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MM-06-2001

Investing in Stocks
Savers and investors have different vestment Trusts, Bond Mutual Risks Associated with
objectives for their money. Typically, Funds, Mortgage-Backed Securities, Stocks
savers have objectives to use their Collateralized Mortgage Obligations, There are several risks associated
money in the next three to five years, Fixed Annuities, Preferred Stock, with stocks. Market risk, business
while investors won’t need their and Guaranteed Investment Con- risk, and financial risk are all part of
money in the next three to five years. tracts.1 owning stocks. Although you as-
Therefore, stocks are not an appro- sume risk in owning stock, the
priate security for a saving objective.
What is a Stock? potential returns are higher than
People who invest in stocks need a other investments.
Stock comes in two types: common
long time frame for their investment
and preferred. This fact sheet will fo- Stock is generally owned for its
objectives. Over the long haul,
cus on common stock. Preferred growth potential. This potential
stocks have outperformed other in-
stock is more similar to a loaner as- growth is obtained through changes
vestment options by a wide margin.
set and will not be discussed here. in the price of a share of stock. If the
Because of the volatility of stock
prices, you should not have any When you buy common stock, you stock increases in value, the investor
money in stocks that you will need become part owner of a company. makes money when the stock is sold
to use in the next three to five years. Common stock owners elect direc- and has a capital gain. However,
tors, who hire the people that stock prices can go down in value
manage the company on a day-to- and the investor can lose money if
Owner vs. Loaner day basis. Owners vote on issues at a the stock is sold at that time. This
Investment securities usually involve stockholders meeting, online, or change in market price of stock is
two types of securities. Those where over the phone. considered market risk.
the investor is an owner or those
When a company makes money, the Beta is a measurement of market
where the investor is a loaner.
board of directors determines what risk. The greater the beta over 1, the
Owner securities include stocks, real
is done with the profit. They can re- greater the risk of price changes. For
estate, equity unit investment trusts,
invest the profit back into the betas under 1, there may be less
equity mutual funds, collectibles,
company or share the profit with the swings in share price.
business ownership, and commodi-
ties. Common stocks are an owner owners via dividends. Dividends are Other types of risk associated with
asset. paid quarterly, annually, or not at all. stock are business risk and finan-
The dividend amount can be ad- cial risk. These risks have to do
Loaner assets for an investor are cer- justed within a year and thus is not a
tificates of deposit, U.S. Treasury steady source of income. For the
Securities, Municipal Bonds, Corpo- stockholder, dividends are current
rate Bonds, Convertible Bonds, income and are reported on each
Zero-Coupon Bonds, Bond Unit In- year’s tax return.
1
Investing for Your Future, A Cooperative Exten-
sion System Basic Investing Home Study
Course, February 2000, Rutgers Cooperative
Extension.

This fact sheet is intended for educational purposes only. Mention of a proprietary product, trademark or commercial
firm in text or figures does not constitute endorsement by Ohio State University Extension and does not imply approval
to the exclusion of other products or firms. For specific advice, consult your financial or legal advisor.
MM-06-2001—page 2

