The following is adapted from Inheriting Chaos with Compassion.
If you inherit an investment portfolio from a loved one after they pass, unless you’re an investor, you might look at the mix of stocks, bonds, and other assets with total confusion. As a financial advisor, I’ve seen it happen before with clients.
If you’re in that situation—or if you’re curious about stocks and how they can be used to grow your wealth—this article can help. To start, let’s answer an important question:
What is a stock, anyway?
When you own stock in a company, what you actually own is equity in that business. Some perceive the stock market as the “Wall Street casino,” but it’s not gambling. When you own a share of a company, its profitability has a direct impact on you.
For example, if a company has a hundred shares of stock, and you own ten of them, you’re a 10 percent owner of the company. You have a participatory interest.
As a part owner, you receive shares of that company’s profits.
There are two components of a stock that generate wealth. The first is through dividends, and the second is the growth of the stock price over the principal (that is, over what you paid for it). Together, these make up your total returns.
Let’s take a look at each of these components individually.
After a corporation has paid all their expenses to operate, they have two choices for what to do with their leftover profit. They may choose to invest that profit back into the company to fuel future growth, such as buying new equipment. Or, they may choose to pay that profit out to shareholders. This profit payout is a dividend.
Dividends tend to be stable, and they tend to increase over time.
When investors receive a consistent dividend, they have a perceived guarantee: this income is often steady even if the stock market price fluctuates. In turn, the stock price tends to stabilize when investors are confident in their returns.
Dividends don’t always last.
In 2008, at the height of the recession, many companies cut their dividends drastically. Wells Fargo, for example, reduced dividends by 85 percent. Ford took their dividends down to zero—a big risk, as it could influence investors to sell shares. As big companies needed more cash internally, they couldn’t afford to pay out profits to shareholders.
Investors who lived off their dividends were hit hard by their companies’ cutbacks. Large market swings aside, dividends tend to be the more stable component of the income investors see in returns, and this drives their decisions about which stocks to choose.
Principal and Growth
The second way that stocks generate wealth is through the growth of the stock price. How much return you see from that growth depends on what you paid for the stock (the principal) and when you decide to sell the stock.
The profit you make from selling the stock at a higher price than you purchased it is called the capital gain. Capital gains are taxed at a lower rate than most people’s income tax rate, making them an attractive tool to grow wealth.
Often what drives changes in stock prices is the public perception of how that stock will perform in the future. A stock rises or falls with how confident people are in that company’s ability to make long-term profits. Shareholders base their confidence on the company’s performance and, even more specifically, their ability to innovate.
Pfizer: The Pressure of Innovation
We can see these influences play out in the history of Pfizer stock. The pressure pharmaceutical companies face to produce new drugs is impacted by two factors.
First, the research and development phase for creating new drugs is a long process, as new drugs go through clinical trials after they are produced. Second, pharmaceutical companies hold patents on their drugs for only a set period of time, after which generics can be made, drastically cutting the profits of the name-brand drug.
Because of these factors, pharmaceutical companies rely on “blockbuster” drugs to turn a large profit in the years between their release and the expiration of their patents.
Pfizer had a string of blockbuster drugs in the ‘80s and ‘90s, and stock prices climbed swiftly, peaking with the success of drugs like Lipitor and Viagra.
This primed the expectation of shareholders that Pfizer would continue to climb at the same rate with new, innovative drugs continuing to hit the market. However, Pfizer didn’t deliver. In the 2000s, Pfizer stock began to fall: as patents on their flagship drugs expired, their new innovations didn’t perform strongly enough to match shareholder expectations. After buying several other pharmaceutical companies, Pfizer’s stock price rebounded in the last decade with new drugs performing well once more.
In this example, we see clearly that stock price is impacted by the company’s innovation and how well their performance matches shareholder expectations. When a company cannot deliver innovation as expected, the stock price is negatively impacted.
Amazon: Buying the Growth Potential
Information about a company’s stock price, their innovation initiatives, their sales, and the strength of their competitors is publicly available, so everyone who participates in the market has access to information about the company’s health and growth potential. As a result, stock prices tend to be fairly close to the reality of what a company’s share is worth because there is so much information to inform buy and sell decisions.
However, there are cases where stock price is driven above the value of a company’s earnings because shareholders believe in the future growth of the company.
Amazon is a primary example: they have a lot of revenue, and they’ve reinvested much of it into growing other parts of their business. Amazon doesn’t have high earnings that could potentially become distributions for shareholders, but their stock price is huge.
People predict that Amazon’s investments in its future growth will pay off and make the company more valuable, so they’re willing to pay a higher price for the stock.
This pushes the stock price up, even though the actual earnings of the company aren’t high enough to support the stock price. It’s not all guesswork.
How companies like Amazon reinvest their revenue is reported publicly, so shareholders can evaluate those plays and make investment decisions based on how they think the company’s developments will pay off.
These perceptions not only shape the fluctuations of today’s stock market, but they also influence the strategies that previous generations have used to invest.
A Word of Caution
As you can see, stocks present the opportunity for wealth generation. That said, investing in the stock market requires diligence, experience, and patience.
You shouldn’t dabble in the stock market, as you’re likely to get burned.
Talk to an experienced financial advisor if you plan to start investing in stocks, or if you inherited a portfolio that contains stocks. The advisor can help you make a plan for either investing in stocks or other assets that support your financial goals.
For more advice on investing in stocks, you can find Inheriting Chaos with Compassion on Amazon.
Jennifer Luzzatto is a Chartered Financial Analyst®, a Certified Financial Planner®, and a NAPFA registered financial advisor. She began her career in financial services thirty years ago as a fixed-income trader in a regional brokerage firm and went on to manage personal trust accounts, institutional portfolios, and a municipal bond mutual fund at a commercial bank. In 1999, she founded Summit Financial Partners, transitioning from banking to financial planning and investment advisory services. Jennifer holds a BA in Psychology and an MBA from the University of Richmond. She lives in Richmond, Virginia, with her daughter and their dog.