What is a Stock?
A stock is a unit of ownership in a company — If you own a stock, that makes you a shareholder, meaning that you may be eligible to receive dividends if the company succeeds and you may have a vote in some company decisions. Stocks are an important part of the global economy, allowing companies to raise money for the operation of their businesses by selling shares (or pieces of ownership) to the public. Shares can be bought or sold via an exchange, such as the New York Stock Exchange (NYSE) or Nasdaq. In limited cases, stocks can be sold privately. Specific regulations set by the Securities Exchange Commission (SEC) govern how companies can manage or distribute their stocks. Stocks can be either common stock, which gives shareholders voting rights on certain company decisions, or preferred stock, which gives shareholders no voting rights but often guarantees them fixed dividend payments in perpetuity.
Corporations issue (sell) stock to raise funds to operate their businesses. The holder of stock (a shareholder) has now bought a piece of the corporation and, depending on the type of shares held, may have a claim to a part of its assets and earnings. In other words, a shareholder is now an owner of the issuing company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have a claim to 10% of the company's assets and earnings. Stockholders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belongs to the corporation, and not to the shareholders.
A person who owns a percentage of the stock has ownership of the corporation proportional to their share. The shares form stock. The stock of a corporation is partitioned into shares, the total of which is stated at the time of business formation. Additional shares may subsequently be authorized by the existing shareholders and issued by the company. In some jurisdictions, each share of stock has a certain declared par value, which is a nominal accounting value used to represent the equity on the balance sheet of the corporation. In other jurisdictions, however, shares of stock may be issued without associated par value.
Shares represent a fraction of ownership in a business. A business may declare different types (or classes) of shares, each having distinctive ownership rules, privileges, or share values. Ownership of shares may be documented by issuance of a stock certificate. A stock certificate is a legal document that specifies the number of shares owned by the shareholder, and other specifics of the shares, such as the par value, if any of the class of the shares.
In the United Kingdom, the Republic of Ireland, South Africa, and Australia, stock can also refer to completely different financial instruments such as government bonds or, less commonly, to all kinds of marketable securities.
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 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 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 safer investments than growth or value stocks. They also are called income stocks.
Key Facts on Stocks
- Investors who do best over the long term buy and hold. That means they own a diversified portfolio of many stocks and hold on to them through good times and bad.
- Investing in individual stocks takes time. You should research each stock you purchase, which includes a deep dive into the bones of the company and its financials. Many investors opt to save time by investing in stocks through equity mutual funds, index funds, and ETFs instead. These allow you to purchase many stocks in a single transaction, offering instant diversification and reducing the amount of legwork it takes to invest.
- There are two main types of stocks: common and preferred. Most investors own common stock in a public company. Common stock may pay dividends, but dividends are not guaranteed and the amount of the dividend is not fixed. Preferred stocks typically pay fixed dividends, so owners can count on a set amount of income from the stock each year. Owners of preferred stock also stand at the front of the line when it comes to the company’s earnings: Excess cash distributed by dividend is paid to preferred shareholders first, and if the company goes bankrupt, preferred-stock owners receive any liquidation of assets ahead of common-stock owners.
Benefits and Risks of Owning Stocks
Benefits of Owning Stocks
There are many potential benefits to owning stocks or shares in a company, including the following:
- Claim on assets: A shareholder has a claim on the assets of a company in which s/he owns stock. However, the claims on assets are relevant only when the company faces liquidation. In that event, all of the company’s assets and liabilities are counted, and after all, creditors are paid, the shareholders can claim what is left. This is the reason that equity (stocks) investments are considered higher risk than debt (credit, loans, and bonds) because creditors are paid before equity holders, and if there are no assets left after the debt is paid, the equity holders may receive nothing.
- Dividends and Capital Gains: A stockholder may also receive earnings, which are paid in the form of dividends. The company can decide on the dividend to be paid in one period (such as one quarter or one year), or it can decide to retain all of the earnings to expand the business further. Aside from dividends, the stockholder can also enjoy capital gains from stock price appreciation.
- Power to vote: Another powerful feature of stock ownership is that shareholders are entitled to vote for management changes if the company is mismanaged. The executive board of a company will hold annual meetings to report overall company performance. They disclose plans for future period operations and management decisions. Should investors and stockholders disagree with the company’s current operation or future plans, they have the power to negotiate changes in management or business strategy.
- Limited Liability: Lastly, when a person owns shares of a company, the nature of ownership is limited. Should the company go bankrupt, shareholders are not personally liable for any loss.
Risks of Owning Stock
Along with the benefits of stock ownership, there are also risks that investors have to consider, including:
- Loss of capital: There is no guarantee that a stock’s price will move up. An investor may buy shares at $50 during an IPO, but find that the shares move down to $20 as the company begins to perform badly, for example.
- No liquidation preference: When a company liquidates, creditors are paid before equity holders. In most cases, a company will only liquidate when it has very few assets left to operate. In most cases, that means that there will be no assets left for equity holders once creditors are paid off.
- Irrelevant power to vote: While retail investors technically have voting rights in executive board meetings, in practice they usually have very limited influence or power. The majority shareholder typically determines the outcome of all votes at shareholder meetings.