with the type of company and its


ability to manage the balance sheet Stock Sectors
and to make money. These types of Utilities—telephones, electric
risk can be managed by diversifica- utilities, gas utilities
tion (owning several different types
Energy—oil, natural gas
of companies in different sectors).
Different sectors of businesses per- Financials—banks, brokers,
form differently in good and poor thrifts, insurance, real estate
economic times. During periods of Industrial Cyclicals—aerospace,
economic contractions, large cost construction, machinery, machine
items (housing, large machinery) do tools, chemicals, metals, papers,
not perform as well as during times than small companies and their
stock prices do not tend to fluctuate building materials
of economic expansion.
as much. The New York Stock Ex- Consumer Durable—autos,
Financial risk is associated with change (NYSE) trades large and housewares, recreation/luxury,
companies managing their income medium sized companies, while multi-industry
and expenses. Owning stock in a va- smaller companies tend to be traded
riety of different companies allows Consumer Staples—food, bever-
over the (NASDAQ) National Asso-
an investor to spread out the risk of ages, tobacco, household goods
ciation of Securities Dealers
a company they own going bank- Automated Quotation System. Services—media, entertainment,
rupt. Thus, diversification helps to personal and business services,
spread out business and financial Investment objectives may be
waste management, transporta-
risks. growth, aggressive growth, value,
tion
or income. Growth and aggressive
growth companies anticipate good Retail—all retail (except drug
Classification of Stocks sales and expansion that will result wholesalers)
Stocks are grouped according to size, in profits and higher share prices. Health—pharmaceuticals, health-
investment objective, and type of Value companies are businesses care services, medical devices,
company. Having different sizes of which may be in a downturn, but drug wholesalers
companies, different types of invest- the future prospects look good so
ment objectives, and different sectors their share prices are undervalued or Technology—computer hardware,
results in diversification thus reduc- priced lower than usual. Income software, electronics, electrical
ing risks. Investors also need to stocks pay good dividends compared equipment, wireless communica-
match their investment objective to other companies but there are no tions
with the appropriate investment. guarantees that these dividends will
When investing in individual stocks,
Companies are grouped according to continue.
how many do you need? Most
size—small capitalization, me- Stocks are often grouped by sectors. people recommend that you hold at
dium capitalization, and large Holding different sectors helps en- least 6–8 individual stocks repre-
capitalization. The assets listed on sure an investor is diversified in senting different sectors.
the financial statement determine the different types of industries. If you
size of the company. Small compa- own individual stocks, all your hold-
nies over time have more growth ings should not be in the same sector
Owning a Share of Stock
potential but also have the largest because if the economy swings in a Owning a share of stock entitles you
potential risk of loss. Large compa- particular direction, you will be af- to any dividend distributed, voting
nies tend to pay more in dividends fected more strongly than if your privilege (if common stock), and an-
holdings were spread out among sec- nual reports of the company. Some
tors. companies will automatically rein-
vest dividends for their shareholders
Morningstar, which is a company to purchase more stock. The costs of
that researches mutual funds, uses these dividend reinvestment pro-
the following sectors in analyzing grams are usually lower than buying
mutual funds. The list below is in or- more stock through a broker but the
der of risk with the safest sectors investor should check costs. This is a
listed first to the most risky but convenient way to buy additional
highest-growth rate sectors last.
MM-06-2001—page 3

shares on a continual basis. Some to Company A. To compare two


companies allow investors to buy di- companies’ price/earnings ratios,
rectly from them so a broker is not they must be comparable industries.
used. However, check the costs and You do not want to compare price/
remember you are not getting finan- earnings ratios of health care compa-
cial advice that a broker might nies to technology companies.
provide. So, you will need to do
your own research. Yearly High and Yearly Low
Newspapers often report on the
When buying stock through a bro-
yearly high price and the yearly low
ker, buying round lots (100 shares)
price of stocks. This provides an in-
is usually cheaper than buying odd
lots (e.g., 30 shares, 5 shares, or 76
dication of how the current price Taxes and Stocks
compares to the yearly high and low There are three types of taxes that
shares) or shares not divided evenly
prices. If the stock price is close to are paid on stocks in non-retirement
by 100. A full service broker, a dis-
the high for the year or close to the accounts. Individual Retirement Ac-
count broker, over the internet, and
low for the year, you can compare counts and Pension Plans are not
direct from the company are all ways
the current price to these figures. taxed until withdrawn and then the
to purchase stock.
money taxed is taxed as ordinary in-
Yield come, except for Roth IRAs where
Deciding Which Stock to Yield is reported as a percentage and the earnings are never taxed. Divi-
Buy reports the dividends paid as com- dends are taxed each year at the
pared to the price of a share of stock. same rate as your income. Those fed-
Price/Earning Ratio Stocks that do not pay dividends do
Price earnings ratios are one statistic eral tax rates can be 15%, 28%,
not have a yield reported. So, if a 31%, etc., plus any applicable state
often reported in newspapers. This company’s stock was $45 a share and
ratio takes the price per share of an and local income taxes.
paid $.60 in dividends, the yield
individual stock and the earnings the would be 1.3% (dividend divided by The other type of tax on stock is
company makes on a per share basis. share price = yield or $.60/$45 = capital gains/loss tax. This tax is in-
So, if a share of Company A was $50 1.3%). A yield is similar to the inter- curred when you sell a stock. Let’s
and the earnings were $1.99 per est paid on a bank account, however, say you purchased a stock at $10 a
share, the price/earnings ratio would companies do not guarantee divi- share and sold it 6 months later at
be 25 ($50/1.99). If Company B had dends so the yield changes daily $15 a share. You have a profit of $5 a
a price of $75 a share and had earn- based on share price and dividends share and because you held the stock
ings of $2.25 per share, the price/ paid. Investors looking for growth for less than 1 year, you have a
earnings ratio for Company B would and income should consider pur- short-term capital gain that is taxed
be 33 ($75/2.25). This means that chasing stocks with higher yields. as regular income. If you held this
Company A stock may be underval- stock for 12 months or 3 years, you
ued compared to Company B or have long-term capital gain which
Company B is overpriced compared Splits is taxed at a lower rate. For those
Sometimes, companies will split taxpayers in the 15% income tax
their shares. So, if you own 50 bracket, they would be taxed at 10%
shares, you now have 100 shares if long-term capital gains rate and all
there is a 2-for-1 split. Your cost ba- other taxpayers are taxed at the 20%
sis per share will be cut in half so if tax rate. Starting in 2001, for invest-
you had 50 shares worth $102 a ments held 5 years or longer, these
share you now have 100 shares rates are 8% and 18%, respectively.
worth $51 a share. Your value in this For individuals taxed at the higher
company is still the same $5100. Be- income tax rate, 20% is much better
cause your cost basis is reduced by than 28% or higher, so this encour-
one-half for each share, a record of ages investors to hold stock long
splits needs to be kept for future tax term. In a situation where you lose
records. Generally, there is no tax- money on a stock that you sell, those
able event when this occurs. losses are subtracted from the capital
MM-06-2001—page 4

