You’ve heard the word many times and you may even have some of your money invested in them.  But do you really know what a stock is and better yet, could you explain what it is to your daughter?  If not, read on….

What is a stock?
At some point, just about every company needs to raise money, whether to start operations, to build a factory, or to take on new staff.  Typically companies do one of two things when they need more cash:

1) They borrow the money from a bank or from individuals, or

2) They raise it from investors by selling them a piece of the company (called stocks or shares in the company)

If you buy stocks and become a shareholder, you are then a part owner in the company with a claim (however small it may be) on every asset (land, buildings, chairs, computers, etc.) and on whatever the company earns.

How do I make money from stocks?
There are two ways you can make money from stocks:

1) When the stock price goes up –  if the value of your stock goes up over time, your stocks could become worth more than you paid for them. And if at that point you sell your stocks, the difference between your purchase price and your selling price is called a capital gain.

For example: if you buy 10 shares of ABC company for $10 each, you will have invested $100.  If the share price goes up to $20 and you sell your 10 shares, you will now have $200, which means your stocks are worth $100 more than they were before. If you sell the stocks for $200 you will then have what’s called a “capital gain” of $100 on your investment. (Your capital gain may be taxable – we’ll talk about investment taxation in a future column).

2) When you receive dividends – when an established company makes a profit, it may choose to pay the profit out to its shareholders, rather than invest it back into the company. These payments are called dividends. Dividends are often paid quarterly and the amount you get depends on how many shares you own and the amount per share that the company decides to distribute.

Of course the flip side is that:

1) If your stock price goes down – and you have to sell your stocks at a time when they are worth less than what you initially paid, you incur a capital loss, which is a fancy way of saying you’ve lost at least some of your initial investment.

2) Dividends are not guaranteed – if the company stops making a profit, or if it goes through a change and decides to reinvest the profit in the company, it can stop paying dividends. At that point you could be out of an income stream.

Why would I invest in stocks if I could lose money?
In spite of the recent turmoil in the stock market, over the last 15 years Canadian stocks* (including reinvested dividends) have increased by an average of 7.09% per year compared to 4% for cash type investments. If you are saving for something that is at least 7-10 years away like retirement, having some of your money invested in stocks or stock mutual funds should help you get there faster.  But before investing in stocks, make sure you have a solid plan and a good understanding of what you’re investing in so you stay calm when the inevitable fluctuations happen along the way.

* As of Feb 2, 2009 – TSX/S&P Total Return

Karin Mizgala is a Vancouver-based fee-for-service financial planner with an MBA and a degree in psychology. She’s the President of LifeDesign Financial and co-founder of the Women’s Financial Learning Centre.