The stock market has provided solid returns (for the most part) for over two hundred years. Today, stocks are integral to almost any portfolio, regardless of age, financial goals, and risk tolerance. While the amount an individual should invest in stocks depends upon your age bracket and financial situation, the fact is that you should invest. However, before you get started, it might be helpful to know just what a stock is and how investing in stocks works.
Stocks are securities that you measure in shares. They offer partial ownership of a company (and its profits) in return for a financial investment. Companies issue stocks to raise capital for various projects and expenses, as well as to dilute stockholder ownership. Typically, you trade stocks on exchanges, though some companies may allow private transactions, as well.
Stocks confer benefits such as profit (when selling shares), dividends, and voting rights. However, not all stocks are the same. So it’s important to do your homework before purchasing a particular equity.
Stocks can be classified into categories such as type and style. The type of stock determines an investor’s rights, while factors like its financial performance determines the style of stock.
What Is a Stock, and How Does Investing in Stocks Work?
To put it simply, a stock is a security – a fancy word for a financial holding that an entity issues. It gives you partial ownership of said entity. You “measure” stocks in units called shares. The more shares you own, the more ownership you have in a company. More on this in a minute.
Companies issue new stocks as needed, such as to fund a new project or float the company through lean times. Selling more shares also dilutes ownership, which can impact shareholders who purchase equities that confer voting rights. Occasionally, a corporation may also issue a buyback for their outstanding shares (shares purchased by shareholders).
You typically trade (buy and sell) stocks on exchanges, such as the Nasdaq and New York Stock Exchange (NYSE). However, some companies may sell stocks in private transactions. A few also offer employee stock in their compensation packages.
Regardless of how a stock trades hands, there are laws that all transactions must follow. These laws prevent fraud, tax evasion, and other illegal practices that used to run rampant in the financial sector. The laws also exist to protect the rights of the stockholders and ensure that corporations follow best practices that benefit the shareholders as well as the company.
The Benefits of Investing in Stocks
There are three main reasons an investor may purchase a stock:
- To sell it (either ASAP or years down the line)
- For the dividends
- To take advantage of voting rights
Selling a stock can provide either short-term or long-term returns, depending on your investment strategy. Some investors like to hold onto stocks for decades and enjoy slow but high returns, while others prefer to make a killing with a little luck and a short-term strategy.
Dividend profits are another benefit to some stocks. While most payouts are small, owning enough stock in one company – or a little stock in a lot of companies – means eventually an investor may earn enough in quarterly dividends to significantly supplement income or investing capital.
Voting rights, while not an integral factor for some, are another benefit some classes of stock confer to shareholders. In a voting stock, owning the majority shares (51%) allows you to make decisions about a company’s future – in a roundabout way.
One of the most important votes a company can hold is on board of director nominations. If a single shareholder owns 51% of a company’s stock, that investor then has 51% of the voting power. This means that one person’s vote can instill a new board of directors. In turn, the board of directors would then vote on a new upper management team – such as the CEO – which would effectively steer the company in a new direction.
Investing in Stocks – Stock Ownership
As we mentioned above, companies issue stocks to build capital for new projects and asset acquisitions. Once a stock has been sold, the incoming capital can be used however the company deems fit.
On the buyer’s side, purchasing a stock confers partial ownership of the company into the hands of the shareholder. Depending on the type of stock, the shareholder may own rights to assets, profits, or voting power in the company. Exactly how much depends on how much of the company a stockholder owns.
Ownership is determined by dividing the number of shares owned by the number of shares the company issued. For instance, let’s say that AwesomeSauce Corp issues 1,000 shares of stock for the first time, and John Jingle buys 100 shares. John now owns 10% stock in the company – which means he gets 10% of the profits (in certain situations – more on that later). If the stock confers voting rights, John would also wield 10% of the influence in the vote.
Separation of Ownership and Control
However, buying stock does not mean that John actually owns the corporation itself. For example, if AwesomeSauce Corp is the best barbecue sauce maker in the world, John can’t walk into a warehouse and help himself to 10% of the company’s barbecue sauce. Additionally, John can’t list the company as an asset against a loan or demand access to 10% of the company’s coffers.
Perhaps the most accurate way to frame stock ownership is that a stockholder owns the shares they purchase (and whatever rights the shares grant them), while the issuing corporation owns the assets.
This distinction is important because of the idea of separation of ownership and control. This practice limits and separates liability on both sides of the transaction in the event of major decisions and events. Just as individual shareholders can’t access a company’s profits at will, so too can’t a corporation access their shareholder’s funds.
