Investing Basics: What Are Stocks? Financial Treat , Stock is an ownership interest in a company, also known as shares or shares. When you buy stock, you buy a partial interest in a company that gives you certain benefits. Understanding what stocks are and how they work is one of the keys to investing because stocks play a key role in building a balanced portfolio.
Companies raise money by selling stock to finance their operations. When companies sell stock, they become shareholders by inviting investors to buy a portion of the company. “Equity” is a way of describing ownership, and “stock” is an alternative name for stock. Companies can also issue bonds to raise capital, although buying bonds makes you a creditor but has no interest in the company.
When you buy stock in a company, you get certain privileges based on the type of stock you own, including:
While stock gives you ownership of the company, owning stock does not give you the right to have a say in the day-to-day running of the company. Owning stock means you trust the company’s executives to run the business as they see fit. If you don’t like how a company is doing, sell your stock and choose a new home for your invested capital.
When private companies decide to sell stock to the public, they do an initial public offering (IPO). When you read that a company is “going public,” it means it’s doing an initial public offering, in which it makes the stock available for investors to buy through the public stock market.
During an IPO, the company and its advisors announce how many shares will be issued and set the IPO price. The money raised by selling shares during an IPO goes directly to the company. After the offering is complete, the shares will trade on the secondary market – also known as the “stock market” – where the share price will rise and fall depending on various factors.
Companies issue a variety of different types of stock. Common stock and preferred stock are the most common variants, and some companies have different stock classes. These different types of shares determine voting rights, dividend payments, and your right to get your investment back if the company goes bankrupt.
As mentioned above, buying stock gives you the right to vote on matters at the company’s annual meeting.
Each common share usually entitles the holder to a single vote at the company’s annual meeting. However, common stockholders rank behind creditors, creditors and preferred stockholders when it comes to recovering their investment when a company goes bankrupt. Common stock usually entitles you to dividends, but there is no guarantee that you will receive them. Companies can choose to pay dividends or not to pay dividends according to their needs.
Preferred stock usually doesn’t give you voting rights, although preferred stock usually entitles the holder to receive dividend payments before common stock holders. Also, if the company goes bankrupt, investors with preferred stock will get back their investment ahead of investors with common stock.
Companies often issue different classes of stock, usually denoted by letters such as A, B, or C. Additional classes of stock are typically issued, each with specific voting rights and exist to help company founders or executives maintain a greater degree of control over the company.
Consider Google’s holding company, Alphabet. Alphabet owns three stock classes. Class A (GOOGL) shares receive one vote per share. Class B shares are held by the founders of the company and have 10 votes per share. Class B shares are not publicly traded and are designed to help founders retain control of the company. Class C (GOOG) shares have no voting rights and are primarily owned by employees and some common stockholders.
Depending on the type of stock you own, the company can share profits with you through dividends. Investors receive quarterly or annual dividends, which are distributed based on the number of shares of the company you own. Preferred stockholders have a preferred dividend claim over common stockholders. No matter what kind of stock you own, the principles of dividends are basically the same.
Suppose a company is earning positive earnings for the quarter and issues a preferred stock dividend of $0.42. If you own 100 shares of the company’s preferred stock, you will receive a cash dividend of $42. Many companies also offer dividend reinvestment plans (DRIPs), which allow you to reinvest cash dividends back into stocks, increase your holdings, and put your money into your portfolio.
Companies sometimes issue stock dividends. If a company declares a 5% stock dividend and you own 100 shares of the company, you will receive an additional 5 shares, bringing your ownership to 105 shares. However, the value of each outstanding share will be reduced by 5%, making your shares worth the same.
The company also issues a hybrid dividend, which is a combination of cash and stock. Hybrid dividends are rare, but have historically been used by companies to share profits with shareholders.
Owning stock makes it possible for you to share in the profits of the world’s most successful companies. The S&P 500, one of the most popular U.S. indices tracking stock performance, provided investors with an inflation-adjusted compound annual return of 7% between 1959 and 2009. With an average return of 4.67%, the stock has outperformed long-term fixed income investments.
While buying is not without risk, investors use stocks as one of the most important tools to increase their savings and plan for long-term financial goals like retirement and education savings. When the stock price goes up, so does your savings. Note, however, that stock prices also fall, sometimes losing all value and becoming worthless. There is no guarantee that you will get your investment back.
Stocks are one of the basic ways to diversify a portfolio. As different industries flourish at different times, investors buy different stocks of companies large and small in different industries to reduce risk. For example, a company that sells paper products may post record sales during an economic crisis such as COVID-19, while an automaker’s sales may underperform. Owning a variety of different stocks can help investors make gains in a booming industry while offsetting losses in other sectors.
Stocks and bonds play complementary roles in building a diversified portfolio. Buying stocks and bonds helps investors capture market gains and protect against losses in a variety of market conditions.
See side by side to better understand the difference between stocks and bonds:
what are they? Fractional Shares in a Company Fractional Shares in Company Debt How Do You Make Money Capital Appreciation and Dividends What are the risks and rewards of paying interest on a regular basis? Usually higher risk for higher returns Often lower risk for lower returns If you are looking for long-term growth, having more in your portfolio considering historically high yields relative to bonds Going long can be a good strategy. As the economy grows, public companies increase revenue and profits, increasing the value of the stock in the long run and benefiting shareholders.
If you’re looking for steady income, you’re better off investing in bonds. While bonds may have lower long-term yields than stocks, a well-chosen bond portfolio offers reliable interest payments and low volatility. The latter is attractive to investors approaching retirement or looking to preserve capital after retirement.