You’ve heard of stocks, but what exactly is a stock? It’s a way to grow your money by owning a slice of a company. Company ownership has made many people very wealthy. Are you next? What to know about stocks and stock types before you start funneling your money into them.
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The terms stock, equity, and share are often used interchangeably. Saying you own equities or shares means you own stocks. But what is a stock, anyway? And why should you care? Can it really make you wealthy?
Definition: What Is a Stock?
At its most basic level, owning stock means you own a piece of a company. Probably a very tiny piece. But it’s still an ownership stake. When you own one stock of Company ABC, you own one share of Company ABC. One unit of ownership. You’re then called a shareholder of Company ABC.
A stock is a security that represents your ownership share (or stake) in that company. Let’s say you own 1,000 shares of Company ABC out of their 10,000 total shares. As such, you’d own 10% of the company.
Companies issue stock as a way to raise money – to grow their business, launch new products, expand into new territories, or pay off debt.[i]
But what’s in it for you? As an investor, buying company stock is a way to grow your money, make it work for you, invest for your future, and soundly beat inflation over time.
Do You Have to Buy a Whole Share of Stock?
A share of stock is the smallest unit of ownership in a company. So what do you do when one share costs thousands of dollars but you want to participate in that company’s growth?
Take Amazon, for example. As I write this, Amazon is trading for $3,287. You used to have to buy at least one entire share. But as a beginning investor, you may not have that kind of cash to invest in Amazon. You now have a couple choices.
One is called fractional shares. Meaning a part, or fraction, of a share. You can buy as much or little of a share of Amazon as you can afford. Not all brokerage accounts offer these, but they’re becoming more widely available.
The other way you could own those pricy shares of Amazon is to buy into an index fund that owns shares of Amazon.
Sometimes companies split their stock. Which means if the stock price is $2,000 and they think more people will buy it if it’s priced at $500, they’ll split every existing $2,000 share into four shares worth $500 each.
As an existing stockholder, the total value of your shares is the same as it was before the split. And now that it’s more accessible to more investors, the price might rise faster.
The most expensive stock in the world today is Berkshire Hathaway A-shares, at a breathtaking $342,987. Warren Buffett has steadfastly refused to split Berkshire Hathaway’s shares.
How to Make Money with Stocks
You can make money from stocks in two ways:
- Selling it at a higher price than you paid for it.
- Participating in incremental profit payouts called dividends, paid in stock or cash, quarterly or annually. Not all stocks pay dividends.
Stock prices fluctuate all the time, even during one trading day. But long-term stock investors trust that their stock will rise in value over time. And given enough time, stocks usually do rise.
Rising in value isn’t a given, though. Companies can lose value or go out of business. When that happens, their investors may lose part or all of their investment. That’s why it’s so important to spread your money out… diversify… not put all your eggs in one basket.
One way to diversify your risk is to buy a managed mutual fund. A mutual fund is a group of stocks that are actively managed. Investors in mutual funds share in the profits and losses of each company represented within the mutual fund. To pay their fund managers’ hefty salaries, they charge fees to mutual fund buyers.
A less expensive way to accomplish the goal of spreading your money and risk among multiple stocks is through index funds. Index funds track a market index. They’re not actively managed like mutual funds are. So their expense ratio is much lower.
One individual stock may be risky on its own. But the stock market as a whole has gained an average annual return of 10% over the past century. The word “average” is the operative word. This is the return for the markets as a whole. Not in any given year (some years are lower than 10%, or even losers). And not for any specific stock.
Benefits of Owning Stocks
You may have heard that the best way to grow wealth is to start a business. To own a company. Well, if you’re not entrepreneurial, don’t yet have the assets to build your own business, or want to spread your risk, you can get paid to help grow other companies.
Here are some benefits to owning stocks.
Stock Ownership Benefit #1: Dividends
As a stockholder of a company that pays dividends, you receive a portion of the company’s profits, either quarterly or annually. Some companies like to keep their investors loyal by rewarding them with these dividends.
The company decides the amount of dividends to be paid. They can, however, keep all earnings and profits to cover their business needs – whether because they’re struggling or because they need it for business expansion. Those who invest in dividend stocks like to see a long track record of increasing dividends.
