What Are Stocks?

A trader works on the floor of the New York Stock Exchange
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Stocks are an investment that allows you to own a portion of a public corporation. They're also called shares or equities. Buying stock in a company makes you a part owner of that company, and in most cases it gives you shareholder voting rights. Investors buy stocks hoping for good returns, which will help them build wealth.

How Stocks Work

Companies sell stocks to gain additional funds to grow their business, launch new products, or pay off debt. The first time a company issues stocks to the public is called the initial public offering (IPO). After the IPO, stockholders can resell their shares on the stock market. Stock market prices are driven by expectations of corporate earnings or profits. If traders think a company's earnings are high or will rise further, they bid up the price of the stock.

One way that shareholders make a return on their investment is from selling shares at a greater value than they were purchased. If a company doesn’t do well and its shares decrease in value, its shareholders could lose part or even all of their investment when they sell.

A second way shareholders profit is through dividends, which are quarterly payments distributed on a per-share basis out of a company's earnings. It is a way to reward stockholders—who are the actual owners of the company—for investing. It's especially important for companies that are profitable but may not be growing quickly.

Types of Stocks

There are two main types of stocks: common and preferred. The stocks tracked on the Dow Jones Industrial Averages and the S&P 500 are common; their values depend on when they are traded. Common stock owners can vote on a corporation's affairs, such as the board of directors, mergers and acquisitions, and takeovers. However, if a company goes bankrupt and liquidates its assets, common stock owners are last in line for a payout, after the company's bondholders and preferred stockholders.

In addition to these two types of stocks, there are other ways to categorize stocks, according to the characteristics of the companies that issued them. These different groupings meet the varying needs of shareholders.

Market Capitalization

Market cap is the total stock market value of a company. You can calculate that by multiplying the share price by the number of shares outstanding. There are three sectors of market cap:

  • Small-cap stocks typically have a market cap of $2 billion or less. They are likely to grow quickly but are riskier.
  • Mid-cap stocks are generally valued between $2 billion and $10 billion.
  • Large-cap stocks usually have a market cap of $10 billion or more. They grow more slowly but are not as risky.

Growth Potential

Growth stocks are expected to experience rapid growth. They don't pay dividends. Sometimes, the companies they represent may not even have earnings yet, but investors believe the stock price will rise.

Value stocks pay dividends since the price of the stock itself is not expected to rise much. These tend to be large companies that aren't exciting, so the market has ignored them. Savvy investors see the price as undervalued for what the company delivers.

Blue-chip stocks are fairly valued and may not grow quickly, but they have proven over the years to be reliable companies in stable industries. They pay dividends and are considered a safer investment than growth or value stocks. They also are called income stocks. 

Sector

Stocks can be grouped by industry sector. Nine common sectors include:

  • Basic materials: Companies that extract natural resources
  • Conglomerates: Global companies in different industries
  • Consumer goods: Companies that provide goods to sell at retail to the general public.
  • Financial: Banks, insurance, and real estate
  • Health care: Health care providers, health insurance, medical equipment suppliers, and drug companies
  • Industrial Goods: Manufacturing
  • Services: Companies that get products to consumers
  • Technology: Computer, software, and telecommunications
  • Utilities: Electric, gas, and water companies

Stock Derivatives

Most people make money from stocks by buying, holding, or collecting dividends. They may buy low and sell high. But there is a third, riskier way to profit from stocks: derivatives. As the name implies, these investments derive their value from underlying assets, such as stocks and bonds.

Stock options give you the option to buy or sell a stock at a certain price by an agreed-upon date. A call option is the right to buy at a set price. You make money when the stock price goes up, by purchasing it at the fixed lower price and selling it at today’s price. A put option is the right to sell at a set price. You make money when the stock price declines. In that case, you buy it at tomorrow's lower price and sell it at the agreed-upon higher price.

Most financial planners will advise individual investors to stick to buying and holding stocks for the long term within a diversified portfolio to gain the highest return for the least risk.

Article Sources

  1. Investor.gov. "Stocks." Accessed Jan. 15, 2020.

  2. Investor.gov. "Initial Public Offering (IPO)." Accessed Jan. 15, 2020.

  3. Investor.gov. "What Is Risk?" Accessed Jan. 15, 2020.

  4. U.S. Securities and Exchange Commission. "Market Capitalization." Accessed Jan. 15, 2020.

  5. Randy Billingsley, Lawrence J. Gitman, Michael D. Joehnk. "Personal Financial Planning." Cengage Learning, 2016.

  6. Investor.gov. "Derivatives." Accessed Jan. 15, 2020.

  7. Investor.gov. "Investor Bulletin: An Introduction to Options." Accessed Jan. 15, 2020.

  8. U.S. Securities and Exchange Commission. "Beginners' Guide to Asset Allocation, Diversification, and Rebalancing." Accessed Jan. 15, 2020.