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Stock Basics: What Happens When You Invest

the Financial Industry Regulatory Authority
February 2, 2014

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 in