Stocks: What They Are and How They Work
A stock is a fraction of ownership in a company. Stockowners, also called shareholders, are entitled to a proportional cut of the company’s earnings and assets (and sometimes dividends).
That means, if you own stock in a company, as the company grows and expands you stand to earn a return on your investment. But you also risk losing all or part of your investment if the company doesn’t prosper. (More on that below.)
If you’re interested in investing in stocks, this stocks 101 guide will provide a basic overview of the different types of stocks, the pros and cons of investing in stocks, and more.
What Is a Stock?
Let’s start with a basic stock definition: Stocks are simply shares in a company, and they are primarily bought and sold on publicly traded stock exchanges. That means you can open a brokerage account and become a partial owner of whatever company you choose when you buy shares in that company.
How to Talk About Stocks
What is the difference between a stock vs. a share? A share of stock is the unit you purchase. “Stock” is a shorthand way of referring to the company that is selling its shares.
So: You might buy 100 shares of a company. If you owned 100 stocks, however, that means you own shares of 100 different companies.
Is trading equities the same as trading stocks? Yes. Equities or equity shares, is another way of talking about stocks as an asset class. You’re not likely to say you bought equity in a company. But your portfolio may have different asset classes that include equities, fixed income, commodities, and so on.
These days, it’s possible to own a fraction of a share of stock, for those who can’t afford to buy a single share (which can happen with very large or popular companies).
Main Types of Stock
Stocks come in two varieties: common stock and preferred stock.
• Common stocks are, as you might guess, the most common. Along with proportional ownership of the company, common stocks also give stockholders voting rights, allowing them voice when it comes to things like management elections or structural business changes.
• Preferred stocks don’t come with voting rights, but they are given “preferred” status in that earnings are paid to preferred stockholders first. That makes this kind of stock a slightly less risky asset. If the company goes under and its assets are liquidated to repay investors, the preferred stockholders are less likely to lose everything, since they’ll be paid their share before common stockholders.
Most individual investors own common stock.
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What Is the History of Stocks?
What are stocks and how did they originate? Historically speaking, all types of assets — property, livestock, precious metals, commodities — have been traded since time immemorial. There are records going back nearly a millennium in the West alone, showing that people traded debt as well as futures and government securities.
Investing in stocks began in Europe in 1602 with the founding of the Dutch East India Company, a so-called “joint stock” company where investors could buy shares. Joint-stock companies helped fund the exploration of the New World, as Europeans then called it.
By 1610, the practice of short-selling had not only taken hold in Amsterdam, it had become such a problem that it was banned by Dutch authorities!
The Trouble With Trading
Stock trading, especially in its infancy in the 17th and 18th centuries, was not the highly regulated industry we know today. Stock markets were rife with scams and schemes and outright fraud. The South Sea Company in England was responsible for one of the most notorious incidents in early finance. The company, which hoped to profit from the slave trade, infamously sold shares to countless investors, and promised them big returns — that never materialized.
As a result, the South Sea bubble burst in 1720, and the company crashed with terrible consequences for the nascent markets abroad. The practice of issuing securities was banned in England for nearly a century — until 1825.
How Stock Exchanges Fuel Economic Growth
International trade furthered the spread of stock exchanges throughout the world, and with it commerce and economies were able to grow and thrive. After all, the stock market, which allows businesses to be publicly traded, is a vital way that companies raise capital for their expansion. At the same time, stock markets also became an important source of liquidity for investors.
The first stock exchange in the U.S. was the Philadelphia Stock Exchange, established in 1790, followed by the New York Stock Exchange in 1792.
How Stocks and the Stock Market Work
A stock is born when a company goes public through an initial public offering (IPO), and issues actual shares that investors can buy and sell. Stocks are typically traded on exchanges, like the NYSE or Nasdaq or the London Stock Exchange (there are 60 major stock exchanges worldwide).
Individual investors can open a brokerage account so they can buy and sell the stocks of their choosing on a given exchange. Exchanges list the purchase or bid price, as well as the selling or offer price.
How Are Stock Prices Determined?
The price of a stock is generally determined by an auction process, where buyers and sellers negotiate a price to make a trade. The buyer makes a bid price, while the seller has an ask price; when these two prices meet, a trade occurs.
💡 Recommended: How Bid and Ask Price Work in Trading
The stock market consists of thousands or millions of trades daily, usually through online platforms and between investors and market makers. So, the auction process is not usually completed between investors directly. Rather, prices are determined through electronic trades in fractions of a second.
Nonetheless, this process still helps determine stock prices, usually following the laws of supply and demand. When a stock’s prospects are high and it’s in high demand, the company’s share price will increase. In contrast, when investors sour on a company and want to sell en masse, the price of a stock will decline.
What Are Some Common Stock Terms?
If you need the whole idea of stocks explained and unpacked, it helps to learn a few key words. While it’s impossible to cover the entire lexicon of stock investing here, this is a short list of helpful stock terms to know:
Dividends
A dividend payment is a portion of a company’s earnings paid out to shareholders. For every share of stock an investor owns, they get paid an amount of the company’s profits. Companies can pay out dividends in cash, called a cash dividend, or additional stock, known as a stock dividend.
