Stock Basics: What Happens When You Invest

How your stocks make money, and what to watch out for when you put your cash in the market.

Feb 2, 2014 at 9:30AM

Stocks last year enjoyed their biggest gains since 1997. All the key market indicators that measure stock performance posted handsome returns. The Dow Jones Industrial Average gained 26.5% in 2013, with the S&P 500 up nearly 30% and the Nasdaq index up 38%. Now is a good time to figure out how stocks work if you're interested in investing. Keep in mind that past performance is no guarantee of future returns.

When you invest in a stock, you become one of the owners of a corporation. Stocks represent ownership shares. You also might hear them referred to as equity shares. What you can make or lose on a stock is known as the return on investment, and it depends on the success of the company you've invested in. If it does well and makes money from the products or services it sells, you should expect to benefit from that success.

You can make money from stocks in two basic ways:

1. Dividends. Publicly owned companies that are profitable can choose to distribute some of their earnings to shareholders by paying a dividend. A dividend is a fixed dollar amount per company share. The more shares you own, the more money you'll receive. Dividends can be paid to you in cash, or you can reinvest them to buy more shares in the company. Many retired investors look for stocks that consistently pay dividends to help generate income, since they no longer work. Stocks that pay a higher-than-average dividend are sometimes called income stocks.

2. Capital gains. During each trading day in the stock market, stocks are constantly bought and sold by investors, and their prices constantly change. When you sell a stock at a price higher than what you paid for it, your profit is known as a capital gain. At the other end, if you sell shares at a lower price than you paid for them, you've incurred a capital loss.

The frequency of dividends and the size of capital gains are determined by how well a company performs. Dividends are generated by a company's earnings and capital gains by price increases, which in turn are influenced by investor demand to buy the stock. This demand largely reflects what investors think about the prospects of a company's future performance. When investor demand to buy a stock is strong, the stock's price tends to increase.

However, if a company isn't profitable or investors sell the stock for some other reason, your shares may be worth less than the price you paid for them. It's a good idea to follow any news about the companies whose stock you own or are looking to buy in the financial and business press. Positive or negative news coverage of companies can affect their stock prices.

The performance of an individual stock also is influenced by what's going on in the overall stock market, whether the market is in a rally or a sell-off. These are known as bull and bear markets. And the market is affected in turn by the economy and public policy in Washington, D.C., most notably the interest rate policy of the Federal Reserve System, the nation's central bank.

There is concern today that, if interest rates increase from their current historic lows, the stock market will stumble. That's because higher bond yields might look more attractive to investors than stocks, and they then might sell stocks and buy bonds. This could cause the stock market as a whole to drop in value, which in turn may affect the value of the stocks you hold. Other factors, such as political uncertainty at home and abroad, energy and weather problems, and soaring corporate profits, also influence market performance.

It's important to remember when you invest in the stock market that stocks are cyclical, and move from strength to weakness and back to strength over time. This cyclical pattern, known as a full market cycle, recurs continuously, though the timing isn't predictable. Sometimes it takes only a few months. At other times, it may take years.

Here's how the cycle works. After a market sell-off, stock prices at some point become low enough to attract investors again. If you and others begin to buy, stock prices tend to rise, which offers the potential to make a profit. This expectation attracts more stock investors and can breathe new life into the overall market.

We saw this happen after the stock market sell-off in 2008, when stocks fell in value by 36%. From that low, stocks have rebounded strongly in the past five years, with the Dow Jones average nearly doubling. Stocks today are higher than they were before the 2008 decline. But nobody can tell you for sure what will happen next.

For more information about investing in stocks, visit the Investors section of FINRA.org.

FINRA is the largest independent regulator for all securities firms doing business in the United States. Our chief role is to protect investors by maintaining the fairness of the U.S. capital markets. FINRA does not endorse, sponsor, or guarantee, nor is it sponsored by, any advertisers on this site, and any dealings with those advertisers are solely between you and the advertisers.

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