Lesson 4: Why invest in stocks?

A stock is an investment that represents partial ownership of a company. As a stockholder, you’re entitled to a portion of the company’s profits and assets and you participate in the company’s growth. You’ll benefit if the company grows and becomes more valuable because this growth is usually reflected in a higher stock price.

First, there’s the potential for long-term growth. Over time, many companies grow and become more valuable, leading to higher stock prices and potential profits for investors. History has shown that the growth rate of a stock investment has one of the best chances of matching or beating inflation over time. We mentioned in lesson 1 that beating inflation is an important aspect of keeping and growing your net worth. Over a long period of time, stocks have had a better return than almost any other type of investment and that’s part of the reason many investors include stocks in their portfolios.

Second, there’s the potential income from stocks that pay dividends. Dividends are the portion of a company’s profit that’s paid out to shareholders. Some companies pay regular dividends, providing a steady stream of income. This can be a great feature for those looking to live off the returns from their investment portfolios.

Third, there’s the possibility of diversification, since there are many different stocks to choose from. This can help reduce the risk of loss from an investment in any one company. Stocks are also very easy and convenient to buy and sell and don’t require maintenance in the same way as an investment like real estate. There is also usually an abundance of information available about stocks’ past and present performance and company financials over time.

Fourth, with stocks you have the chance to earn capital gains, which is the profit earned on the increased value of an asset. In Canada, capital gains are given preferred tax treatment compared to interest income, like you would earn from bonds. Not only are capital gains often taxed at a lower rate than interest income, but the tax on capital gains doesn’t usually need to be paid until the gain is actually realized — that is, until the investment is sold. Capital losses can also be used to offset capital gains and reduce the tax owing.

One of the trickiest aspects of stock investing is how volatile the stock market can be, especially in the short term. Individual stocks or industry groups can be even more volatile.

There are many factors that can create this volatility: company news and business outlook, inflation, the economic cycle, political events and changes in investor sentiment can all affect a stock’s price. The prices of international stocks will also be affected by currency exchange rate fluctuations.

Company-specific risk refers to the potential for a particular company's stock price to decline due to factors unique to that business. This could include issues like management decisions, changes in product demand, or unexpected financial results.

If you need income from your investments, stocks that pay dividends can provide that, but those payments aren’t secure in the same way as the interest payments on fixed-income investments.

Diversification involves spreading your investments across various types of investments and investment classes with the aim of reducing risk and improving potential returns. Stocks can play an important role in a diversified investment portfolio.

Stocks are generally considered higher-risk investments compared to bonds or cash, but they also offer the potential for higher returns. Including stocks in your portfolio can balance more conservative investments and help you achieve your long-term financial goals.

Within the stock portion of your portfolio, you can further diversify to reduce risk and enhance potential returns. Here are some strategies to consider:

When it comes to picking stocks, investors have two powerful tools at their disposal: fundamental and technical analysis. Fundamental analysis evaluates a company's financial health and performance to help you understand its true value and growth potential. This allows you to identify strong investment choices from the outset of your selection process. In contrast, technical analysis examines historical price movements and trading volumes to identify patterns that can guide your buying and selling decisions.

Both methods aim to determine a fair price for a stock at any given time, which can be challenging. The goal is to buy at a reasonable or discounted price, enabling you to benefit from a rising stock price as the company grows and its value increases. We’ll dive deeper into fundamental and technical analysis in the next lesson.