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by Douglas Gerlach
There are many advantages to investing in stocks. But in order to make the most of them, you need to understand a few essentials about stocks and the stock market.
How a Stock Market Works
The stock market might seem mysterious, but the inner workings of the market are no big secret. Have you ever attended an auction? When you buy an item at auction, you aren't buying from the auctioneer. It's the auctioneer's job to match buyers with sellers, and to get the best price possible for the seller. Since there's no fixed price for any auction item, the selling price is set by the amount that a buyer is willing to pay. The stock market works in similar fashion. It's an auction-based market, and a stockbroker is an intermediary who serves to match buyers and sellers of stocks. While much of the process of matching remote buyers and sellers is done electronically these days, the floor of the New York Stock Exchange still has specialists who try to match stocks' buyers and sellers.
How a Stock's Price is Set -- and Why it Changes
The price of a stock trade depends upon how little the seller will accept and how much the buyer is willing to pay. So what are all those prices you see in the stock tables in the newspaper? The prices you see are the prices of the last trades of the prior day. You can also find the best price that buyers will pay for a share at the current time, as well as the best price that sellers will accept. If you're buying, the price you pay for shares may be worse or may be better than the most recent quoted price - by a little or a lot.
A stock's price is constantly changing - rising and falling by a few pennies (or even a few dollars). There are many factors that can cause a stock's price to change, and not all of them are rational. Investors often buy or sell a stock out of fear or some other emotion, and not because it's the "logical" thing to do. In addition, investors often exhibit a herd-like mentality, basing their own buy or sell decisions on what everyone else is doing. Sometimes, this overreaction can create opportunities for investors who are willing to run against the pack, buying a stock when it has been temporarily depressed or selling when a stock's price has been elevated for no apparent reason.
The Advantages of Stocks
Over the long term, common stocks have tended to outperform nearly all other assets. In the history of the U.S. stock markets, common stocks have had an average annual return of about 12 percent since the end of World War II. Of course, there have been some rocky patches along the way - years in which the market has dropped 20 percent or even more. While these periods can be painful, it's important to realize that the market has eventually recovered from each downturn and then marched onward.*
The Stock Market Marches Onward and Upward
If there's one thing we've learned in the 200-year history of the U.S. stock market, it's that the markets are incredibly resilient. The stock market goes through some bad periods, to be sure, but at some point it has always bounced back.* Of course, there is no guarantee of future performance, but the longer you have before you need to start taking money out of your portfolio, the better your chances of eventually earning a decent return from your investments. But most financial professionals are quick to counsel that you shouldn't invest heavily in the stock market if you need your cash from those investments in less than five years. That doesn't mean you should avoid investing in stocks entirely if you're 58 years old and looking to retire at age 63 - after all, you'll likely be drawing down your retirement funds for 15 to 20 years (or even longer), so stocks could still be part of your overall financial plan.
Avoiding Capital Gains Tax
Another advantage of long-term investing comes from avoiding unnecessary taxes. Whenever you sell a stock at a higher price than you purchased it, you must pay a gains tax on the profit. There are different rates for capital gains based on how long you owned the stock. Under current tax regulations, if you own a stock for less than a year, your capital gains tax rate will be the same as your federal tax bracket - if you are in the 28% tax bracket, your short-term capital gains tax rate is also 28%.
However, if you hold a stock for longer than a year before selling, your capital gains tax rate is 20% - which is less than the short-term rate for most investors. Investors in the lowest federal tax bracket, the 15% bracket, pay a 10% long-term capital gains tax. And if you hold a stock that you bought in 2001 or later for five years or longer, you become eligible for a special tax rate of 18% (or 8% if you're in the 15% bracket). Of course, the full tax regulations are much more complicated than this. You should consult your personal tax advisor regarding your own situation.
While all this talk about percentages and tax brackets can be confusing, the most important thing to remember is that taxes can significantly reduce your portfolio's overall returns. If you trade stocks frequently, even if you are able to do so profitably, capital gains taxes can take a big bite out of your returns. In fact, academic research has demonstrated that frequent traders are often less successful with their portfolios than long-term investors, due to the effects of taxes and commissions. Constantly buying and selling stocks can be great for your broker and accountant, but it's unlikely to fatten your portfolio.
Tomorrow:
Investing in Stocks
In our next lesson we'll talk about investing strategies and styles, finding the right approach for you, and most important of all, becoming a disciplined investor.
Further reading:
Evaluating Investments: Part 1
Tips for Managing Taxes
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Topics This Issue
How a Stock Market Works
How a Stock's Price is Set
The Advantages of Stocks
Avoiding Capital Gains Tax
Open a ShareBuilder Account
Key Points
The Stock Market is an auction-based market, where buyers and sellers are matched at a price acceptable to both.
The Standard & Poor's 500 Index is commonly used to measure the performance of the stock market. Over the past 75 years, the S&P 500 has grown an average of 12% per year. While the market does sometimes decline, the S&P 500 has ended the year higher in 54 of the past 75 years.* The stock market marches on!
Here's how capital gains taxes can affect your investments. You purchase 1,000 shares of stock at $10 per share (we'll leave commissions out of the equation for now): 1,000 shares @ $10/share = $10,000 (this is what's known as your "cost basis"). If, after a few months, the share price of your stock increases from $10 to $15 a share, you decide to sell in order to "lock in" a healthy 50 percent profit. Your capital gains in this case would be $5,000 ($15,000 proceeds - $10,000 cost basis = $5,000 in capital gains).
If you're in the 28% federal tax bracket, since you owned the stock for less than a year, your capital gains tax rate is 28%, and you now owe the IRS a total of $1,400 in capital gains taxes: $5,000 capital gains - $1,400 capital gains tax = your net profit of $3,600. You can see how important it can be to manage the tax bill that results from your portfolio. If you hold stocks for the long-term, you can end up paying much less in taxes.
See Tax basics for Investors center for more on capital gains taxes.
* Past performance is not a guarantee of future results. Individual experience will vary with stock selections and changing market conditions.
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