For instance, if a corporation goes belly-up, a judge cannot order the shareholders to empty their pockets and pay off the company’s debt. In the reverse, if Mr. John Jingle were to declare bankruptcy, he couldn’t claim 10% of the company’s assets to pay off his debts, either.
Types of Stock
There are several ways to classify stocks, but one of the most important is by type. There are two types of stocks the everyday investor should be aware of: common and preferred. Each of these carries their own benefits and drawbacks, which means that which one is “better” depends upon personal preference.
Common stock is what the average person images when they think about the stock market. This type of stock gives shareholders the right to vote in meetings and typically yields the highest returns over time. However, there are some drawbacks to common stock.
For instance, common stockholders can receive dividend if the board votes to issue dividends. However, the board is not required to issue dividends to common stockholders.
Furthermore, in the event that a company is liquidated, common stock shareholders may receive some of the proceeds – but not always. We’ll cover this point more in depth below.
Preferred stock, on the other hand, does not confer voting rights to shareholders. They also tend to yield lower returns over time. However, preferred shareholders are more protected in certain situations.
For instance, if a company issues both common stock and preferred stock, preferred stockholders will receive a dividend even if and when common stock owners do not. Additionally, preferred stocks can be redeemed on a specific date, similar to a bond.
One of the reasons that an investor may choose to invest in preferred stock over common stock is due to the investor pecking order. In the event that a company is liquidated, preferred stockholders are amongst the first groups to receive funds from the settlement. On the other hand, common stockholders may never see a penny from liquidation proceedings.
For instance, let’s say that AwesomeSauce Corp is run into the ground by its competitor, BetterSauce Inc. During bankruptcy proceedings, it’s revealed that selling off AwesomeSauce’s assets will only provide enough money to pay back preferred shareholders. In this example, the funds from the sale will only be distributed to preferred stockholders, while common stock owners will not receive a payout.
Styles of Stock
Another common way to classify stocks is by style, which can also be divided into two primary categories: growth stocks vs value stocks. It’s worth noting that whether an investor or firm believes a company falls into either category is somewhat subjective (which is why our AI is here to help…but we digress).
Growth stocks are shares sold by a company that an investor believes may have great potential. In theory, as the company expands, so too will the stock’s price. Growth stocks can be either short-term or long-term, depending on how quickly the company realizes its potential.
While growth stocks seem like a fantastic deal at first glance, they’re not so black and white. First off, just because an investor believes the company has potential doesn’t mean that the potential actually exists. Furthermore, even if the investor is right about the company’s product or services, there’s no guarantee the market will ever capitalize on the company.
Growth stocks are also generally expensive, which means that the cost of investing in a single share is too pricey for small-time investors. Higher prices also mean that growth will likely occur more slowly. Moreover, a company that actively and aggressively pursues expansion may go through cycles of sharp stock price increases followed by dips.
Another downside of aggressively growing companies is that they rarely pay dividends. Because dividends are funded by a company’s profits, a company that throws all of its revenue into expenses and expansion won’t have anything left for its shareholders.
Growth stock companies also have a higher risk of failing, especially younger growth companies. While they may offer great promise on paper, market volatility can thwart even the mightiest of investors and send them scurrying to sell their investments in a matter of months.
The point with growth stocks is simply this: where there is high volatility and risk, so too is the potential of high reward.
Value stocks, on the other hand, are securities an investor believes to be underpriced. This may be due to an analysis of a stock’s fundamentals or the industry in which the company functions. There are a few key reasons an investor may think a stock to be undervalued, such as:
- Low P/E ratio
- High book value
- Above-average dividends
- High earnings
Many value stocks are large companies that have temporarily fallen on hard times. For instance, the markets crashed in early 2020 as a result of the coronavirus pandemic. When it did, many large companies shed half or more of their share price overnight. Many companies did nothing wrong, and the chances of the stocks making up the losses within a year were decent. But a panicking market determined that for a short term, many solid corporations were trading as value stocks.
Typically, value stocks aren’t so evident, however. For most investors, it takes time and practice to learn the market enough to determine value stocks and make investing in stocks of that kind simple. Even then, it’s easy for an investor to make a bad call, as the market is notoriously fickle.
Value stocks are also about the long game. Some may see rapid growth. But the majority of them experience large returns over a period of years or even decades, rather than months.
This is one of the main reasons that value stocks are risky. If you bet on a stock believing that is has potential to grow in the next 12 months, but the issuing company shutters its doors in 12 months, you may lose an inordinate amount of money on a bad call.
There you have it: Everything you need to know about investing in stocks.
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