What Are Stocks?

A trader works on the floor of the New York Stock Exchange
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Definition: Stocks allow you to own a portion of a public corporation. Initially, they are sold by the original owners of a company to gain additional funds to help the company grow. This is called the Initial Public Offering. The owners sell control of the company to the stockholders. After the IPO, the shares are resold on the stock market.

Stock prices are driven by expectations of corporate earnings, or profits.

If traders think the company's earnings are high, or will rise further, they  bid up the price of the stock. One way that stockholders make a return on their investment is when they buy a stock low, and sell it high. Conversely, if the company does poorly, then the shares decrease in value, and the stockholders lose part or sometimes even all of their investment when they sell.

A second way that stockholders profit is if the company pays a dividend. These are usually quarterly payments distributed to stockholders on a per share basis. The company's board of directors pays dividends out of earnings. It is a way to reward stockholders, who are the actual owners of the company, for their investment. It's especially important for companies that are profitable, but may not be growing quickly.

Types of Stocks

There are two types of stocks, common and preferred. The stocks tracked by the Dow Jones Averages and the S&P 500 are common.

The value of these stocks depend on how they are traded at any given time. Common stock owners can vote on the corporation's affairs, such as the Board of Directors, mergers and acquisitions and takeovers.

Corporations may also issue preferred stocks. They have the properties of both common stocks and bonds.

Their values rise and fall along with the company' common stock prices. However, they are like bonds in that they always make a fixed payment. For that reason, most preferred stockholders don't sell them.

In addition to the two types of stocks, there are many different groupings of stocks that are often referred to as types. The stocks are grouped according to the characteristics of the companies that issued them. These different groupings meet the varying needs of stockholders.

Market Capitalization: Market cap is the total stock market value of the company, or the share price multiplied by the number of shares outstanding. There are three sectors within this.

  1. Small cap stocks have a market cap of $2 billion or less. They are likely to grow quickly, but are riskier.
  2. Mid cap stocks have a market value of between $2-$10 billion.
  3. Large cap stocks have a market cap of $10 billion or more. They grow more slowly, but are not as risky.(Keep in mind that these category levels vary somewhat depending on who is making the definition.)

Growth Potential: This measures investors' expectations of companies' future growth potential. Growth stocks typically don't pay dividends, and sometimes the companies they represent may not even have earnings yet, but the stock price is expected to rise quickly.

Value stocks usually do pay dividends, since the price of the stock itself is not expected to rise much. These are usually large companies that are't exciting, and so the market has ignored them. Therefore, savvy investors see the price as undervalued for what the company delivers.

Blue chip stocks are fairly valued, may not be growing quickly, but have proven themselves over the years to be solidly run companies in stable industries. They usually pay dividends, and are considered a safer investment than growth or value stocks. They are also known as income stocks

Sector: Stocks are also grouped by industry sector. Here are the nine most common sectors:

  1. Basic Materials - Companies that extract natural resources.
  2. Conglomerates - Global companies that are in different industries.
  3. Consumer Goods - Companies that provide goods to sell at retail to the general public.
  1. Financial - Banks, insurance and real estate.
  2. Healthcare - Healthcare providers, as well as health insurance, medical equipment suppliers and drug companies.
  3. Industrial Goods - Manufacturing.
  4. Services - Companies that get the products to the consumer.
  5. Technology - Computer, software and telecommunications.
  6. Utilities - Electric, gas and water companies. (Source: Yahoo Finance, Industry Browser)

Stock Derivatives

Most people make money from stocks by either buying, holding and collecting dividends, or buying low and selling high. However, there is a third, more risky way to profit from stocks, and that's with derivatives. Like 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, and you make money when the stock price goes up, you buy it at the lower price and immediately sell it at that day's price. A put option is the right to sell, and you make money when the stock price declines, known as a market correction. In that case, you buy it at tomorrow's lower price, and sell it at the agreed-upon higher price.

Short selling is when you borrow a stock from your broker, sell it at today's higher price, and then buy it at tomorrow's lower price and return the stock to your broker. Short-selling is very risky, because if the stock price rises, you are out the difference. There is theoretically no limit to how high the stock price could rise. That's why most financial planners 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. 

Frequently Asked Questions About Stocks