What is a Stock? Learn About the Common Types and How to Buy Them
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If you follow the news, you’ve probably heard experts talk almost obsessively about stocks and the stock market.
The stock market is up. The stock market is down. Now’s the time to buy stocks. Now’s the time to sell. And on and on.
If you’re not familiar with finance, you might find yourself wondering what a stock is and why they matter so much.
What is a Stock?
At the most basic level, a stock is a small piece of ownership in a company. In the past, stocks were usually represented by physical certificates issued by the company. These days, most stocks are held electronically and stock certificates are mostly collectors’ items without true value.
Stocks give companies a way to raise money without taking on debt.
Stock Investment Basics
Consider the following example.
Your friend Joan starts a craft soda company making, bottling, and selling her own sodas. She does very well but realizes that she needs some additional money to expand operations so she can start selling soda in the next town over.
Joan doesn’t like the idea of debt, and you want to get involved in the soda business. So she agrees to sell you a share in her company.
What is a Share?
Joan can decide to issue stock in her company, dividing up ownership among 100 shares. Let’s say she decides to keep 80 shares and sell 20 to you. When you buy those shares in her company’s stock, you’ll own 20 percent of the company and the money you paid can be used to fund the soda company’s expansion.
Down the road, you might want to sell your shares. If you find someone willing to buy them, you can sell the shares for whatever price you agree upon.
While you own the stock, you are a part-owner of the company. That means you have the right to a say in how the company is run. You may get to vote on major decisions, such as who should sit on the board of directors. If you own a large amount of a stock, you may have a greater influence over these decisions.
Most major companies have issued millions of shares of stock, so it’s unlikely that you’ll ever accumulate a share significant enough to impact the business. For example, Coca-Cola has issued nearly one billion shares of stock.
Make Money, Lose Money
Over time, the value of a stock can change. Joan’s soda might show up on a television show, causing sales to double overnight. She might also produce a bad product, causing people to stop buying from her.
As the success of the business changes, so will the value of the business’ stock. If the business does well, you could sell your stock for more than you paid for it.
If Joan’s company continues to grow, she might decide to sell more stocks to raise more money for expansion. This is often how small companies grow large over time. One or a few founders sell some of their stock in the company to raise money until people across the country and the world own shares.
Stocks vs. Bonds
Stocks and bonds are both issued by companies to raise money, and they are both good investment vehicles if you’re looking to grow your savings. However, the way that the two function is very different.
What are Stocks?
Stocks give you an ownership stake in the company itself. You can have an impact on how the company is run by voting on issues presented to shareholders.
The value of stocks can rise and fall. So, in theory, there is no limit to the amount of money you could make by investing in a stock. However, the stock’s price may fall or stay the same. Buying a stock is like making a bet on that company doing well in the future.
What are Bonds?
Purchasing a bond is like lending money to a company. The company will ask for a specific amount of money and offer to pay a certain rate of interest. You can calculate exactly how much you will have to invest and exactly how much money you will receive in return.
In that way, there is a cap on your return. However, unless the company defaults on its debts, you won’t lose money. That means that bonds tend to be safer investments than stocks, though they are not without risk.
Types of Stocks
There are a few different types of stock that you should know about.
Common stock is the type of stock people typically think about. They provide an ownership share in the company and voting rights. If the company pays dividends, owners of common stock will receive those dividends.
Preferred stocks are less common than common stocks. They generally don’t give the owner of the stock the right to vote at company meetings, but they provide other benefits.
For example, preferred stock owners get preferential treatment when it comes to dividend payments. They might receive payments when common stockholders don’t, or they might receive larger payments.
Preferred stockholders are also ahead of common stockholders when it comes to getting money out of a company that goes bankrupt.
Growth Stocks vs. Value Stocks
Unlike common and preferred stocks, the difference between growth stocks and value stocks is not a legal one. Instead, it is a difference of perception in the financial community that can impact how you decide to invest your money.
Stocks that are considered “growth stocks” are generally issued by successful companies that are still expected to grow significantly in the future. A new tech company that has designed a major app used all around the world but that still has lots of room to grow in the market would be a good example of a growth stock.
A “value stock” is one that appears underpriced when you consider its current performance.
Investors often look at measures such as sales, earnings, and book value to determine how much, approximately, a stock should be worth. When a stock is selling for much less than these measurements indicate that it should be, the stock might be called a value stock.
You buy a value stock in hopes that the price increases once the rest of the market realizes that the stock is currently undervalued.
Here are some of the most common questions people have about stocks.
Why Buy Stocks?
The primary reason to buy stocks is to use them as investments. If you leave your money in a savings account, it will grow very slowly over time through the interest payments you receive.
If you purchase a stock, the stock’s value might increase significantly. You could also receive dividend payments, which can provide an income stream or further increase the value of your investment.
Stocks are risky in the short-term due to their volatility. However, as long as you diversify your investments into multiple stocks, you can feel confident that the value of your investment will increase in the long-term.
Since its founding in 1928, the S&P 500 Index has seen individual years with nearly 50% swings both upwards and downwards. When you average those changes over the past 90 years, the index has increased by about 10% per year on average.
What are the Risks of Owning Stocks?
The primary risk of owning stocks is that they might decrease in value. Think about huge companies that have gone bankrupt, like Blockbuster or Enron. Anyone who invested in those stocks lost nearly all of the money that they invested.
The other risk is that the stock you buy will have decreased in value by the time that you need to sell. You can’t predict how and when a stock will increase or decrease in value. If you’re forced to sell your stock when its price is low, you won’t benefit from a later increase in price.
How Can I Buy Stocks?
These days, buying stocks is easy. You can sign up for an online brokerage account from companies like Vanguard or Fidelity, or even buy stocks on your phone using an app like Robin Hood. You can also buy stocks online with a broker.
If you want to diversify and buy more than one stock at a time, you can look into stock mutual funds. These let you invest your money in a single fund while purchasing small amounts of stock from dozens or hundreds of companies, thereby reducing your risk.
Stocks are a Single Component of a Successful Portfolio
Stocks are a good way to invest for the long-term, but they’re only one part of a successful investment portfolio. You should also consider holding other investments, such as bonds, real estate, or even cash and cash equivalents. It’s never too late to learn about investing and portfolio diversification.
The correct mix of investments will depend on how much risk you’re willing to take on. That typically varies depending on your age, future financial needs, and personality. Whatever you decide to do with your money, make sure you do plenty of research, and you might even consider taking an investment course.