Stocks should be a central part of any long-term investment program. But what are stocks, exactly?
Even without being an active investor you hear about stocks all the time: the stock market did this today or XYZ company issued new stock, etc. To understand what all this means, it helps to know the nuts and bolts about stocks.
This article is a basic introduction into what stocks are and how they work. Topics covered include:
- What are stocks?
- What are the different types of stocks?
- How stocks work
- Buying stocks
- How does investing in stocks work?
Stocks represent both opportunity and risk for investors. As an opportunity, they should not be ignored by anyone looking to build wealth for the future. Because of the risk, though, it's important to know what you're getting into when you buy stocks.
What is a Stock?
A stock represents a share of ownership in a corporation.
In simplest terms, imagine you and a business associate were starting a corporation. You agree to share the duties and each put up half the money, in exchange for which you each own half the company.
As a result, each of you would be entitled to half of the profits.
If you decide to put some of those profits back into the company to invest in equipment, more space, etc., those costs would come equally out of your shares of the profits.
That's simple enough, but a larger corporation may have a great many investors who put different amounts of money into the company at different times.
In that situation, dividing the ownership of the company into a large number of shares helps keep track of who owns what. It also divides ownership into increments that can readily be bought or sold.
So if a company issued 1 million shares, for example, each of those shares would represent a one-millionth share of the company. Earnings would be divided equally among those shares and, when one of those shares was sold, that same portion of the company would pass on to the new owners.
Once you buy a stock, you own a piece of that company. The value of that stock will now depend on the future success of that company.
Types of Stock
Not all stock is the same. Corporations may issue stock on the basis of how it can be purchased, whether it grants voting rights or takes precedence over other forms of stocks. Here's more about the main types of stock:
Privately held stock
When you hear about stocks as investments, it usually refers to stocks that are publicly traded - but a lot of stock in companies is held privately.
This means it can only be bought and sold under certain circumstances that are spelled out in a shareholders' agreement. Normally, only large investors or people involved in starting or actively running a company will be able to own private stock in a company.
Publicly traded stock
Companies which have shares available for anybody to buy on a stock exchange are called "public companies."
When a company wants to raise money from the general public, it will have an initial public offering (IPO) of stock. In an IPO, shares are issued a set price. Once those shares have been purchased, they are registered to trade on a stock exchange. They can then be bought and sold at any time, at a price determined by supply and demand in the market.
Note: A company can have both types: stock that is publicly traded and stock that is privately held. This is important because the amount of privately held stock reduces the amount of earnings available to public shareholders.
Voting and non-voting shares
Since buying stock means you own a share of a company, it often means you have a voice in how the company is run.
This doesn't mean participating in the day-to-day management of the company; but it does mean voting on major decisions like selecting a board of directors, changes in the financial structure of the company or fundamental shifts in company goals.
However, owning stock doesn't always mean you get these voting rights. To keep more control of the company for themselves, management may issue some stock without voting rights.
Voting rights are important because they help hold company management accountable. The marketplace often recognizes the value of voting rights by paying a higher price for voting shares than for non-voting shares.
Most stock that is traded is known as "common stock," but there is also another type of stock called "preferred stock."
Preferred stock dividend payments take priority over common stock dividends if the company is having financial difficulties. Holders of preferred stock also take precedence over common stockholders in the event the company goes bankrupt.
Despite these advantages, preferred stock values and dividends are not guaranteed. Also, preferred stocks may not have the same voting rights as common stocks.
Generally speaking, preferred stocks are less volatile than common stocks. This means they should have milder downturns, but may also have less upside.
How Do Stocks Work?
Once a stock is publicly issued, it is traded on an exchange - so investor demand for the company determines its price.
That demand is based both on the current earnings of the company and on expectations for its future outlook. The value of those earnings depends on company-specific factors, conditions in the industry generally and in the economy as a whole.
Company management can also make corporate finance decisions that affect the stock. These include raising or cutting the dividend, issuing new stock or buying back existing stock.
When a company issues new stock, it's known as "dilution" because it waters down the value of existing stocks - the company's earnings now have to be spread over a greater number of shares.
Key Stock Terms
Here are some basic definitions you should know as you start to buy stocks:
Stock prices are subject to change whenever the market is trading, depending on investor demand for the stock. Buying or selling is based on whether investors think the current price is lower or higher than the long-term value of the stock.
This is sometimes known as the "top line." It represents the money a company takes in without accounting for the company's expenses.
These represent the company's "bottom line" or what the company made after revenues are reduced by expenses. Earnings are generally reported on a per-share basis.
Companies may pay part of their earnings back to shareholders in the form of dividends. These are set in advance and generally paid quarterly, but they are subject to change.
Since investing involves judgments about a company's future value, the growth rate of sales, earnings and dividends can be just as important as the current level of those financials. The tricky part is that future growth rates are likely to differ from those experienced in the past.
How to Buy Stock
The simplest way to buy a stock is to open a brokerage account. Online brokers can give you immediate access to stocks trading on a variety of different stock exchanges, and generally offer the cheapest trading terms.
When you buy or sell a stock, you need to be very specific about what security you want to trade, whether you are buying or selling, how many shares you want to trade, and at what price you are willing to trade.
How Does Investing Work: Building a Stock Portfolio
For most investors, buying an individual stock is just a start. It's very risky to tie up too much of your money in any one stock, so investors generally put together a portfolio of different stocks.
How you do this depends on whether you simply want investments that mirror the stock market as a whole or whether you want to pick individual stocks that you think will do better than average.
Owning a variety of stocks is known as diversification. It's generally less risky than putting all your money in just a few stocks. Besides owning multiple stocks, owning different types of stocks (in different sectors like technology, manufacturing, finance, etc.) helps diversify your investment risk.
Where Do Stocks Fit with Other Investments?
Stocks are generally considered to have a fairly high level of risk and opportunity. There are other investments that offer either lower or higher risk and opportunity than stocks.
One way to manage the overall risk level of your portfolio is to own stocks along with investments that have different risk and reward characteristics. How you divide up your portfolio among things like stocks, bonds, cash and real estate is known as asset allocation.
Asset allocation is very important to the long-term performance of your portfolio. You can base your asset allocation on both your individual characteristics and your outlook for different types of assets.
Taking the next step
Alternatively, if you don't want to make decisions about your asset allocation, you can use a robo-advisor to determine an asset allocation for you. This type of asset allocation is generally made based on the past risk and reward of different asset classes and not on an assessment of how things will perform in the future.
Understanding the basics of how stocks work is just the beginning. What you will find as you start to invest is that there are a great many things that can impact the value of a stock. Most investors never stop learning about how and why stock prices move, but you can also work with a financial advisor to help you find and execute your investing strategy. Select a financial goal below to see a curated list of investments and financial advisors ready to help.