Stocks—also known as shares of stock, equities or corporate equity—are a fundamental part of many people’s financial plans. But while stocks can be an important element of a well-balanced investment portfolio, they’re not the only way to make money. It’s crucial to understand what stocks are, how they work and how they fit into an overall plan for building wealth.
When a public company issues stocks, they’re sold in the initial public offering or “IPO.” Investors then trade those shares in the secondary market for profit. The price of a share is influenced by a wide range of factors.
One major factor is the economy and its effect on inflation and interest rates. A growing economy typically results in higher inflation, causing investors to discount the future cash flows of companies and pushing their stock prices down. Lower interest rates, on the other hand, make future cash flows more valuable, which can lead to higher stock prices.
Another important factor is earnings growth and profitability. Revenue growth tells analysts whether the company’s products and services are gaining in popularity, while earnings growth gives them an idea of how efficiently the company manages its assets and resources to produce profits. Ultimately, a stock’s price is determined by how much the market believes the company is worth—a number known as its intrinsic value or fair value.
Some stocks pay dividends, which are periodic payments of a company’s profits to shareholders. However, it’s essential to remember that not all companies pay dividends. Often, young and expanding companies don’t pay dividends, preferring instead to reinvest their profits in growing their businesses. Older and established companies, on the other hand, may be able to sustain or even grow their dividends over time, which can provide investors with additional income to help fund their retirement.
Investors can also earn profits from the purchase and sale of stocks by using techniques like technical analysis. This type of analysis focuses on price movements, looking for patterns in stock prices and charts that might indicate when it’s a good time to buy or sell. However, this type of analysis can be dangerous if used alone and should always be considered in conjunction with other fundamental analysis.
In addition to making money on purchases and sales, long-term holders of stock can benefit from the tax advantages offered by a qualified individual retirement account (QIA). This type of account allows investors to hold shares of stock for longer periods without having to pay taxes on their gains, as long as the account is held in a tax-deferred environment. This can be a great feature for those who plan on retiring early or need to have access to their funds sooner rather than later. However, it’s essential to develop a comprehensive financial plan that reflects your investing horizon and the level of risk you’re willing to take in exchange for the potentially higher returns stocks offer versus other investments. This can help you determine how much of your portfolio should be invested in stocks, and in what forms.