What Are Two Benefits and Two Risks of Buying Stock?

Investing in the stock market involves purchasing shares, which represent small units of ownership in publicly traded companies. This allows individuals to participate directly in the potential growth and financial success of businesses and the broader economy. This article explores some primary advantages and disadvantages associated with buying stocks.

Benefits of Stock Ownership

A significant advantage of owning stocks is the potential for capital appreciation. This occurs when a stock’s market value increases, allowing investors to sell shares for more than they paid. This growth is often linked to a company’s improved financial performance, innovation, or increased demand, leading to higher investor confidence and a rising stock price. Any profit from selling stock for more than its purchase price is considered a capital gain.

The taxation of these gains depends on how long the stock was held. Profits from shares held for one year or less are classified as short-term capital gains and are taxed as ordinary income. For stock held longer than one year, profits are considered long-term capital gains, which typically receive more favorable tax treatment at lower rates. This distinction can significantly impact an investor’s after-tax return.

Another financial gain from stock ownership can come from dividends. Many companies distribute a portion of their earnings directly to shareholders as cash dividends. These payments can provide investors with a regular income stream, separate from any increase in the stock’s price. While not all companies pay dividends, and the amount can fluctuate, they represent a tangible return on investment.

Dividends are categorized for tax purposes as either qualified or non-qualified. Qualified dividends, which meet specific criteria, are taxed at lower long-term capital gains rates. In contrast, non-qualified, or ordinary, dividends are taxed at an investor’s standard income tax rates. This distinction significantly impacts the after-tax return an investor receives from dividend income.

Risks of Stock Ownership

Despite potential gains, stock ownership carries inherent risks, including the possibility of losing the original investment. A primary risk is market volatility, referring to rapid and unpredictable fluctuations in stock prices. Various factors influence market movements, such as economic data, interest rate shifts, geopolitical events, and investor sentiment. A sudden market downturn, often called a bear market, can lead to significant declines in investment value, regardless of individual company performance.

Investors can lose money if they sell shares when prices are lower than their purchase price. There is no guarantee that an investment will retain its value or generate a profit, as market conditions can change rapidly. While historical trends show market recovery over time, short-term volatility can result in considerable financial losses if investments need to be liquidated during a downturn.

A second significant risk is company-specific risk, also known as unsystematic risk. This pertains to factors unique to an individual company that can negatively impact its stock price, irrespective of the broader market. Poor management decisions, competitive pressures, industry downturns, or operational failures can cause a company’s stock to decline sharply.

In extreme cases, a company might face bankruptcy, which can lead to a significant or complete loss of the investment. In bankruptcy proceedings, common stockholders are typically last in line to receive any remaining assets after creditors, bondholders, and preferred shareholders have been paid. While a company may attempt to reorganize, existing common stock is frequently cancelled or rendered worthless, leaving little to no recovery for shareholders.