What Are Stocks and How Do They Work?
A stock is a type of investment in a company. Companies issue stock shares to raise money in order to finance operational needs and to fuel growth, and investors buy those stock shares for the opportunity to generate a return on their investment.
What Is a Stock?
A stock is a type of financial security that represents the ownership, or equity interest, of a fraction of a corporation. That equity is established on a per share basis, and the owners are often referred to as shareholders or stockholders.
Thus, when you buy a share — or multiple shares — of stock, you are purchasing a proportionate claim on a company’s net assets and future earnings.
- You own 10,000 shares of Vision Global Corp stock, which is currently priced at $80 per share.
- There are a total of 1,500,000 Vision Global Corp shares outstanding.
This means that your investment is worth $800,000.
Why Do People Buy Stocks?
Investing in stocks can be a key part of your personal finance strategy. The primary reason most people buy stocks is to generate a long-term return on their investment (ROI) that exceeds that of other prominent asset classes, such as bonds, real estate and commodities. Generally, this is achieved in two ways.
- Dividends are payments made by a company to its shareholders. Normally, the payments represent a portion of current year net earnings, but special dividends — funded with retained earnings or asset sales — are sometimes made.
- Price Appreciation
- This is when the price of a stock increases since purchase. Like a rise in the value of your home or any other asset you own, the increase represents a potential gain that can be realized upon sale.
While many investors benefit from both high dividend yield and price appreciation, some do not. Not all stocks pay dividends, and many suffer from price depreciation rather than appreciation. As a result, prudent investors avoid establishing highly concentrated positions in a few stocks. Rather, they build diversified portfolios that include a variety of companies spanning different industries and geographic regions.
Beyond the potential financial benefits, most stocks also offer investors voting rights on key governance matters. Given their relatively small and uninfluential ownership positions, this is rarely a focal point for individual investors. However, institutional investors with significant ownership stakes tend to highly value voting rights.
What Kinds of Stocks Exist?
Not all stocks are the same, and it’s important to understand their differences and most important distinctions before investing.
Public vs. Private Stocks
There are publicly traded stocks and privately held stocks. The former is what most people think of when they hear the phrase “stock market.” Publicly traded stocks consist of fairly well-known companies whose shares are traded on highly regulated exchanges, such as the New York Stock Exchange and the Nasdaq stock market.
Private markets involve much less regulation than public markets, and they are comparatively illiquid and volatile. To protect unsophisticated U.S. investors from these pitfalls, the Securities and Exchange Commission (SEC) largely limits investment in this space, allowing only relatively wealthy and/or highly knowledgeable, accredited investors to buy privately placed securities.
Common vs. Preferred Stocks
Most equity investors own publicly traded common stock. These offer voting rights and the possibility for dividends and price appreciation, but there is another type of stock favored by some investors — preferred stock.
Preferred shareholders rarely have the right to vote on company matters, but they are entitled to receive dividend payments before common shareholders. Often, they receive these payments at a higher dividend yield. Preferred shareholders also have a priority claim on assets in the event of a bankruptcy proceeding or liquidation.
This priority positioning manifests itself via the risk-return tradeoff, the investment principle that shows that a higher level of return is only achievable by assuming a higher level of risk. While common shareholders may have greater return potential than preferred shareholders, they also face an increased risk of losing their money because they sit at the bottom of the capital stack.
Different Classes of Stock
Some companies issue different classes of stock. Generally, this is done when the company wishes to differentiate shareholder voting rights and/or dividend offerings across classes.
For example, the Class A common shares of a certain company may provide greater voting power per share than the Class B common shares of the same company. Alternatively, the Class A1 preferred shares of a certain company may provide higher dividend yields than the Class B1 preferred shares of the same company.
How Do I Buy and Sell Stocks?
Publicly traded stocks are created when a company sells shares of its business to raise funds for current and future operational needs. The sales process, which is commonly referred to as a stock issuance, gives new investors an ownership stake in the company and a claim to net assets and future profits.
The Primary Market
The forum for direct exchanges between issuing companies and investors is known as the primary stock market. This differs from the secondary stock market, which is the forum where previously issued stocks are traded amongst investors.
The latter market is where the vast majority of investors buy and sell their stocks — via public stock exchanges, such as the New York Stock Exchange and the Nasdaq. These well-developed platforms offer investors a secure and highly liquid way to conduct trades instantaneously, amidst continuous price fluctuations resulting from supply and demand changes.
The law of supply and demand states that, for every stock transaction, there must be a buyer and a seller. If there are more buyers for a stock than sellers, the price will trend up. Conversely, if there are more sellers of the stock than buyers, the price will trend down.
The Secondary Market
Secondary market transactions are executed via stockbrokers, with an increasingly large portion of volume flowing through online brokerage firms, such as E*TRADE, Charles Schwab and TD Ameritrade. Traditionally, these middlemen have charged commissions for the service of matching buyers with sellers. However, the evolution of automated trading platforms — coupled with fierce competition throughout the brokerage industry — has led many brokers to drastically reduce or eliminate commissions for certain assets, including stocks.
This transition reflects a shift away from a transaction-oriented business model to one focused on cultivating deeper client relationships. For the leading firms, this entails providing a broader, highly integrated service offering that is inclusive of custodial banking, advisory support and customized research, data and tools.
What Are the Alternatives to Stocks?
A company may choose to issue bonds, rather than stocks, to raise capital. Bonds are financial securities that represent a loan made by an investor, known as the bondholder, to a borrower. Bonds are paid back once they mature — at a predetermined time — and investors usually receive interest payments in the interim.
Issuing bonds can enhance the return potential for investors, but it also increases the issuing company’s financial obligations. Ultimately, this increases the volatility associated with future cash flow and elevates the company’s overall level of risk.
Investors should also be aware that the longer the duration of a bond, the more sensitive its price will be to interest rate movements. Hence, their interest payments run the risk of being lower than anticipated.
Mitigating the Risks of Investing in Stocks
Stocks, particularly publicly-traded, common stocks, are a staple in nearly every investment portfolio. They have a history of high returns, but they expose investors to a lot of near-term risk, as we saw during the Great Recession and the early days of the COVID-19 pandemic.
For this reason, stocks should be viewed as long-term investments. Moreover, prudent investors should strive to achieve a high degree of diversification across their stock holdings. Doing so provides for balanced economic exposure, which has been shown to bolster long-term investment performance and minimize downside risk.
Years ago, achieving an appropriate level of diversification was a complex and costly endeavor. Today, it’s a simple and inexpensive process, thanks to the myriad of low-cost index funds and exchange traded funds (ETFs) that provide exposure to different industries and geographic regions.
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