When you think of investing, you probably think of the stock market. But if you’re like most Americans, you didn’t learn much about stocks in school. Many parents don’t talk to their children about investing and stocks either, leading many young adults at a loss when it comes to getting into the stock market.
For starters, what exactly is a stock?
Do you actually own anything when you buy a stock, or is it akin to buying a chip in a casino, worth only what the person selling it says it’s worth? Are there different types of stock? How do you buy and sell stocks? The questions go on and on — and here are the answers.
What Are Stocks? Do You Really “Own” Part of a Company?
A share of stock is a slice of ownership in a publicly traded company. Think of it like a pie. If you’re one of six people who are going to divide a pie evenly, your share of the pie is one-sixth. When it comes to stock, your share of the pie (the company) is based on the number of shares you own. If there are 1 million outstanding shares and you own one share, you are part owner with a one-millionth ownership stake in that company.
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So, when you own stocks, you own a piece of the companies represented by those stocks.
Owning shares in a company comes with some perks. First and foremost, when the value of the company increases, you benefit because your share of the company grows in value along with the whole enterprise.
Moreover, your ownership of shares gives you rights to join shareholder meetings and cast your vote on important decisions that need to be made. For example, you can vote on new members of the board of directors, mergers and acquisitions, and other decisions that will steer the company in one direction or another in the future.
Should the company fail and be forced to go through liquidation, you own a share of the company’s assets. Once the assets are liquidated and all debts are paid, you’ll be entitled to a percentage of the remainder based on the number of shares in the company you hold.
How Do Stocks Work and What Determines If a Company Is Public?
Some people think the stock market is so shrouded in complexity that it takes a Wall Street pro to understand the inner workings of equities (assets that represent ownership in a company). In reality, that’s not the case.
The process of creating a stock starts when a private company decides that it’s time to go public. The management of the company determines what it believes is the value of the company, the percentage of ownership in the company it’s willing to sell, and the amount of money it plans to raise.
From there, the company launches an initial public offering (IPO), offering shares for sale to the public on an exchange like the Nasdaq or the New York Stock Exchange, or an over-the-counter market. At this point, you’ll have access to buy or sell it through the brokerage of your choice.
Types of Stocks You Can Invest In
There are several different types of stocks and different ways of classifying them.
For example, stocks may be classified by their market capitalization, the rights they bestow to the stockholder, or the type of price movement the stock experiences in the market.
Market Capitalization Classifications
One way to classify a stock is by market capitalization, or simply market cap, which is the total amount of money a publicly traded company would be worth if you added up the value of all outstanding shares. The different classifications include:
- Penny Stocks. A penny stock is a stock that trades with a value of under $5 per share or a total market cap of less than $500 million. These are the highest risk stocks on the market.
- Small-Cap Stocks. Small-cap stocks trade with a total market cap of between $500 million and $2 billion. These are still smaller companies and considered to be relatively risky investments, but are a more stable option than penny stocks.
- Mid-Cap Stocks. Mid-cap stocks trade with a market cap in the range between $2 billion and $10 billion. These companies are finding their footing and often grow to become leaders within their industries.
- Large-Cap Stocks. Large-cap companies are the big leagues. They trade with market caps over $10 billion and tend to represent some of the most well-known and stable companies on the market.
- Blue Chip Stocks. Blue chip stocks represent companies that hold leadership positions in their industries. These companies are large, well-established companies that often pay dividends. They also tend to be some of the most stable stocks on the market.
Shareholder Rights (Common vs. Preferred Stock)
Another way to classify stock is based on the rights shareholders have when they own them. In this case, there are two classifications:
- Common Stock. As its name suggests, common stock is the most common form of stock to buy. Common shares give the holder voting rights, access to declared dividends, and a claim to assets should the company find itself in liquidation.
- Preferred Stock. Unlike common stock, preferred stock offers the shareholder no voting rights. In exchange, these shareholders have the first right to dividends. They are also paid prior to common shareholders in the case of a liquidation.
Market Performance (Growth, Income, and Value Stocks)
Finally, stocks are often classified by the market performance you can expect when investing in them. There are three primary classifications in this category:
- Growth Stocks. Growth stocks represent companies with strong growth metrics. These companies are known for producing above average revenue and earnings growth, as well as share price appreciation.
- Income Stocks. Income stocks are stocks that pay compelling dividends. These companies are generally well-established, with the best of the best being in the blue chip category. Known for slower, steadier growth than other types of stocks, income-focused stocks are best for the risk-averse investor.
- Value Stocks. Finally, value stocks represent companies trading at what investors perceive to be a discount. Investors buy these undervalued stocks “on sale” in the hopes of generating outsize returns as the stock price returns to its fair value.
Pros and Cons of Stocks
As with any other investment vehicle, stocks come with their own list of pros and cons that should be carefully considered before investing.
Pros of Stocks – Reasons to Own Shares of Public Companies
Stocks are one of the most popular investment vehicles in the world, so it’s only natural that there are plenty of benefits to getting involved. Some of the most important benefits include:
- Wealth Building Potential. A well-balanced portfolio of stocks will help you build your wealth over time. As the value of the stocks grow, compounding gains could turn small monthly contributions into a solid nest egg that provides a comfortable retirement.
- The Ability to Make a Difference. Although investing is primarily about earning money, your investments have the potential to make a difference in the world. Investments in biotechnology companies show support for the development of life-saving medicines, and investment in green energy companies makes a global environmental impact. Your investment dollars have the potential to make a difference, not just in your financial well-being, but in the world.
