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stock is an investment that represents a unit of ownership in a company. - Capital appreciation and dividends are the two primary ways that shareholders earn returns on their stock investments.
- By investing in stock funds or buying fractional shares of stocks, investors can build diversified stock portfolios.
A stock is an investment in a company. But unlike private equity investments, which are typically reserved for accredited investors, thousands of stocks are available for anyone to buy and sell on public exchanges.
For this reason, stock investments are some of the most well-known and popular ways to invest and build wealth.
Let's take a closer look at what a stock is, how stock investing works, and the ways that stock investors can make money.
What is a stock?
A stock, also known as equity, is a security that represents a fractional share of ownership in a company. When you purchase a stock from a company, you become a shareholder, and the small piece you own is called a share.
Investors buy and own stocks in hopes that the company will succeed. When the company does well, its stock owners share in those profits.
Conversely, shareholders can also expect their returns to be diminished if the company underperforms or declines. And in the worst-case scenario, a stock owner's shares could become worthless if the company was to go bankrupt.
How do stocks work?
Companies can issue their stock shares either privately or publicly. While private shares are typically only available to accredited investors, accreditation isn't required to invest in stocks that are traded on public exchanges such as the New York Stock Exchange or Nasdaq.
Private companies "go public" to raise money for business initiatives such as launching new products or services expanding its reach. They do this through initial public offerings (IPOs), where companies are required to meet SEC financial transparency requirements and share price is typically decided by an investment bank. Once the IPO has been issued and the stock begins trading, supply and demand dynamics will move its price up or down.
How to buy and sell stocks
Investors can buy and sell public stocks by opening an account with a stock broker. There are now a large number of brokers who don't charge commissions for stock trades and allow clients to buy fractional shares of stocks.
Investors can instantly diversify their stock holdings by investing in stock funds (ETFs or mutual funds), which allows you to spread your money across a variety of stocks. Some funds are actively managed while others track benchmark market indexes, such as the S&P 500.
"Stock picking can be a time-consuming activity if done correctly. Therefore, I always advise [investors] to buy an index or ETF such as one on the S&P 500, like VOO, or on any other sector of interest," says Shanka Jayasinha, CIO of S&J Private Equity.
Note that ETFs and mutual funds charge an annual management fee, referred to as the fund's expense ratio. It's important to know what you're paying in fund fees as high expense ratios will eat into your overall returns.
How do stocks offer returns?
There are two primary ways that shareholders can earn returns on their investments: capital gains and dividends.
Capital gains are the profits from when you sell a stock. This happens when you sell it for more than you paid for it.
Capital gains example: Let's say that you bought 100 shares of ABC company at $50 per share for a $5,000 investment. Ten years later, ABC shares are trading at $100. If you sold your shares at that moment, you'd receive $10,000. You'd profit $5,000 for an annualized return of 7.18%.
Dividends are regular payments to shareholders. Each company can set its own dividend schedule but quarterly payouts are most common.
Dividends example: You purchase 50 shares of XYZ stock which pays a quarterly dividend of $1. In this example, you'd receive $50 per quarter and $200 per year in annual dividend payments from the company. If the company raised its quarterly dividend to $1.10, your quarterly payout would increase to $55 ($50 x $1.10 = $55) and your annual dividend income would grow to $220.
Dividends give investors a means of realizing income without having to sell any of their shares - even during years that the stock price declines. Because of this, dividend-paying stocks are often very attractive to investors who are in or near retirement.
Stock investing vs. stock trading
In contrast to buy-and-hold investors, active traders try to make a profit on short-term fluctuations in a stock's price. While investors may focus heavily on a company's fundamental and long-term prospects, traders tend to rely more on news events and technical analysis to inform their decisions.
Related Article Module: Trading and investing are two approaches to playing theIf you have the time that it requires to research and manage trades, trading can offer faster returns than investing. However, investing is the way to go if you want to earn passive income on your stock holdings. And if you do decide to dabble in trading, it's important to think through your trade plan before taking any position and stick with it no matter what.
Types of stock
Stocks can be classified in a variety of ways. Below we break down a few of the major types and explain their differences.
Common vs. preferred stocks
There are two main types of stocks: common stocks and preferred stocks.
- Common stock: As the name suggests, this is the most common type of stock. Common stockholders typically receive quarterly dividends and voting rights. However, those dividends fluctuate and are not guaranteed.
- Preferred stock: Preferred stocks pay a higher, fixed dividend than common stock, but their share prices don't appreciate as much as common shares do. Preferred stockholders also get paid those dividends before common shareholders, even in the event of bankruptcy.
"If you buy 100 shares of Coca Cola Company stock, you're most likely buying the common stock," says Robert Johnson, a professor of
Holders of common stock also "elect the board of directors and vote on corporate issues" explains Anthony Denier, CEO of the trading platform Webull. "The disadvantage is that in bankruptcy proceedings, common shareholders are last in line for the company's assets."
Denier adds that preferred stock offers "stable dividends" and the yields are often "higher than the same company's common stock dividends." And he notes that if the company is running short on cash, "preferred shareholders receive their dividends before common shareholders."
Class A vs. Class B shares
In some cases, companies may sell separate Class A and Class B shares. The major difference between the two is typically that Class B shares will have more voting rights.
For example, Coke common stock shareholders receive one vote per share, while Class B shareholders receive 20 votes per share. Typically, companies create share classes in this way because they want the voting power to remain with a certain group.
Other stock categories and classifications
Let's say that you're an average retail investor who only has access to common stock. You can filter your stock search in a variety of ways such as by size, industry, style, or location.
One option is to look at the company's market capitalization - or in other words, its size. Some investors may only want to focus on well-established, large-cap companies. Others may want to include small-cap and mid-cap companies which, while often more volatile, could also offer outsized returns.
Companies can also be grouped by industry. Tech, industrials, financials, and consumer staples are just a few industry sector examples. Investing in stocks from a variety of industries helps to improve your portfolio's diversity.
With style-driven investing, you look for stocks that fit in with a particular investing strategy such as growth, value, or dividend investing. And, finally, stocks can be classified by geography. For example, U.S investors may want to broaden their exposure to emerging markets by investing in foreign-company stocks.
How to make money investing in stocks
When investors are able to take advantage of compounding returns over many years, their profits can increase exponentially. That's why time in the market, rather than perfect timing, is likely to be most important to your success.
"Time is the greatest ally of the investor because of the 'magic' of compound interest," Johnson says.
With this in mind, Johnson recommends that investors "begin investing in a low-fee, diversified equity index fund and continue to invest consistently whether the market is up, down, or sideways."
According to Goldman Sachs, US stocks have shown an average 10-year return of 9.2% in the past 140 years. But this upward movement hasn't happened along a straight line.
According to the Schwab Center for Financial Research, the market suffered intra-year setbacks of 10%+ in 11 of the past 20 years, demonstrating the relatively high short-term risk of stock investing. Yet, it finished in positive territory in all but five of those years.
The financial takeaway
A stock gives an investor a small ownership share of a company and the stock's returns will generally be based on the company's performance. Investing in stocks is a common way for investors to build wealth for themselves.
However, there are no guarantees. Whenever a public company fails, it's stock investors are likely to suffer as well. But the more stocks you own, the lower your risk of taking a big portfolio hit as a result of one wrong stock pick.
Thankfully, you don't need a huge account balance to build a diversified stock portfolio with your broker. Through the use of ETFs, mutual funds, or fractional shares, it's easy to invest in dozens or hundreds of stocks with minimal capital.
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