Legendary investor Benjamin Graham, used
to talk about the stock market as a living, breathing thing. Mr. Market,
he called it. "Mr. Market is very obliging indeed," he wrote in The Intelligent
Investor, his classic 1949 book. "Every day he tells you what he thinks
your interest is worth and furthermore offers to buy you out or to sell
you an additional interest on that basis. Sometimes his idea of value appears
plausible and justified by
business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly."
That, in a nutshell, is the story of stocks. Some days their prices make sense. Other days they seem ridiculously expensive or cheap. The key to investing is to determine which is which on any given day, and then take advantage of it. Thatís how Warren Buffett, a former student of Benjamin Graham, made his billions. And thatís what this installment of Money 101 will begin to equip you for.
For starters, when you purchase a share of common stock, you are buying a piece of the company. The firm sold the shares originally in order to raise money -- sometimes at its initial public offering, or IPO. But since then, the shares have traded freely in the open market, rising or falling in price depending on the fortunes of the issuer.
Your stake is generally very small. If
you buy 100 shares of AT&T at a cost of several thousands of dollars,
for example, you own just 0.0000001 percent of the firm. But even the smallest
holding can occasionally bring huge rewards. Consider Microsoft. If youíd
picked up 100 shares of the company in 1986, when the stock was first sold
to the public, your piddling 0.000003 percent stake in the fledgling software
firm would have cost you
$2,100. By late 1998, after seven stock splits (see below), those 100 shares would have grown into 7,200 shares. And though that would have represented an even tinier percentage of the company than 100 shares did in 1986, that sliver of ownership would have grown in value to more than $800,000.
Now obviously few people could afford to buy stock at $800,000 a share. That's why companies generally declare a stock split when the price climbs to somewhere between $60 and $120 a share. A two-for-one split, for example, means that if you used to own 100 shares, you now own 200. But the value of your total holding remains the same because the price of each individual share is cut in half.
To understand why the value of a stock
can rise so much over time, just consider what's happened to the company
in the meantime. When you bought those 100 shares of Microsoft in 1986,
your share of the ownership stood for about $135 a year in annual earnings.
Twelve years later, it stood for $16,560. No wonder Mr. Market valued Microsoft
so highly. In fact, while news reports and rumors may drive a stock's price
up or down suddenly, the most important long-term factor influencing the
price is earnings. If a company's earnings
rise over time, its stock price will too.
You can make money on stocks in two ways.
The most important is the one we mentioned earlier: the price appreciation
that occurs when a stock keeps rising. But many companies also pay yearly
dividends, or cash payments that represent a portion of profits. The two
kinds of earnings are treated very differently by the tax man. The appreciation
in price is not taxed at all so long as you continue to hold the stock.
taxable only when you sell the stock and realize a capital gain (the difference between what you paid
for the shares, plus commission and fees, and what you received when you sold), and then only at the prevailing capital gains tax rates, which often are lower than the income tax rates. Your dividends, on the other hand, are taxed along with the rest of your income each year at a rate that's determined by your tax bracket. Thus, for
buy-and-hold investors, stocks represent a great way to build up profits that can remain tax-free until you sell.