Stocks are an investment that allows you to own a portion of a public corporation.
Learn more about stocks, how they work, and how they can help contribute to your wealth.
What Are Stocks?
Stocks represent ownership in a publicly-traded company. When you buy a company's stock, you become part-owner of that company. For example, if a company has 100,000 shares and you buy 1,000 of them, you own 1% of it. Owning stocks allows you to earn more from the company's growth and gives you shareholder voting rights.
- Alternative name: Shares, Equity
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—where prices are driven by supply and demand.
The more people selling a stock, the lower the price will drop; the more people buying a stock, the higher the price will rise. Generally, people buy or sell stocks based on 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 by selling shares at a higher price 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.
The profit made from selling a stock is known as capital gains.
The other 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 and incentivize stockholders—the actual owners of the company—for investing. It's especially important for companies that are profitable but may not be growing quickly.
The third, riskier way to profit from stocks is from derivatives, which 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. When the stock price goes up, you make money 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 long-term within a diversified portfolio to gain the highest return for the least risk.
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. Stocks can be grouped by industry sector, including:
- Basic materials: Companies that extract natural resource
- 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 companies
- Health care: Health care providers, health insurance, medical equipment suppliers, and drug companies
- Industrial Goods: Manufacturing companies
- Services: Companies that get products to consumers
- Technology: Computer, software, and telecommunications
- Utilities: Electric, gas, and water companies
They can also be grouped based on potential and value. Growth stocks are expected to experience rapid growth, but they usually don't pay dividends. Sometimes, the companies may not even be making a profit yet, but investors believe the stock price will rise. These are typically younger companies that have much room for business growth and additions to their business model.
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 to be reliable companies in stable industries over the years. They pay dividends and are considered a safer investment than growth or value stocks. They also are called income stocks.
- Stocks represent ownership in a company.
- The primary way to make money from a stock is by an increase in its share price and dividend payouts.
- Stocks can be grouped by sector, valuation, or value.