Last week we looked at stock investments, explaining that this option provides persons with the opportunity of buying ownership into a company. Let’s now outline the ways in which you can make money by investing in shares, while highlighting some of the possible risks.

When you invest in stocks, there are two main strategies that you can employ to make a profit. You can choose to hold the stocks over time and reap the benefits that come with share ownership, or decide to buy and sell the stocks to receive trading gains. To be successful in either method, it’s best to learn more about stocks with the help of professional advisors.

Sharing the profit

If a company makes a profit, the management may choose to pay a dividend to the shareholders, which is a portion of the profit earned. Dividends are issued to stock owners relative to the number of shares that they own. If you own 1,000 shares in a company that declares a $2 dividend for each share, then you will receive a payment of $2,000.

With the resale strategy, investors hope to buy stocks and sell them to other investors for a higher price. If you bought 5,000 units at $2 per share, your initial investment would be $10,000 in addition to any transaction fees. If the market price of the stock increased to $3, your holdings would be valued at $15,000. You could then attempt to sell your shares and pocket the profit.

Profit comes with risk

Despite providing opportunity for profit, stocks also present risks that you must consider before proceeding. There are various negative occurrences that can affect a company’s viability, which could adversely affect the price of its stock in trading on the market.

Stock prices can also be affected by fluctuations in supply and demand, investors’ perceptions about the stock market, the general economic climate, and the attractiveness of other investment options. One major risk is that if you wish to convert your shares for cash, you may have to sell them for less than the price you paid for them.

If you are hoping to use the dividends from your stocks for an income, you could face the risk that the company may not make any profit, or choose to reinvest the gains made into the business. In some extreme cases, you could forfeit your entire investment, as the company may become insolvent and your asset value may be lost.

Where’s the beef?

Imagine that buying shares was like owning livestock, that is, cows. You buy a cow for J$30,000; when the market price of beef increases, you decide to sell it for J$40,000. You would have made a profit of J$10,000 less the expenses of keeping and selling the cow. This is similar to the capital gain you would receive from buying a stock and reselling it when the market price increases.

However, let’s say you had to get back your cash in an emergency, but the market price for beef determined that you could only sell your cow for J$25,000. In this case, you would lose at least J$5,000 on your original investment. Similarly, with stocks, you may be forced to sell your holdings at a time when the stock price has fallen, and you would experience a capital loss.

If people were afraid to buy beef because of reports of mad cow disease, then you could be stuck with an asset with little value because no one wanted to buy it. Sometimes, unfavourable reports of a company’s performance can negatively influence investors’ perceptions of the value of its stock. This could result in your inability to resell the stock due to a lack of demand for it.

Milking the dividends

Instead of selling the entire cow, you could decide to harvest its milk for sale. Since the milk supplies an income, this is similar to investing in the stock of a company that provides regular dividend payments. You would be less concerned about fluctuations in the price of beef, as you could continue to earn from your asset.

However, if the cow stopped producing milk, or it needed all its milk to feed its calves, then you would lose this income source. Similarly, while companies may wish to distribute some of their profits to shareholders, sometimes financial challenges cause them to make a loss, or they may decide to retain all their gains to help develop the business.

You could also decide to use your cow for breeding purposes, or continue to buy more cows. Eventually, you would have a large herd that could be milked for income and/or sold for profit. This could be compared to reinvesting your dividends, or committing regular sums to buy more stock. Over time, your asset value would increase and provide you with a significant source of wealth.

So, you don’t have to be ‘cow-ardly’ about investing in stocks, once you understand how they can increase your net worth and you are willing and able to accept the possible risks involved.

Copyright © 2011 Cherryl Hanson Simpson. No reproduction without written consent.

Originally published in The Daily Observer, October 20, 2011

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Cherryl is a financial consultant and coach, founder of Financially S.M.A.R.T. Services. See more of her work at www.entrepreneursinjamaica.com and www.financiallysmartonline.com. Contact Cherryl