What is a Stock?
A stock is a financial asset or security that represents ownership of a company’s equity. In effect, when you buy a stock, you are buying a small share of that company.
Companies issue stocks to raise capital, allowing them to finance their growth and expansion or repay debt. In return, investors who purchase these stocks become shareholders in the company, giving them certain rights, such as voting on major operational decisions and potential financial benefits, such as dividends.
Stocks are traded – that is, bought and sold — primarily on stock exchanges such as the New York Stock Exchange. These exchanges are regulated by governments with the aim of protecting investors from fraud and unethical practices.
What is the difference between stocks and shares? While the terms “stocks” and “shares” tend to be used interchangeably, a share is a unit of a stock.
A shareholder owns at least one share of a company’s stock, which grants them ownership of a stake in the company. Their ownership is relative to the number of shares they own as a proportion of the total number of shares the company has issued, known as shares outstanding.
For example, if a shareholder owns 10% of a company’s outstanding shares, it does not own a 10% stake in the company but a 10% stake in the share issuance.
In return for their investment, shareholders can receive a share of the company’s profits, which are paid out as dividends. The amount of dividends received is based on the number of shares an investor holds.
Some companies do not pay dividends but reinvest the profits to drive the growth of the business, which increases the share price. Some companies also buy back shares, which supports the share price by reducing the number of shares outstanding.
Types of Stocks
There are two main types of stocks:
- Common stocks
- Preferred stocks
Most stocks traded on exchanges are common stocks. These give shareholders a portion of ownership in the company and the right to vote at shareholder meetings.
Common stockholders can receive dividends if the company pays them, and they benefit from capital appreciation. If the company performs well financially, the value of the stock can increase, and shareholders can sell their shares for a profit.
Preferred stocks give shareholders a greater claim on the company’s assets and earnings than common stockholders, although they typically do not have voting rights in the company. Preferred shareholders are entitled to receive dividend payments before common shareholders, which can make them an attractive option for investors seeking income.
There are different ways to categorize stocks that can inform investors’ strategies:
- Growth Stocks: Represent companies with rapidly growing earnings, such as technology firms. High-growth companies tend not to pay dividends as they reinvest their profits, but their fast growth results in strong capital appreciation.
- Income Stocks: Belong to companies that pay out stable or growing dividends consistently. Investors buy income stocks to receive regular income from the dividend payments.
- Value Stocks: These are considered to be good value for money as their share prices are low relative to their earnings – as indicated by the price-to-earnings (PE) ratio. Investors buy value stocks as they view them as oversold and expect the price to recover in the future, allowing them to see the stock for a profit.
- Blue-Chip Stocks: These stocks give investors ownership in large, well-established companies with a strong history of profit growth that typically pay dividends.
Stocks can also be categorized by market capitalization (market cap), which refers to the value of a company based on the share price and the number of shares issued.
Stocks can be small-cap, mid-cap, or large-cap.
Micro-cap stocks are the smallest of the small-cap stocks with the lowest share prices, also known as “penny stocks”. These are highly speculative stocks in small companies that have limited earnings but could become growth stocks if their products or services take off.
How Do You Trade Stocks?
After a company goes public through an initial public offering (IPO), its stock becomes available for investors to buy and sell on an exchange. Stock exchanges provide a way for investors to buy and sell stocks.
To buy a stock, you must have a brokerage account with a financial institution or online platform.
Each stock has a unique ticker symbol – typically made up of 1-5 letters abbreviating the company name – to identify the company. You look up the ticket for the stock you want to buy, check the purchase and sell price per share, known as the bid and offer, and execute a trade to buy the number of shares you want.
The money for the shares is deducted from your account balance, and the shares are deposited in the account.
To sell a stock, you select your shares, specify how many to sell, and execute the trade.
Share prices are determined by demand and supply. The more buyers there are for a stock, the higher the price. If there are more sell orders for a stock, the price falls.
Pros and Cons of Investing in Stocks
Stocks have historically generated some of the highest returns to investors among asset classes.
Stock prices can be highly volatile, subject to market fluctuations, economic events, and investor sentiment, which can lead to significant short-term losses.
Many companies pay dividends to their shareholders, providing a steady income stream for investors in addition to potential capital gains.
The value of stocks can drop, leading to capital losses, especially in the short term. There is a risk that investors may lose some or all of their initial investment.
Stocks offer a wide range of investment options across industries, sectors, and geographies, allowing investors to diversify their portfolios.
Stock investing requires research, analysis, and a good understanding of the market, which may not be suitable for all investors.
Stockholders have a say in the company’s major decisions and can vote at shareholder meetings.
Unlike fixed-income investments, there are no guaranteed returns on stocks.
Stocks are relatively liquid, making it easy to buy and sell shares when needed, providing flexibility to access your funds.
Emotional reactions to market swings can lead to impulsive decisions, potentially damaging the profitability of long-term investment strategies.
Over the long term, stocks have the potential to outpace inflation, preserving and increasing investors’ purchasing power.
Investors may incur brokerage fees and taxes on capital gains.
Stocks can appreciate in value, offering the potential for significant profits on investments.
Shareholders have limited control over the company’s day-to-day operations and management decisions.
Stocks are relatively accessible to a range of investors through brokerage accounts and online platforms.
If a company goes bankrupt, common shareholders may receive little or nothing of their investment after creditors are paid.
Stocks are well-suited for long-term investors, as they have the potential to outperform other investment types.
Short-term price fluctuations can be unsettling for some investors and may lead to impulsive decisions.
Some countries give residents tax advantages on long-term stock investments, such as lower capital gains tax rates.
Stocks can be influenced by external factors such as economic and geopolitical events and interest rate changes, which can affect the value of investments.
A stock represents ownership in a company that is traded in the form of shares listed on a stock exchange. In exchange for investing their capital, shareholders can benefit from share price appreciation and, in some cases, dividend payments.
It is vital to understand that investing in stocks carries potential rewards and risks, including the opportunity to build wealth over time, receive dividend income, and participate in the growth of companies, as well as the potential for capital loss if the value of the stock declines.
Diversifying your capital investment across different stocks and other assets can mitigate some of the risks, helping to protect your portfolio from the negative impact of poor performance in an individual single stock.