Growth stocks
Growth stocks are shares of companies that demonstrate a strong potential to increase revenue or earnings thereby ramping up their stock price
Market capitalization
To figure out a company’s market cap, multiply the number of outstanding shares by the current price per share. A company with 10 million outstanding shares of stock selling at $30 per share, has a market cap of $300 million.
Spread
Spread is the difference between two financial measurements; in finance there are a variety of different spreads. When talking specifically about a stock spread, it is the difference between the bid price and the ask price — or the bid-ask spread.
The bid price is the highest price a buyer will pay to purchase one or more shares of a specific stock. The ask price is the lowest price at which a seller will agree to sell shares of that stock. The spread represents the difference between the bid price and the ask price.
Stock split
A company usually initiates a stock split when its stock price gets too high. A stock split lowers the price per share, but maintains the company’s market cap.
A 10-for-1 stock split of a stock selling for $1,000 per share, for instance, would exchange 1 share worth $1,000 into 10 shares, each worth $100.
Value stock
Value stocks are shares of companies that have fallen out of favor and are valued less than their actual worth.
Volatility
Volatility in the stock market occurs when there are big swings in share prices, which is why volatility is often synonymous with risk for investors. While volatility usually describes significant declines in share prices, it can also describe price surges.
Thus, volatility in the equity market can also represent significant opportunities for investors. For instance, investors might take advantage of volatility to buy the dip, purchasing shares when prices are momentarily lower.
Is It Possible to Earn Money by Buying Stocks?
Now that you have a working stock definition, let’s look at whether buying them has the potential to help you meet your financial goals. How does buying stocks earn you money? There are two possible ways.
• Over time, stocks may increase in value if the company grows, expands, and prospers. Since each share represents proportional ownership, a stock is worth more when the business’s overall value increases — and may also command higher market prices due to demand. That means you may earn money by selling your stocks at a profit at some point.
• Stockholders may also earn dividends on a company’s profit, which may be paid in cash or as additional stock. Dividends are typically paid on a regular basis, such as quarterly or annually, though executives may also decide to cut dividend payments if the company is faltering.
Owning stock can create a form of passive income, since you could earn dividends just by holding onto your shares. This strategy is called dividend investing.
Stocks make up the foundation of many investment portfolios because of their potential for returns in the long run. On the other hand, the same dynamic that gives stocks their exponential growth potential also adds considerable risk to owning stock.
Buying Stocks: Risks and Rewards
Although buying stocks can sometimes result in a profit, it’s also possible to see significant losses — or even to lose everything you’ve invested.
Stocks might lose value under the following circumstances:
• The market as a whole experiences losses, due to wide-reaching occurrences like economic recessions, war, or political changes.
• The issuing company falters or goes under, in which case individual shares can drop in price and the company may forego paying dividends. This is also known as “specific” or “unsystematic risk,” and may be slightly mitigated by having a diversified portfolio.
Diversifying your portfolio — buying a variety of different stocks as well as other assets like bonds and cash equivalents — is one way to help mitigate the risks of investing. But it’s important to understand that it is possible (and even likely) that you may lose money by investing.
That said, scary news headlines can blow things out of proportion. A certain amount of market fluctuation is absolutely normal — and, in fact, an indicator that the market is healthy and functioning.
Furthermore, the market’s overall value has increased on average over the last century, even taking into account major collapses. In fact, the S&P 500, an index tracking the performance of America’s largest publicly traded companies, saw an annual return of approximately 10% between 1926 and 2020 — a time frame that includes both the Great Depression and the 2008 housing fiasco.
Should You Invest in Stocks?
When you consider the average return of the stock market over time, including boom and bust cycles, the stock market can offer investors the hope — but not the guarantee — of long-term growth for their money.
The difficulty with stocks is that they also come with a high degree of risk; some are riskier than others. There are different ways to invest in stocks that can help mitigate some of that risk.
*Investing in mutual funds, which are like giant baskets of many stocks, may help to distribute risk. Holding one single stock is riskier than holding many.
*Investing in index funds, which track a market index, may be less risky.
Why Do Companies Issue Stock?
When a company decides to go public, part of that decision is based on the need to raise capital in order to help the company grow. By making shares available on public exchanges to the wider investing market, a company may benefit from having more people buy its shares.
The downside for companies that go public is that the value of the company is now subject to market demand and other economic factors. In addition, public companies are highly regulated.
Why Do People Buy Stock?
Due to their growth potential, stocks may offer investors a possible way to build wealth over time, given that they tend to have higher average return rates than many other kinds of assets.
Take bonds, for instance. Bonds are a type of asset sometimes called a “debt instrument” wherein you lend your money to a company or government in exchange for a promise that it will be returned, plus interest, within a set amount of time.
Bonds do offer some growth potential, typically with less risk exposure than stocks. But over the past century, bonds have seen an average return of about 5-6% . As you’ll recall, that’s about half of the annual growth rate actualized by stocks over the same time period. Remember, past performance doesn’t guarantee that the future will be the same.