Ownership Benefit #2: Growth of Your Money
Stocks are a great tool to grow your money and save for long-term financial goals like retirement and education.
Selling an asset such as a stock (or real estate, for that matter) for more than the purchase price produces a capital gain, which may be taxable.
As already noted, over the long haul, stocks have been very good for investors – giving a 10% per year return overall during the last 100 years. That’s a better return than most other investment options.
Ownership Benefit #3: Right to Vote
One of the less-recognized rights of stock ownership is that you’re entitled to vote for a change of leadership if the company is mismanaged. The company holds annual meetings to report on their performance. They also reveal plans for future operations and expansion, and communicate management decisions.
If stockholders disagree with the company’s plans or team, they can vote them out. In the real world though, your right to vote won’t count for that much unless you’re a majority owner.
Take Apple, for example. In 2020, they had 17.5 billion shares of stock outstanding. If you own 100, 200, or 500 shares, your voice will go unnoticed.
Ownership Benefit #4: Limited Liability
When you own shares in a company, your personal liability is limited. You’re not personally responsible for company losses.
Risks of Owning Stocks
Along with the benefits of owning stocks come some risks. Consider these carefully.
Stock Ownership Risk #1: Loss of Capital
There’s no guarantee the stock you bought will rise in value. It could go down. We saw this during the COVID market bloodbath in February 2020. Your stock could also decrease in value due to a company underperforming their competition. Or any number of other things.
Ownership Risk #2: Irrelevant Voting Power
As a practical matter, you probably won’t own enough shares to have a majority, so you won’t be able to impact company leadership or operations with your vote. The majority shareholder usually gets to do that.
Ownership Risk #3: Last in Line in a Liquidation
As a shareholder, you have a theoretical claim on company assets. However, the only time that matters is in the case of a company liquidation… if the company goes out of business. In that situation, all the company’s assets and liabilities are counted. Once creditors are paid off, shareholders can claim the rest.
But usually when a company liquidates, it’s because they have little choice. So the chances of having assets left for equity holders after creditors get paid are slim to none.
That’s why stocks are considered riskier than bonds. Creditors (i.e., bond holders) always get paid first. If no assets remain after that, the shareholder gets an empty bag.
Stocks Start with an Initial Public Offering
When a private company decides to sell shares of stock to the public for the first time, they have an Initial Public Offering, or IPO. They issue a certain number of stocks and set an IPO price.
The funds raised in the IPO go straight to the company. Once the IPO is complete, those stock shares are traded on the secondary market – in other words, the stock market. Once there, stock prices rise and fall in the same way as any other stock.
Types of Stocks
One way to diversify your risk is to buy different types of stocks. They could be in different industry sectors – financials, consumer goods, healthcare, tech, etc.
Or they could be different based on their potential and value.[ii]
Growth stocks are stocks that are expected to grow rapidly. They usually don’t pay dividends. Heck, sometimes they don’t even show a profit yet. But investors have high hopes for them. Growth stocks are usually young companies with high perceived growth potential.
Value stocks generally pay dividends. The underlying stock price is not expected to rise much. What’s more, value stocks are large companies that may be seen as stodgy and unexciting. They’re ignored or out of favor. However, if they’re making enough profit to pay a dividend, and are committed to ongoing dividends, they may be worthy of your investment dollars.
Blue-chip stocks are large, reliable companies in stable industries that have fared well throughout many years. They’re usually considered safer than value stocks and certainly safer than growth stocks.
Income stocks are stocks that pay dividends (i.e., income). They can be either value stocks or blue-chip stocks.
Invest in stocks as if you’re investing in a company… because you are. You can make money based on stock price increases over your purchase price, through dividends, or both. Be very cautious about putting all your eggs in one basket. But don’t shrink from long term investing in the stock market out of fear. If you have enough time to ride a few waves, you should be fine.
[i] https://www.investor.gov/introduction-investing/investing-basics/investment-products/stocks Accessed on January 27, 2021
[ii] https://www.investor.gov/introduction-investing/investing-basics/investment-products/stocks Accessed on January 27, 2021