo owner, you can’t see its price change from the time you leave in the morning to when you return at night. But stocks are different, because what price someone is willing to buy or sell a stock that’s listed for trading on a stock exchange or marketplace is always being displayed when the stock exchange or marketplace is open, and almost always changing. And what influences that price also changes. Yes, 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. But in the short term, other things come into play. To name just a few: how many people are around to buy and sell, whether those people need their money to buy something else, whether they have “extra” money to spend that day or whether they’re just fed up waiting for one stock price to move while other stocks are going to the moon.
That’s why stock prices can frequently get disconnected from what they “should” be worth, what a stock analyst says they’re worth and what they’re going to be worth tomorrow when nothing has really changed.
Why should I own stock?
If it’s so hard to know what a company is “really” worth, how do you know what’s a reasonable price for a stock?
It is sometimes hard to know whether you’re paying too much or, on the other side, whether the bargain you found is a bargain “for a reason.” Over a long period of time though, 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 portfolios1. Capital gains on stocks are given preferred tax treatment as compared to interest income earned from investments like bonds, and capital gains tax doesn’t usually need to be paid until the gain is actually realized — that is, until the stock is sold. Losses on stock sales can be used to offset gains and reduce the tax owing2.
That’s not to say that everything is positive about holding stocks. Diversification is important because stocks can be volatile and individual stocks or industry groups can be very volatile, especially in the short term3. If you need income from your investments, stock dividends can provide that, but those payments aren’t secured in the same way as the interest payments on fixed income investments — think bonds or GICs.
To sum it up, three things will really help you take advantage of the historically higher returns from stocks.