The second part of our Financial Empowerment series is geared towards basic investment education. What is a stock? What is a bond? What about mutual funds, ETFs, and LDBs? Just kidding, that last one is made-up.

First, stocks. Stocks, sometimes called equities, are shares of ownership in a publicly-traded business. “Publicly traded” simply means the shares are available to anyone with enough greenbacks to buy them. As a shareholder, you may cast votes for the company’s Board of Directors, you can vote on important shareholder issues like takeover offers, and you’re entitled to a share of the company’s profits.

Companies typically distribute profits in the form of dividends. Dividends are income paid by a company to shareholders on a semiannual or quarterly basis. There are many formulas companies use to determine how much in dividends they will pay in a given year, but suffice it to say that stockholders treat dividends like gold and approving a dividend reduction is career suicide for a board. Young businesses will often not pay dividends, as they must reinvest every last nickel of profit into the business in order to grow. As a shareholder, you invest in these companies (and forgo the current dividends) because you expect their shares to be worth significantly more in the future.

Stocks are traded on exchanges like the New York Stock Exchange, Euronext (in Paris), and the London Stock Exchange. The first stock exchange was founded in Amsterdam in the early 1600s and for the first four centuries of stock trading, trades were handled by human traders yelling at one another to negotiate a price. Now, the lion’s share of transactions is performed by computer algorithms which match buyers and sellers by price and share quantity.

Historically, the stock market has been a great place to invest for the long term. Over the past century, the S&P 500 (a basket of US-based stocks) has returned an average of 10% per year, with roughly half of those returns coming in the form of dividends.

Although the market has had strong average historical returns, there are a couple of caveats that go alongside. First, stocks go up AND down, and sometimes the market goes sharply down for a long time (think 1929, 2000, and 2008). Second, although the S&P has returned an average of 10%, there are only a few years where the return has been near 10%; most years are much higher or much lower. Finally, perhaps the biggest risk of all, stock investments are not guaranteed and a stock can go to zero. It doesn’t happen often, but it does happen. Pets.com and Enron are two relatively recent examples. The (sort-of) silver lining is that you as a stockholder cannot be personally liable for the debts or claims of the company. Your exposure is limited to the value of your shares only.

How does one select stocks, and how much of a portfolio should be invested in stocks? For that matter, what causes stock prices to go up and down? We’ll cover strategy, analysis, and asset allocation in later blog entries.  

Submitted by - Ben Sadtler