What’s so “common” about Common Stock?
An Introduction to Investment Planning – Part 4
If you are the kind of person who “follows the stock market,” that is, you watch the stock prices crawl across the bottom of the TV screen while your dentist is up to his elbows in your mouth, or in the evening you catch the closing figures for the S&P/TSX Composite, Dow Jones Industrial Average, NASDAQ or S&P 500, then today’s post may be for you. When people think of investing, investing in stocks is what most people are probably thinking about.
Stocks represent ownership in a company. It can therefore be referred to as an equity investment, unlike ownership of a bond, which represents a debt that is owed to you by the issuing entity. Common stock is distinguished from preferred stock in that it has the lowest priority in terms of ownership structure. If you own stock in a company that goes bankrupt and is liquidated, common stockholders only get paid from the proceeds after the bondholders, preferred shareholders and everybody else who is owed money gets paid in full.
Common stockholders do, however, have a number of benefits that bondholders and preferred stockholders do not. First, they generally have a right to vote. With your vote you have a say in electing the board of directors and voting on various corporate policies. In practice, most retail investors do not own the quantity of shares necessary to make a difference, so the right to vote may not be that significant.
When people buy stock, they are usually seeking two benefits, income from dividends and capital gains. A single word to describe this would be “return.” They want a return on their investment.
Income from Dividends
If you own a small business, whether incorporated or not, you are generally seeking an income. You are putting (investing) money and labour into this venture with the hope of receiving an income in return.
In the case of the shareholders of a corporation, that income typically comes in the form of dividends. As a company generates earnings from its business, it uses that money to pay its expenses such as interest payments on debt and taxes. Assuming the company consistently earns more than its expenses it can use that money to reinvest in and expand the business and it can also pay dividends to its shareholders.
Although frequency varies, a major corporation, like any one of Canada’s big five banks, pays its dividends quarterly. Dividend policy is set by the board of directors and is usually at a fixed amount each quarter. Among the wide variety of companies, though, the yield can be quite different. One company may pay a yield of less than one percent a year while another may pay greater than five percent. And then there are companies that pay no dividends at all.
Companies that do not pay dividends may be so focussed on growth that they need all their available earnings to reinvest in the company. This is most often the case in younger companies that are growing rapidly. For years, Microsoft and Apple, to name two of the most well-known tech companies, didn’t pay dividends.
The return for an investor comes, then, in the growth of the company’s business which usually leads to growth in the company’s share price. This potential for participation in the growth of the company is a particular attribute of common stock that is not available to bondholders, as they are lenders to the company, not owners. Nor is participating in the growth of the company typically available to preferred shareholders who are primarily interested in dividend income. As an example of participating in company growth, five years ago, Amazon, which does not pay a dividend, traded at about $300 per share. Its current share price is greater than $1,700. If you had invested $10,000 five years ago, your investment would be worth over $56,000 today.
The biggest risk is that you could lose some or all your money in a common stock investment. A few months ago, Amazon was trading at over $2,000 per share. In the space of a few months it had lost about 15 percent of its value. Worse returns are certainly possible. Sometimes the stock of certain companies have been forced to cease trading in the course of a day, and they just never come back.
No doubt you have heard of the expression, “no risk, no reward.” That certainly applies to investing in common stocks. If you were to create a spectrum of risks, cash would be at the no-risk end while common stocks would be at the higher risk end. Within the world of stocks, some are riskier than others, but risk cannot be eliminated entirely. Having said that, if you look at charts of the major stock markets in the last twenty years, you will see dramatic ups and downs but you will also see that the stock market is up compared to where it was two decades ago.
The question to ask yourself is, are you able to tolerate the volatility of the stock market in exchange for a probable increase in the value of your assets when compared to the relative security of bonds and GICs?
Ways to purchase common stocks
Individual stocks on an exchange
You may open a brokerage account with a discount brokerage to do it yourself, or you can open an account with a full-service firm where an investment advisor will make specific recommendations for you. In either circumstance, you are likely to pay a commission or a fee to your broker in order to make the purchase. There are certain procedures and parameters you need to decide on when you buy stocks on an exchange that makes the process a bit more challenging compared to mutual funds, but once learned, it is not difficult.
As is the case, with bonds, there are mutual funds available for which the underlying assets are common stocks in a wide variety of companies.
Exchange-Traded Funds (ETFs)
Like mutual funds, there are equity ETFS available for purchase. Unlike mutual funds, ETFs are traded on an exchange so some of the mechanics and decisions to be made about purchasing ETFs and stocks are identical.
One difference that both mutual funds and ETFs have compared to the purchase of individual stocks is that with these funds, you are not “putting all your eggs in one basket.” The purchase of a single stock is inherently risky, because your investment is entirely in that one position. With a mutual fund or ETF you are diversifying your investment among many different stocks. This can be done by purchasing many individual stocks as well, but it is a more laborious process as you need to make a number of purchases, and is more difficult if your account is smaller.
In an upcoming post, I will delve a little more deeply into mutual funds and ETFs as these are perhaps the most popular means of investing in Canada.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.