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Wednesday, April 11, 2012

Basics Part 2

Some people wonder about how you make money on stocks. There are basically two ways.

The first is rise in share value. Let's pretend that you bought 100 shares of a Wizzy Cola Inc. for $10 per share in 2011. You hold onto Wizzy stock for a long time because it is doing well. Let's say that you haven't bought any new shares in Wizzy over the next five years, but the value of Wizzy Cola is now $15 per share. You originally spent $1000.00 (100 shares at $10 per share), but now your shares are worth $1500 (a $500 dollar profit.) If you hold onto Wizzy, then you have an unrealized gain of $500. It is unrealized because you haven't actually sold the stock and received the $500 in profit. Once you sell the stock, it becomes a realized gain. This is when the tax man comes knocking.

The second way to earn money on a stock is through a dividend. Some companies (usually older, or more established companies) pass out a certain amount of money per share to shareholders (usually quarterly, or every three months). This can be based on profits, but is usually fairly constant.

For example, Wizzy Cola Inc., declares a dividend in March of 5 cents per share. If you own 100 shares of Wizzy, you receive $5. Then in June, Wizzy declares a dividend of 5 cents per share. Again, you receive $5 dollars. In September, Wizzy (after a great summer) declares a dividend of 7 cents per share. Now, you receive $7.00. At the end of the year, Wizzy declares a dividend 5 cents per share. You receive $5 dollars.

During the year, you have received $22 dollars in dividends on your 100 shares. You can elect to receive this as a payment, or more wisely, use it to buy more shares. This is one way to build up your share balance.

For example, you own 100 shares of Wizzy, which you bought at $10 per share in January. In March, Wizzy shares are still worth $10 per share, so with your dividend, you buy 1/2 of a share ($5 worth). In June, Wizzy shares are worth $15, so you buy 1/3 of a share with your dividend. In September, Wizzy is worth $14 per share, so you buy 1/2 share with your dividend (of $7), and in December, Wizzy is $15 again, so you buy 1/3 of a share with your dividend.

Throughout the year you have purchased (1/2 +1/3+1/2+1/3) or 1.667 (one and two-thirds) new shares with your dividends. You now own 101.667 shares of Wizzy. Wizzy is now worth $15 per share. The total value of the Wizzy shares you own is now $1525.01, up from $1000 when you purchased it in the beginning of the year. If you sell your stock at $15 per share, then you would end up with $1525.01, raking in a $525.01 profit.

More in the next segment. Please comment or email me.

Stock Basics

When you are a kid, someone (a parent, grandparent, aunt) assists you in opening your first savings account. You are convinced to place your communion money, or allowance, or whatever you have managed to scrape together and not spend into a savings account and marvel at the accrual of compound interest. Someone pays you just to hold your money. Now, of course, fees chew up more than the pittance banks hand out in interest, and savings accounts often become losing investments. Even if they don't have fees, the sub-par interest rates (currently below 1% for most banks) don't even keep pace with inflation.

So you look for somewhere else to park your money. Somewhere that you hope will provide returns that are better than inflation.

Many people look to stocks for this. "Stock" basically refers to part ownership of a company. Stock is usually divided into "shares" or pieces of the company. Now a company can have billions of pieces or "shares" available, making it theoretically possible for a company to have billions of owners. Usually, though, you buy a certain number of shares based on how much money you have, how much you want to buy etc.

Now, you don't actually go in and run the company day-to-day, as you would if you owned a computer repair shop or a small business. For most of us, this is because someone like Bill Gates owns many more shares than we do (and usually owns more "powerful" shares, but we won't go into that), and so he or people that he votes for will run the company. So you and Bill Gates are now partners, but it is not an equal partnership. Bill Gates will have a lot of say over what happens in Microsoft. Depending on how many (or few) shares you own, you will have little or no say. You will trust that Bill or his appointees will do what's right to make the company more valuable (thus potentially increasing your share price) and thus hopefully making you richer. So at this point, it may come down to trust, especially if you are new to investing. You trust that Bill will want to get rich, and that he will want to see Microsoft grow and succeed, and this is probably true.

So, if you bought stock, congratulations! You are now part owner of a very large, famous, wealthy company with probably little or no say in how the company is run, but hopefully it will make you money! More on stocks in the next post.

Please feel free to comment below or e-mail me.