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September 18, 2013

Seven things you need to know about stocks

Common shares, preferred shares, initial public offerings and dead cats bouncing. Find out if equity investing is for you.

Twitter announced plans to launch an initial public offering (IPO) last week. It’s the first major social media company IPO since Facebook went public in May 2012, so investors will be watching closely. I’m not a fan of investing in stocks myself, for a couple of simple reasons. First, I don’t have time to do the research correctly. And second, a decision to invest in individual companies can quickly throw your balanced portfolio out of whack. Pick up a couple of bank stocks and all of a sudden you’re heavily overweight in the financial services sector.

Still, equities play a central role in the global economy and so it’s important to understand how they work. Here are seven things you need to know:

1. Buying a stock means you own part of the company that issued the stock

Let’s start with the basics. Companies issue shares in order to raise money for use in the business. By “going public,” a company agrees to abide by market regulations and to allow investors to buy and trade its company-issued stock. Unlike a bond, which is effectively a loan to the company, a stock provides you a share in the company’s ownership.

2. Not all stocks are created equal

There is common stock and there is preferred stock. Typically, common stock holders get a vote on major strategic decisions like who sits on the board of directors. Preferred stock holders tend not to get a vote. There are advantages to being a preferred shareholder, though. Preferred share prices tend not to fluctuate as much as common stock prices. And if the company that issued the stock goes bankrupt and is liquidated, preferred shareholders receive money back before common stock holders do. (Although business taxes, employees and creditors are paid before any shareholders.)

3. Dividends are the gift that keeps on giving

Nothing is forever, of course. And not all publicly traded companies issue dividends. But those that do can provide you with a nice little income boost, depending on how many shares you own and what level of dividend the company decides to pay. Again, there’s a benefit to being a preferred shareholder. While not all preferred stocks carry a dividend, companies can’t pay dividends to common shareholders until they’ve done so to preferred stock holders.

4. The money you earn from stock investing will be taxed

Stocks make you money when they pay a dividend and/or when you’re able to sell them for more than you paid for them. That income is taxed, though. If you hold the stock in a registered plan (like a registered retirement savings plan), you don’t pay tax until you withdraw money from the plan. If you hold the stock outside a registered plan, you pay tax in the year you either earned the dividend income or realized a capital gain from selling the stock at a profit. (Investment earnings within a tax-free savings account are not taxed.)

5. IPOs aren’t for everyone

When a company like Twitter decides to sell stock for the first time, it issues an IPO with the help of a group of financial institutions. They deal the stock to institutional investors and, in some cases, to their retail clients. As a result, IPOs are seldom available to the general public. The rest of us have to wait for the initial purchases to happen, and then buy shares from those early stock holders in what’s called the secondary market (on exchanges like the Toronto Stock Exchange). There’s another reason IPOs may not be for you. Because these are brand-new stocks, it’s more difficult to determine what each share should be worth. An IPO price is determined based on careful analysis by its dealers, but until a stock has traded broadly, you can’t know for sure whether or not the price is right.

6. A company’s stock price is a prediction

The truth is that valuing stocks can be quite complicated. There are standard measures, such as the price-to-earnings ratio (which compares the share price to annual earnings per share). But what many fail to realize is that at any given time, a company’s stock price reflects investors’ opinions on the firm’s current and future earning potential. This is what people mean when they say the stock market is a leading indicator. Its values indicate how well investors believe the companies being traded will do in the future. Sure enough, stock markets tend to drop before an economic downturn.

7. My favourite bit of stock market jargon

That’s easy: dead cat bounce. It’s applied to stocks that -- in the midst of a sharp decline -- enjoy a minor, short-lived recovery followed by a further drop in price. The idea is that even a dead cat will bounce a little if it falls from a great enough height. My affection for the term has nothing to do with a dislike for cats, by the way. I just like jargon that’s easy to visualize.

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