Takeaways
- A stock is a security that gives the holder ownership in the issuing company.
- Stocks are predominately bought and sold on stock exchanges.
- Companies issue stock to raise money to operate their businesses.
- The two main types of stock are common stock and preferred stock.
- Stocks have traditionally outperformed many other types of investments.
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What Are Stocks?
A stock is a financial security that represents a piece of ownership in a company. Stocks, also called equity, are issued by a company to investors who want to invest in it. The issuing company sells shares in exchange for cash.
Depending on the type of stock, it represents a vote on specific company matters and entitles the shareholder to a portion of the company’s profits. Investors who purchase stock are called shareholders.
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How Do Stocks Work?
Public companies sell their stock to investors on public stock exchanges, such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automatic Quotation System (NASDAQ). Public equity investing has become the cornerstone of many investors’ portfolios.
Investors can purchase shares, or stock, through online stock brokerage accounts. These platforms offer research capabilities, allowing investors to compare potential investments. You can purchase stock to gain exposure to specific industries, geographic regions, sizes of companies, or dividend-paying companies.
Companies issue shares to investors for various reasons, including raising capital to invest in new projects, paying off corporate debt, expanding into new geographies, launching new products, or acquiring other companies.
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When you purchase stock, you hope the price goes up in the future. This capital appreciation allows investors to sell shares to other investors and realize a gain on their investment. For tax purposes, depending on how long you hold the stock, you can consider the gain on these sales as short-term or long-term capital gains.
For investors saving for retirement, your 401(k)-retirement account is probably investing in stocks. Most employer-sponsored 401(k) plans offer an à la carte menu of investment vehicles that invest in stocks. These include mutual funds, exchange-traded funds (ETFs), and target-date funds, which are investments that pool money together to invest for a specific purpose or investment thesis.
Learn More -> What is a Roth IRA?
Types of Stock
The two main types of shares issued by companies are preferred shares and common shares. Companies issue these types of shares for different purposes. Investors in preferred and common shares have distinct rights. Here is the difference between preferred and common shares.
- Preferred Shares: Typically, preferred shares do not have voting rights for publicly traded companies, but they do have a right to dividend distributions. Cumulative preferred shares have a claim on any unpaid distributions of the company before other equity shareholders, such as common shareholders. Preferred shareholders also sit higher in the capital stack if the company goes bankrupt.
- Common Shares: Have voting rights and the right to receive dividend payments. These are the most common shares issued by public companies and can be easily bought and sold on public stock exchanges.
How Can You Buy Stocks?
Stocks are often bought and sold on stock exchanges like the NYSE or NASDAQ. When a private company decides to go public, it has an initial public offering (IPO), where investors can purchase shares of the stock for the first time on an exchange. After a company’s IPO, it can issue more stock to raise capital. Investors can purchase shares through their online brokerage account or a stockbroker.
Try This -> Deep Dive: How to Buy Stocks?
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How Do You Earn Money from Stocks?
Not all investments are created equally. Stocks represent a terrific way for those new to investing to get started making money. Investors make money from stocks in two main ways.
- Capital Appreciation: Capital appreciation is the difference between what you buy stock for and what you sell it for. Investors make money when the stock price increases and lose money when it decreases.
For example, if you buy stock ABC for $100 per share and it appreciates to $150 per share in six months, you will make $50 in profit if you sell the share. Conversely, if the price decreases to $50, you will lose $50.
Learn More -> What Is Dollar-Cost Averaging?
- Dividends: Well-established and mature companies that generate significant cash flow will reward shareholders by paying them dividends. Dividends are payments made by a company to its shareholders from profits it doesn’t want to reinvest in the business. If you are investing for retirement, dividend-paying stocks can be attractive to generate passive income.
For example, if you buy ABC stock for $100 per share and it declares a $10 per share dividend, you will receive a $10 payment in your online brokerage account. If the stock also appreciates up to $150 per share in six months, you will make $50 in capital appreciation and $10 in dividend income.
Related -> What is a Dividend Reinvestment Plan (DRIP)?
Smart Summary
Investing in stocks is an excellent way to increase your net worth and put your money to work. Investing in dividend-paying stocks can give you a passive income stream, and investing in stocks that you believe will go up in value can earn you money from capital appreciation.
Before investing in individual stocks, you should always research the stock before purchasing and ensure you understand the risks associated with that stock. If you don’t want to invest in individual stocks, you can diversify your investment by investing in mutual funds or ETFs.
