You’ve heard of the stock market and, maybe you’ve even invested in a few stocks. But, do you really know what a stock is and how it works? Do you know the difference between a stock and a share? How about a common or preferred stock? Do you understand how investing in stocks can help you achieve some of your long-term financial goals? Keep reading for answers to all of these questions and more.
What is a stock?
A stock, also referred to as an equity, is a type of security that represents fractional ownership in a publicly traded company. When you buy a stock, you are purchasing a piece of a company. Individual units of stock are referred to as shares.
Investors purchase stocks as a way to grow their money through capital appreciation or dividend payments. With capital appreciation, you don’t stand to benefit from potential gains until you sell your shares of stock. If the company has done well and its stock has gone up in price, you can sell it for more than you paid at purchase and make a profit. However, if the company's stock goes down and you sell at a lower price than you purchase it at, you can lose money.
Investors can also benefit from purchasing dividend-paying stocks. A dividend is a way for a company to share a portion of its profits with its shareholders. Investors typically receive dividend payments on a quarterly or annual basis and dividends tend to grow over time.
What is a share of stock?
While often used interchangeably, a stock and a share represent different things. A stock represents fractional ownership in a company. A share represents the exact size of your investment. It’s a unit of stock ownership you hold in a company.
For instance, you may decide that you are interested in company ABC and you want to purchase stock. Next, you have to determine how many shares you want to purchase. Let’s say company ABC has issued 10,000 shares of stock. You may decide to purchase 100 of those shares. The number of shares you purchase represents how much of the company stock you own which is 1% in this example.
How do stocks work?
Companies issue stock to raise money to operate their business. A company might need money to pay off debt, to fund the launch of a new product, or support expansion into a new market.
Before a company can issue stock, it must go through the process of becoming public. An initial public offering (IPO), refers to the first time a private company offers shares to the general public. Once a company has gone public, investors can purchase shares of the company stock on an exchange (a market where stocks are bought and sold).
Why should you own stocks?
Owning stocks is one way to help you grow your money over time. Historically, if you stick with stocks over the long term (15 years), you will see a reward in the form of positive returns. However, there is no guarantee that a company's stock price will go up. Like all investments, there is risk involved, and you can lose money.
Owning stocks can also help to protect your money from inflation. Inflation is the rise in the price of goods and services over time. Generally, each year the cost of living gets a bit more expensive, or a lot more expensive depending on the rate of inflation.
A basket of groceries that cost $50 last year might cost you $52 this year. If you simply put your money in a checking account or stuff it in your sock drawer, your money will lose purchasing power over time. Because companies often grow with the economy (and inflation), when you invest your money in stocks, there is the potential to keep up with the pace of inflation.
What are the different types of stocks?
There are two main types of stocks – common stocks and preferred stocks.
Both common and preferred stocks represent fractional ownership in a company and provide investors with the opportunity to potentially grow their money over time. When people talk about stocks, they are generally referring to common stocks.
When you own common stocks, you are given the right to vote at shareholders’ meetings. This means you get to voice your opinion on important decisions like hiring the board of directors. Typically, you get one vote per share.
Preferred stockholders, on the other hand, typically don’t get the right to vote. As a preferred stockholder, you may also receive fixed dividend payments, similar to a bond. And, in the event the company you’ve invested in goes bankrupt and assets are liquidated, you can expect to get paid out before the common stockholder.
How do I trade stocks?
Stocks are bought and sold on an exchange. You can think of an exchange as a market where those who want to sell their stocks can connect with those who want to buy them. The largest stock exchange in the world is the New York Stock Exchange. Globally there are other exchanges like the London Stock exchange or the Tokyo Stock Exchange. The Nasdaq is an online global marketplace and was the first electronic exchange. In addition to stocks, other assets like bonds and commodities are also traded on an exchange.
One of the easiest ways to trade stocks is to open a brokerage account, either at a local brick-and-mortar location or online. Traditional brokers have human representatives who take your orders for stock trades, and online brokers allow you to place trades through a computer or your phone. Some brokers offer automated investing advice, and others let you figure it out for yourself.
Is it risky to own stock?
All investments involve some degree of risk. There is no guarantee that your investment will grow, and the market can (and will) go up and down. Diversifying your investment portfolio with different asset classes (stocks, bonds, real estate) and investing for the long-term are two ways you can minimize your overall risk.
What is shareholder ownership?
A shareholder is a person who owns shares in a corporation. The amount of shares an individual owns represents the amount of shareholder ownership they hold in that corporation. For instance, if a company issues 10,000 shares and you own 100 of them, then you have 1% shareholder ownership.
What is the difference between stocks and bonds?
A stock represents fractional ownership in a company. A bond is a loan from you to a company or government. The main difference between a stock and a bond is how they generate profit. With a stock, you make money through capital appreciation, assuming the stock rises in value over time, or dividend payments. With a bond, you make money through fixed interest payments.
How to compare common and preferred stock
Both common and preferred stocks represent fractional ownership in a company and provide investors with the opportunity to potentially grow their money over time. One of the main differences between common and preferred stock is that common stockholders have the right to vote, preferred stockholders do not. With common stocks, value is largely obtained through capital appreciation. Preferred stocks perform similarly to bonds in that their value is largely obtained through fixed dividend payments.