Stocks represent ownership shares in a company. When a company earns a lot of money, shareholders generally benefit from a rise in the stock price. However, the price of a stock doesn't always reflect what is going on with the issuing company. Stocks carry no guarantees, and there is a chance you could lose a significant amount of money by buying a stock at the wrong time. Investing in stocks involves a number of different considerations.
Stocks tend to be more volatile than most other types of investments, such as bonds and mutual funds. It isn't uncommon for the stock market as a whole to trade up or down by 3 percent in a single day; individual stocks can occasionally move by 20 percent or more in one trading session. Even if you aren't an active trader, this type of volatility can be gut-wrenching.
Stocks are often cited as having the best long-term returns of any major investment class. While it is true that the long-term returns of the stock market are around 10 percent annually, those are truly long-term averages. Stocks can go long periods of time without gaining much, or even going down in value. According to a February 2009 article in The New York Times, during the 10-year period from January of 1999 to January of 2009, the S&P 500 index, which includes 500 American large-capital corporations, had an average annual return of negative 5.1 percent, after adjusting for inflation.
Capital Gains Tax
One of the advantages of investing in stocks is that you may qualify for a better tax rate. Bonds and certificates of deposit pay interest that is taxable at ordinary income rates, which can be as high as 35 percent as of 2012. The capital gains rate for stock profits is just 15 percent. However, stocks only qualify for the better rate if you hold them for longer than a year. If you sell a stock one year or less after you bought it, you don't qualify for the capital gains rate and must pay ordinary income tax on those profits.
As in life, there is no such thing as a free ride in the stock market. Buying and selling stocks costs money. In addition to paying fees or commissions to your broker, you may also have to pay just to have an account, although this is becoming less common. Every dollar you pay in costs reduces the net return you earn on a stock investment.
Although there are thousands of stocks in the stock market as a whole, each stock is an individual entity. While stocks in general tend to follow the direction of the market as a whole, many stocks trade down when the market is up and vice versa. If you buy the wrong stock, you may still end up losing money even if the market as a whole goes on a 10-year rally. Diversification is often a good strategy when it comes to investing in the stock market.
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