What Are Stocks? Types, Benefits, Risks, Explained
A stock represents 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 that if you own stock in a company, as the company grows and expands you stand to earn a return on your investment as your shares gain value. But you also risk losing all or part of your investment if the company doesn’t prosper.
Key Points
• Stocks represent fractional ownership in a company, offering potential returns through appreciation and dividends.
• Stocks may be either common or preferred, with common stocks being the most common.
• Stock prices are typically determined by supply and demand, influenced by factors such as market conditions and company performance.
• Investing in stocks may help build wealth over time but also carries risks, including potential loss of investment.
• Diversifying a portfolio with various stocks and other assets can help mitigate investment risks.
What Are Stocks?
Stocks are shares of ownership in a company, and they are primarily bought and sold on publicly traded stock exchanges. That means you can open an online brokerage account and become a partial owner of whatever company you choose when you buy shares in that company.
How Do Stocks Work?
Stocks are a type of financial security, or asset, and they are traded on public exchanges. A stock is created when a company goes public, typically through an initial public offering (IPO), and issues shares that investors can buy and sell. Stocks are usually traded on exchanges, like the NYSE or Nasdaq.
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.
The price of a stock is generally determined by supply and demand via 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.
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, often conducted in fractions of a second.
When a stock’s prospects are high and it’s in high demand, the company’s share price could increase. In contrast, when investors sour on a company and want to sell en masse, the price of a stock will likely decline.
Types of Stocks
Stocks generally fit into two categories: common stock and preferred stock.
• Common stocks are the most common type of stock. Along with proportional ownership of the company, common stocks also give stockholders voting rights, allowing them to have voice when it comes to things like management elections or structural business changes. Most individual investors own common stock.
• 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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Benefits of Stocks
For investors, the primary benefit of owning stocks is that they present the opportunity to generate a return. While stocks do have risks, by and large, the stock market tends to rise over time, meaning that an investor owning a diversified stock portfolio could benefit from the market’s gains over time, too. Though there are no guarantees.
Further, stocks allow investors to diversify their portfolios to a good degree. 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.
Again, it’s important to understand that it is possible (and even likely) that you may lose money you have invested when a company’s stock or the market takes a downturn. It’s also important to remember that a certain amount of market fluctuation is absolutely normal — and, in fact, an indicator that the market is healthy and functioning.
Risks of Stocks
As discussed, owning or investing in stocks has its risks, too. Though buying stocks can sometimes result in a positive return, it’s also possible to see significant losses — or even to lose everything you’ve invested.
Stocks might lose value under the following circumstances (though there could be many others):
• 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 forgo paying dividends. This is also known as “specific” or “unsystematic risk,” and may be slightly mitigated by having a diversified portfolio.
• A lackluster financial report, such as a quarterly earnings report showing declining sales, could lead to a stock’s value declining.
How to Buy 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. For most investors, there are two main account types through which they might buy stocks: tax-deferred retirement accounts and taxable brokerage accounts. There are also accounts that allow for automated investing.
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-saving or planning 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.
• A 401(k): The 401(k) plan 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: Individual retirement accounts, or 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 IRAs – two of the most common are the traditional and the Roth IRA, though typically only the traditional IRA is tax-deferred. Roth IRA account holders contribute after tax-dollars, which grow tax-free. Each type of IRA offers unique benefits and limitations.
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 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.
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.
Stock Terms to Get Familiar With
The stock market is chock full of unique jargon and terminology. As such, it can be helpful to learn some of the lingo so you better understand what’s going on, and what you’re doing.
Stocks and Shares
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.
Further, trading equities is the same as trading stocks. 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.
It’s also possible to own a fraction of a share of stock (called fractional shares), for those who can’t afford to buy a single share (which can happen with very large or popular companies).
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.
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 prospect of generating returns — but not a guarantee of such returns.
The difficulty with stocks is that they also come with a degree of risk; some are riskier than others. There are different ways to invest in stocks that can help mitigate some of that risk.
Ultimately, the choice to invest in stocks — and which specific stocks — will come down to the individual investor, their risk tolerance, and goals. It may be helpful to speak with a financial professional for guidance, too.
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. Although relatively risky, stocks tend to offer better return-generating 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. But again, there are no guarantees, and you should always do your research before investing in a stock or other asset.
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FAQ
How do stocks make money?
Stocks can earn investors returns primarily through appreciation — meaning that they gain value, and investors sell them for more than they purchased them for — or by paying out dividends.
How are stock prices determined?
Stock prices are mostly determined by supply and demand among traders and investors. When a specific stock is in demand, values might rise — conversely, when many investors are selling a stock, its value might fall.
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.
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