FREQUENTLY ASKED QUESTIONS

+ WHAT'S A STOCK?

A stock represents a stake in a company. When you own a share of stock, you are a part owner in the company with a claim – however small it may be – on every asset and every penny in earnings. Now, unless you own a significant chunk of one company’s stock, it’s not as if you have a real say in how things are done. Owning 100 shares of Microsoft makes you, technically speaking, Steve Ballmer’s boss, but that doesn’t mean you can call him up and give him a tongue-lashing. Nevertheless, it’s that ownership structure that gives a stock its value. If stockholders didn’t have a claim on earnings, then stock certificates would be worth no more than the paper they’re printed on.

+ HOW DO YOU MAKE MONEY ON STOCKS?

There are two possible ways. The first way is when a stock you own appreciates in value – that is, when people who want to buy the stock decide that a share is worth more than you paid for it. They might decide that because the company that issued the stock has earnings that are improving, for example. If you hang onto a stock that has gone up in value, you have what’s known as unrealized gains. Only when you sell the stock you can lock in your gains. Since stock prices fluctuate constantly when the market is open, you never really know how much you’re going to make until you sell. The second way is when the company that owns the stock issues dividends – a payout that companies sometimes make to shareholders.

+ WHAT ARE THE ADVANTAGES OF STOCKS FOR RETIREMENT?

Stocks historically have produced long-term gains that are bigger than those of any other asset class. Since 1926, large stocks have returned an average of 9.8% per year. What’s more, they didn’t lose ground during any period of 20 years or longer during that time. Those qualities make stocks much more appealing for long-term savings than, say, Treasury bonds (which have had about 5.4% average annual gains since 1926) or stashing cash under your mattress. Stocks’ return potential gives them the best chance to beat inflation over long periods. That’s why they’re an essential part of a good retirement portfolio.

+ WHAT ARE THE RISKS WITH STOCKS?

Stocks carry a much greater risk of short-term losses than bond and cash (the other two major asset classes). Since World War II, Wall Street has endured a dozen bear markets (defined as a sustained decline of more than 20% in the value of the Dow Jones industrial average). As a result, it’s generally not a good idea to invest a big chunk of money in stocks if you’ll need to spend the money within five years or so.

+ WHAT ARE THE DIFFERENT TYPES OF STOCKS?

There are thousands of stocks to choose from, so investors usually like to put stocks into different categories: size, style and sector. Thinking of stocks this way helps you diversify – that is, to choose several stocks that are different enough from each other that they won’t all tank at the same time. (Ideally, at least.) By size. A company’s size refers to its market capitalization, which is the current share price times the total number of shares outstanding. It’s how much investors think the whole company is worth. Companies are typically referred to as either “small-cap,” “mid-cap” or “large-cap.” Large-cap companies (those with market capitalizations in the tens of billions of dollars) tend to have more stable stock prices than small caps, so they’re less risky. But small caps usually have higher growth potential. By style. There are two major styles: growth and value. A growth stock is issued by a company that is expanding at an above-average rate. Catch a successful growth stock early on, and the ride can be spectacular. But the greater the potential, the bigger the risk. Growth stocks race higher when times are good, but as soon as growth slows, those stocks can tank. A value stock tends to be slower and steadier, with strong fundamentals. In general, it trades at a lower-than-average earnings multiple than the overall market. A value investor might think the underlying business is still sound and that its true worth isn’t yet reflected in the stock price. By sector. Standard & Poor’s, a well-known data provider, breaks stocks into 10 sectors and dozens of industries. Generally speaking, different sectors are affected by different things. So at any given time, some are doing well while others are not.

+ HOW DO I BUY A STOCK?

The most common way is through a broker. Brokers are paid to trade stocks and other securities on behalf of customers. (This is different than giving investment advice, though some brokers may also be registered investment advisers.) There are two kinds of brokers: full-service and discount. Full-service brokers dispense advice and can even manage your portfolio – for a price. For example, a full-service broker may charge between 1.0% and 1.5% of the dollar amount of a stock purchase. So if you were to buy $5,000 worth of stock with a broker fee of 1.0%, you would have to pay $50 for that transaction. Some full-service brokers offer flat fees instead. By contrast, discount brokers may do little more than complete transactions for you – at a more reasonable price. Some online discount brokers, for instance, offer trades for under $10. One type of discount broker, known as a share broker, charges a fee per share traded. Share brokers typically charge less per share for larger trades. No matter what kind of broker you choose, read the fine print about fees. For example, sometimes there are strings attached to cheap trades, such as requirements to make a certain number of trades per month or to maintain a minimum balance

+ CAN YOU BUY STOCKS THROUGH A MUTUAL FUND?

Definitely – and this is often a better idea than buying them individually, in part because you get greater diversification for your dollar.

+ HOW ARE STOCKS TAXED?

Yes. Put as much money as you can into tax-sheltered retirement accounts, such as 401(k)s and IRAs. That’s because the investments in those accounts grow tax-free until retirement – meaning you’ll wind up with way more money in your old age than you would have otherwise. When you own stocks outside of tax-sheltered retirement accounts such as IRAs or 401(k)s, there are two ways you might get hit with a tax bill. If your stock pays a dividend, those dividends generally are taxed at a rate of up to 15% at the end of each year. In addition, if you sell a stock, you pay 15% of any profits you made over the time you held the stock. Those profits are known as capital gains, and the tax is called the capital gains tax. One exception: If you hold a stock for less than a year before you sell it, you’ll have to pay your regular income tax rate on the gain – a rate that’s usually higher than the capital gains tax.

+ WHAT ARE DIVIDENDS?

A dividend is a payout that some companies make to shareholders that reflects the company’s earnings. Often paid out quarterly (every three months), dividends give stockholders a steady return, regardless of what happens to the stock price. Typically, older, well-established companies pay dividends, while newer companies do not. Dividends are not guaranteed, so a company can stop paying them at any time. To keep your money growing as fast as possible, it’s smart to keep reinvesting your dividends rather than spending them when you receive them. The easiest way to do this is to sign up for a dividend reinvestment plan (DRIP), which will make reinvestment automatic.