gains you made. If you had no other If you start with this method you Investing for Your Future, A Coopera-
gains that year, up to $3000 of net must continue to use it each time tive Extension System Basic Investing
capital loss a year can be deducted you sell shares in a mutual fund. Home Study Course, February 2000,
against other income. See your tax This works well when the shares Rutgers Cooperative Extension. Can
advisor for the details of capital you have owned the longest have be obtained from OSU Extension. Ask
gains/losses. the lowest cost basis. for Bulletin 884. This bulletin is also
available online at:
http://www.investing.rutgers.edu
Determining Cost Basis Record Keeping
There are two different ways to de- Keep track of all confirmations when
Morningstar Mutual Funds: User’s
termine your cost basis when selling you buy or sell stock. If your year-
Guide, October 1996, pg. 34.
stocks, FIFO and specific identifica- end statement includes these
tion. A third method, average cost confirmations, you can throw indi- Investment Basics: Part 3: Stocks,
method, is only used for selling mu- vidual confirmations away and keep Cooperative Extension Service, Kan-
tual fund shares. all of the year-end statements, in- sas State University, Manhattan, May
• First in first out or FIFO uses the cluding reinvestment purchases. 1995.
first shares purchased as your cost These are used to determine cost ba-
basis. This is a good method when sis of your stock when selling. Schwab on THE BASICS. Cost Basis
the first shares you purchased were Having a separate folder for each and Your Taxes, 1998,
the most expensive. company owned allows you to file a www.schwabon.com
copy of the most recent annual re-
• Specific identification is a second port, a listing of reasons why you
method of determining cost basis. bought this stock, and research re- Other OSU Extension fact sheets in this
In this method you identify the ports about the company. series:
particular shares you are selling. MM-01 Start with Mutual Funds
Before selling shares, you instruct MM-02 Financial News You Can Use
the broker or fund company which
shares you plan to sell. This MM-03 IRA—Individual Retirement
method allows you control over the Account
capital gains taxes you pay because MM-04 Retirement Planning
you determine how much will be
MM-05 Investing in Bonds
paid by the shares you select to
sell. Long term or short term gains
can also be controlled. Written by: Ruth Anne Mears, Ph.D,
C.F.P., C.F.C.S., Family and Consumer
• Average cost is the third method Sciences Agent, Licking County, Ohio
and is only used with mutual State University Extension, January
funds. In this method the average Conclusion 2001.
cost is determined by dividing the Stocks are a growth investment. Di-
total cost of all shares purchased, versification is an important Visit Ohio State University Extension’s
including any invested dividends, consideration when investing in WWW site “Ohioline” at:
stocks. At least six to eight different http://ohioline.ag.ohio-state.edu
by the total number of shares held.
companies in different sectors helps All educational programs conducted by
to reduce risk. As with all invest- Ohio State University Extension are
available to clientele on a nondiscrimina-
ments, accurate records need to be tory basis without regard to race, color,
kept to determine cost basis when creed, religion, sexual orientation, national
origin, gender, age, disability or Vietnam-
individual stocks are sold. era veteran status.
Keith L. Smith, Associate Vice President
for Ag. Adm. and Director, OSU Extension
Resources Hearing impaired readers may request
American Savings Education Council information about educational topics by
calling TDD #1-800-589-8292 (in Ohio) or
Suite 600, 2121 K Street NW 1-614-292-1868 (outside Ohio). For those
Washington, DC 20037-1896 with physical disabilities, special arrange-
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202-775-9130 programs can be made by contacting
www.asec.org 1-614-472-0810.