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.
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.
There are different types of stocks, too (which you can learn about here).
There are three main reasons an investor may purchase a stock:
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.
However, buying stock does not mean that John actually owns the corporation itself. 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.
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