More Good Thing From "The Man"!
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. That's how Warren Buffett, a former student of Benjamin
Graham, made his billions. And that's 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 you'd 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. It becomes 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. |
