When a company needs money, it has two main choices for raising that cash: it can borrow money, or it can raise it from investors by selling shares in the company. These shares are called stocks or equities. Buying a stock makes you a part-owner in the company.
The key thing to remember is that a stock’s return is composed of two parts – dividends and capital gains.
Dividends are a portion of the company’s profits that are returned to investors as an incentive to stay invested. Large, established companies often pay dividends to investors. These dividends offer income even if the company is not experiencing dramatic growth; and they do add to your current-year income for tax purposes.
Capital gains, on the other hand, accrue when the value of the stock rises above the purchase price. The good news, though, is that capital gains don’t trigger income tax until you sell your shares.
How to choose stocks
Generally, when a company’s earnings increase, its stock price rises. As an investor, you share the wealth because you can either sell the stock for a higher price than you paid, or hold on to it in the hope it will continue to increase in price.
The opposite is also true: as earnings fall, a stock’s price is likely to fall. In that case, you share the pain.
Investors use any number of strategies to try to ensure they choose stocks that will increase in value. They evaluate revenues, profits and other measures of financial health, as well as the company’s growth prospects and market conditions in the industry and the economy overall.
The bottom line, though, is that there is really no foolproof strategy for stock-picking. Choosing equity investments inherently exposes you to a certain amount of risk.
That said, there’s also the potential for higher returns on your investment, which is why stocks have long served as one of the key tools for wealth building.