How to Make Sense of Stocks

Stocks, company shares, equities — whatever you call them, these securities are a fundamental part of many people’s investing plans. But that doesn’t mean they are easy to understand. Stocks, which represent partial ownership of a publicly-traded company, are complex investments with significant near-term risks.

Stock prices fluctuate based on the law of supply and demand. If more investors are willing to buy a share of a company than there are sellers at that moment, the price will rise. If there are more sellers than buyers, the price will decline.

It is important to view stocks as long-term investments. In addition, prudent investors try to achieve a high degree of diversification among their stock holdings. This helps reduce near-term investment risk and enhances long-term returns.

The allure of a home run, like the FAANG quintet (Apple, Amazon, Netflix, Google parent Alphabet and Facebook) at an early stage, is certainly part of what drives investor enthusiasm for stocks. However, the fact is that these rare home runs are few and far between. A stock’s overall return, which includes both capital gains and dividends, will ultimately determine whether or not it is a good investment.

To make sense of stock performance, you need to look at both price and total returns, compared to an appropriate benchmark that is consistent with your investment style and risk tolerance. Also, when comparing returns, remember that any payments of income or interest will distort the results.

There are a variety of reasons why a stock might rise in value, including a growing company’s sales and earnings, the growth of its industry, or the company’s ability to raise more money from investors. In contrast, a stock might fall in value due to a shrinking company’s sales and earnings, or because of the decline of its industry.

A company needs money to design new products, hire more employees and expand into new markets. To raise that capital, it issues shares of stock to the public. Investors then purchase these shares, hoping to profit if the company grows and the price of its stock rises.

Besides revenue and profit growth, another reason that shareholders might find stock attractive is that some companies pay out regular dividend payments to their owners. These dividends typically represent a portion of a company’s current year profits. However, special dividends – funded with retained earnings or asset sales – are sometimes made as well.

Stock analysts use a wide range of financial ratios and tools to help them figure out what a share is worth. These include revenue and profit growth, debt levels and a company’s ability to produce consistently profitable results. A company’s ability to do this demonstrates that it has the potential to continue growing its business. As such, its stock is worth more to investors than a competing company that hasn’t been successful at achieving this goal.