Everything You Want to Know about Common Stocks
Most investors want to invest in something with the potential for high capital appreciation and a steady income. An investor needs to opt for long-term investments that will grow their capital into a considerable sum.
This is where common stocks play a significant role. Common stocks allow investors to participate in a company’s growth and make plenty of profits.
What Are Common Shares?
Common or ordinary shares are equity instruments that represent ownership of a company or corporation. Furthermore, unlike preferred stocks, these give the holders voting rights in shareholder meetings. This allows them to elect corporate directors and vote on various corporate decisions.
Shareholders owning a company’s common stocks are its partial owners. However, they only have a residual claim. This means they can be compensated with dividends after the company pays its creditors, bondholders, and preference shareholders.
The sections below cover more details on common shares, their advantages, and the precautions one must take before investing.
Why Are Common Stocks Issued?
Businesses raise money through ordinary shares or common stocks for various reasons, including business expansion, upgradation, debt repayment, and working capital requirements.
Furthermore, it enables the company to diversify voters and distribute shares to a larger population. Besides raising capital, companies can promote themselves to a larger public by issuing common shares.
Advantages of Investing in Common Stock
Let’s look at the advantages of investing in common stocks:
- Voting Rights
The shareholders of common stocks can actively participate in electing the corporate directors. Each common share stands for one voting right. That is, holding the majority of stocks in a corporation can make an investor or institution a decision-making body.
Furthermore, common stockholders can participate in corporate meetings and take a stand on various vital decisions and changes under the company’s consideration. By participating in a company’s growth, shareholders can benefit themselves and the company.
- No Maturity Date
Ordinary stocks have no specified maturity date. Therefore, investors can hold on to their stock investments as long as the company keeps operating.
Common stocks are apt for long-term investments, which yield decent returns and allow the company to grow. The common stockholder will also benefit from higher returns as the company expands its operation and generates more revenue and profits.
- High Returns
Common stocks or voting shares are known to yield higher returns than many other forms of investments like bank deposits, bonds and real estate, given the higher returns underlying risk attached to these is also too high. In fact, equities tend to deliver the highest inflation-beating returns over the long term.
Also, returns from voting shares depend upon the company’s stock valuation. Thus, a company with rising stock valuation can generate massive returns.
- No Legal Obligations
Thriving companies can earn large stock valuations, and these valuations, in return, can help investors earn proportionally high dividends. Furthermore, as soon as investors sense a sinking market, they can opt-out by selling their shares without any legal consequences.
- High Liquidity
Buying and selling common stocks is very easy as they have high liquidity. This gives the stockholder an option to modify or diversify their investments at any time.
Risks Involved with Investing in Common Stocks
Although common stocks can earn high returns over the long term, they still involve risks, which are listed below.
When investing in stocks, one must remember that high returns come with high risks. The stock market valuation of a company ultimately depends on its performance and market sentiments; therefore, underperforming companies will often cause losses for their investors.
Moreover, stocks are sensitive to considerable volatility. There is no way for any investor to reliably estimate what returns they will get if any.
- Uncertainty in the Case of Company Liquidation
Common stockholders are the last in line when it comes to the liquidation of the company. Therefore, if a company decides to liquidate, its assets are first allocated to bondholders, creditors, preferred stockholders, and finally to the common stockholders.
Second, if a company’s earnings are insufficient, there is often uncertainty about successful dividend distribution to common shareholders. Companies also do not have any obligations to pay dividends.
What Are the Differences Between Common Stocks and Preferred Stocks?
Preferred stocks or preferred shares are a unique type of share with preferential rights to receive dividends before common stockholders. Here are the differences between preferred shares and common stocks:
- The main difference between preferred stocks and common shares is their voting rights. A common stockholder can directly participate in voting related to company decisions, whereas preferred stockholders cannot.
- Common stockholders get the last priority over a company’s assets and dividends after creditors and other investors. In contrast, preferred stockholders are paid dividends before common stockholders.
Crucial Tips to Successfully Invest in Common Stocks
Here are some tips to consider before investing in common stocks.
- Prepare a Blueprint
It is crucial for an individual to carefully analyze their income and allocate a certain percentage of it to the stock market. People with higher incomes and fewer liabilities tend to have a higher risk tolerance, and they prefer high-risk investments like common stocks.
However, people with lower incomes generally opt for stable or defensive investments. So, access your risk tolerance and income level before investing.
- Use a Stock Market Simulator
Various stock market simulator apps are available that help investors understand how the market moves and practise investing. These simulators provide an immersive simulation of equity markets by randomly generating data and figures.
Investors can use the free virtual money available in the app to buy virtual stocks and learn how online brokerages work. This can cultivate confidence among beginners and their potential to read equity trends.
- Invest for Long-Term
Investments over a year are considered long-term investments for equity related investments, and they attract less taxation than short-term investments. Long-term capital gains of more than ₹1 lakh will attract a 10% tax. In contrast, short-term capital gains from stock investments are charged with a 15% tax rate.
- Know about the Industry
Before investing in a company’s share, an investor needs to have a decent knowledge of the following things:
- The company’s sector
- Its products and services
- Its reputation and stock valuation
Furthermore, one can narrow down the list by considering the company’s ability to maintain a competitive advantage or, in Warren Buffet’s terms, a “moat” in the market.
Organisations with a high growth prospect are easier to evaluate. Companies with high moat often yield more significant returns over time. However, high moats are sometimes limited to emerging companies.
What to Look for in a Company Before Investing
Here are some major factors to look for in a company before investing.
- Price to Earnings Ratio
A stock’s PE ratio justifies its price. An overvalued stock has a high PE ratio, whereas an undervalued stock has a low PE ratio.
- Debt to Equity Ratio
The D/E ratio determines a company’s leverage levels, which is the ratio of the company’s total debt to the owner’s equity. A high D/E ratio means the company is overburdened with debts and at an increased risk of default.
How to Start Investing in stocks?
Here are the steps you can follow to start investing in stocks.
Step 1. Create a Demat account and a trading account with a reputed stock broker.
Step 2. Link your primary bank account in the broker app and add funds from the bank account.
Step 3. Carefully choose the stock that you want to invest into.
Step 4. Make a clear note of your basic expenses and analyse your financial capability to invest in stocks.
Step 5. Select the number of units and purchase the stock, considering your financial capability.
Step 6. After the purchase confirmation, the amount will be debited, and the share will be credited to your Demat account.
Investing in the stock market may involve financial risk as it is volatile and subject to market risk. However, those with a high-risk appetite and sound knowledge of the stock market can invest in common stocks. Investors will get the chance to make high profits with the added advantage of taking part in the decision-making process of the company.
As it’s often said, you should not put all your eggs in one basket; always try to diversify your investment in more than one asset or investment class. To invest in fixed income instruments
Frequently Asked Questions
What is the difference between preferred stocks and common stocks?
The primary difference between preferred stocks and common stocks is that common stocks have voting rights, whereas preferred stocks do not. On the other hand, the preferred stock will have preferential rights over company dividends compared to common stock.
Which is more profitable, preferred stocks or common stocks?
Generally, common stocks show a higher potential for returns and higher risk values than preferred stocks.
Is there any limit to my investment in the stock market?
No. There is no limit to investment, although it is advisable to be careful about investing a large sum of money in equity markets.
When should I start investing in the stock market?
There’s no age limit to investing in the stock market. Individuals under the age of 18 have to open their Demat account through their guardian or parent. Although it is advisable to start as early as possible to benefit from the compounding effect.