- Ownership. An investment in a stock is a decision to purchase ownership in the company represented by that stock. This ownership gives you a tangible asset that confers voting rights, access to dividends, and a share of the company’s earnings and assets.
Cons of Stocks – Why You Might Stay Away from the Market
While there are plenty of reasons to consider investing in stocks, there are also some drawbacks that investors should consider before diving in.
- Volatility. The stock market is known for upward and downward movement known as volatility. Many beginners are drawn to the allure of fast-paced stock trading or day trading, which often leads to losses. Even as a long-term investor, you’re going to make the wrong move from time to time, and sometimes outside factors can lead to stocks declining across the board. With stocks, you’ve got to be prepared to take the bad times along with the good.
- Research Required. You should never blindly invest in a company because you read a single article or a friend told you about it. A wise investment choice is an educated one that has been well-researched. Therefore, in order to invest in stocks, you’ll have to be willing to put in the time to get to know just what you’re buying when you buy them.
- Ownership. While ownership has its perks, it can also be viewed as a drawback. In any company, owners are the last to get paid. This may prove to be a big deal in the event of a liquidation, especially if all assets are sold and the amount of money remaining isn’t enough to cover debts, let alone pay shareholders.
How to Buy and Sell Stocks (Hint: You Need a Broker)
In order to take part in the stock market, you’ll need to buy and sell stocks. The best way to do so is by opening a brokerage account.
There are several brokers on the web, and you don’t want to sign up for the first you see. Each may have unique offers and price structures. When signing up for a broker, consider the following:
- Fees. Commission-free trading is commonplace. So, if the broker charges commissions, it’s not likely your best option. Moreover, you’ll want to look into the brokerage’s fees for other assets like options and futures contracts, mutual funds, and other assets you might want to purchase as you gain experience.
- Available Assets. Not all assets will be available at every broker. Make sure the broker you choose offers access to the stocks and other assets you want.
- Promotions. Plenty of online brokers also offer free perks to attract new customers. For example, you’ll find cash bonuses or promotions for free shares of stock just for signing up for many of them. If you have your choices narrowed down to a couple of brokerages, these bonuses are great tiebreakers.
Once you sign up for a brokerage account, simply deposit funds into your account, find the stocks you’re interested in buying, and click “Trade” or “Buy.” On the next page, you’ll outline the number of shares you’d like to buy and submit your order.
When it’s time to sell, log into your brokerage account, search your stock, and click “Trade” or “Sell.” Next, outline the number of shares you’d like to sell and complete your order.
With stocks being such a popular investment vehicle, it only makes sense that there are several commonly asked questions surrounding them. Some of the most common questions include:
What’s the Difference Between Stocks and Bonds?
When you buy a stock, you’re purchasing ownership in a company. With bonds, you’re funding debt being provided to the company, basically providing them with a loan.
Stockholders have benefits like access to dividends, exposure to price appreciation, and voting rights. But the price of shares can and usually do fluctuate up and down.
As lenders, bondholders don’t have any shareholder rights, but they have the benefit of being paid predetermined coupon rates (interest). In the event of a liquidation, bondholders are paid back before stockholders.
What Is the Stock Market?
The stock market is a combination of stock exchanges where equities are bought and sold. Exchanges like the New York Stock Exchange and Nasdaq, as well as over-the-counter exchanges, make up the market.
What Are the Best Stocks for Beginners?
The best stocks for beginners are stocks representing stable, blue chip companies. Beginners should steer clear of penny and small-cap stocks to avoid added risk.
It’s also important for beginners to invest in companies they know. The more you know a company, the more educated your investment decisions will be. Even if you buy the company’s products on a daily basis, take the time to do your research to understand the company from an investor’s perspective.
How Are Share Prices Determined?
Although you would think that stock prices would be determined by a company’s fundamentals, the primary driver of prices in the stock market is the law of supply and demand.
When there are more buyers than sellers, the price of the stock increases to entice more stockholders to sell their shares. When there are more sellers than buyers, the price of the stock falls, enticing more investors to dive in.
What If You Can’t Afford to Buy a Full Share of Stock?
Years ago, if you couldn’t afford to buy a full share of stock, you’d have to find a different company to invest in. These days, brokers like Robinhood, Fidelity, and TD Ameritrade have made fractional shares available.
Now, if you want to make a $100 investment in a $1,000 stock, you simply buy one-tenth of a share with many popular brokers.
What Are Dividend Payments?
Dividend payments are a portion of a company’s profits paid out to its shareholders.
When a publicly traded company earns a profit, it must decide what it’s going to do with the money. Usually companies hold a portion of — if not all — the profits to fund future growth.
In some cases, companies will declare dividends — payments of profits directly to shareholders. Companies usually do this when they’re confident they have enough money to fund growth, and can comfortably pay excess profits to investors.
The company then declares a dividend, paying investors a share of earnings based on the number of shares they hold.
What Does Shorting a Stock Mean?
Selling a stock short, or shorting a stock, means the investor is placing a bet against the company’s growth. To short a stock, short sellers borrow shares that are then sold in the market immediately. When the price of the stock falls, the investor repurchases the shares at the new, lower price, repaying them to the lender, and making a profit on the spread between high and low prices.
However, this is a risky bet. The borrowed shares must be returned regardless of which direction the stock goes. If the stock price spikes higher, the short seller is in for big losses when they have to repay the lender.
Stocks are an integral part of the financial system in the United States. Not only do they give the buyer ownership of the companies they invest in while offering an opportunity to build wealth, they give companies a means to raise much needed capital for growth.
All told, stocks are one of the building blocks that have made the developed world what it is today.