Along with helping you build wealth to achieve financial goals like retirement or homeownership, investing in stocks is also a possible way to keep up with inflation. As tempting as it may be to stash your cash under your mattress, the value of those paper dollars decreases over time, which means the $100 you squirrel away today might be worth only $95 ten years from now, due to inflation.
On the other hand, if you’d invested that money, it might have nearly doubled in the same amount of time. Of course, that new total would still be subject to inflation, but it could still be a lot more competitive than the dusty paper bills
Getting Started Investing in Stocks
If you decide that investing in the stock market is the right move to help you reach your financial goals, you’ve got a variety of ways to get started. Let’s look at two main account types: tax-deferred retirement accounts and taxable brokerage accounts.
Before you even sit down to choose your first stock (or learn to evaluate stocks in general), you’ll need to decide what kind of investment account you’ll use.
Tax-Deferred Accounts
These accounts are typically used for retirement purposes because they offer certain tax advantages to investors (along with some restrictions). Generally, investors contribute pre-tax money to these accounts — meaning contributions are tax deductible — and pay taxes when they withdraw funds in retirement.
• The 401(k) is commonly offered to W-2 employees as part of their benefits package. Contributions are taken directly from your paycheck, pre-tax, for this retirement account. In most cases, taxation is deferred until you take the funds out at retirement.
• IRAs may be useful investment vehicles for the self-employed and others who don’t have access to an employer-sponsored retirement account. There are a number of different types of IRA – two of the most common are the Roth and the traditional IRA – and each type offers unique benefits and limitations to savers.
Taxable Accounts
• You can also open a brokerage account, which allows you to buy and sell assets pretty much at will. However, there are no tax deductions for investing through a brokerage account.
Also, the interest and dividends you earn are subject to taxes in the year you earn them, and you may incur taxes when you sell an investment. Tax rates are usually lower for “long-term” assets, or those held for a year or longer; taxes on “short-term” capital gains (on securities held for less than a year) tend to be higher.
Different brokers assess different maintenance and trading fees, so it’s important to shop around for the most cost-effective option.
Choosing Your Investments
Once you have a brokerage account, you can typically choose which assets to invest in, including individual stocks as well as mutual funds, index funds, and Exchange-Traded Funds (ETFs), which are pre-arranged “baskets” of stocks that can help build diversification into your portfolio. Typically, ETFs are subject to management fees, but many brokers even offer commission-free ETFs, which can help you start investing at the lowest cost possible.
Of course, no matter what type of account you open or who your broker is, you’re ultimately responsible for the risk you take in buying stocks. That’s why it’s important to carefully vet stocks before you invest in them.
If you’re considering investing in a company directly, researching its financial history and learning more about its earnings patterns can help you make the most educated choice possible. It’s also important to keep your own goals and values in mind when learning what to look for in a stock.
Automated Investment Options
If all that footwork sounds exhausting, that doesn’t necessarily mean investment isn’t right for you. You might consider an automated investing option (also known as a “robo-advisor”), which offer pre-built investment portfolios based on your goals and timelines. It’s similar to a pre-built house: there are some adjustments you can make, and different models to choose from, but your choices are limited.
That said, many investors choose automated options because the algorithm on the back-end takes care of most of the basic maintenance for your portfolio. Also, robo advisors can help you get started with a minimal amount of research and effort.
The programs may charge a small fee in exchange for creating, maintaining, and rebalancing a portfolio. Some may also allow you to choose specific stocks or themed ETFs, which can help you support companies or industries that share your values and vision.
The Takeaway
Stocks, also known as “shares” or “equity investments,” are small pieces of ownership of a larger company. Stocks come in both common and preferred varieties, which offer stockholders different benefits and risks.
Stocks, although relatively risky, tend to offer better earning potential than other asset classes like bonds or long-term savings accounts. Even taking major financial crises into consideration, the market’s overall trend over the last 100 years has been toward growth.
So, if you’re ready to take matters into your own hands and become an investor, you may want to start by opening a stock trading account with SoFi Invest. You can trade stocks, IPO shares, and ETFs right from your phone or laptop. Even better, SoFi members have access to complimentary financial advice from professionals. Why not get started today — your future self will thank you.
FAQ
What is a stock vs a share?
A share refers to the unit of stock investors buy. Stock is a more general term that refers to the company that issues those shares. So you would buy 100 shares of Company A; you wouldn’t buy 100 stocks (that would imply you owned shares of 100 different companies).
What is shareholder ownership?
Shareholder ownership is specifically based on your ownership of shares in the company. If you own 20% of a company’s shares, you don’t own 20% of the company — you own 20% of the shares.
What is the difference between stocks and bonds?
Companies issue stock in order to raise capital. Investors who own shares of stock will see the value of their holdings rise or fall according to the value of the company. Bonds are a loan of capital to a company or government, which in turn guarantees to repay the bondholder the full amount, plus interest, within a certain time frame.
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