What are stocks?
September 8, 2022 8 min read
Figuring out how stocks work can feel intimidating—especially if you’re new to investing. Between all the new vocabulary (what are dividends, anyway?) and the different kinds of stocks, it can be hard to know where to start.
Find out what stocks are, how they work and some different kinds of stocks to know about. Plus, getting to know the potential benefits and risks of investing in stock can help you make informed decisions about how to invest your money.
- Stocks are a kind of investment that gives people shares of ownership in a company.
- The two main types of stocks are common stocks and preferred stocks.
- Before making any kind of investment, it’s important to do the research and know about the potential benefits and risks. Talking to a qualified expert might help too.
What are stocks?
Stocks are a type of investment that gives people a share of ownership in a company. They’re also referred to as “equities.”
When starting to learn about stocks, there are a lot of new words and phrases. Here are a few to know about:
- Capital appreciation and depreciation: When the current market value of a stock is higher than the price paid for the stock, that’s capital appreciation. Basically, it’s the positive difference between what was paid for a stock and its current price. And if the current market value of a stock is lower than the price paid, that’s capital depreciation.
- Capital gain or loss: When an investment (like stock) is sold for more than what was paid for it, that profit is called capital gain. When an investment is sold for less than what was paid, that’s capital loss.
- Dividend: The money that a company pays to its shareholders. While companies can pay dividends at any time, dividends are often issued according to a schedule.
- Mutual fund: A mutual fund is a company that pools money from many different investors, then invests that money in different investments, including stocks. So instead of buying shares in individual companies’ stock, someone can choose to buy shares of a mutual fund.
- Return: The gain or loss on an investment.
- Security: This refers to different investment products, including stocks and bonds.
- Share: A share is a unit of ownership of stock. An investor might buy a single share of stock, multiple shares or even a fraction of a share.
- Shareholder: Someone who owns at least one share of a company’s stock.
- Stock exchange: A central hub where investors can buy and sell stock is called a stock exchange. It can be a physical location or an electronic hub. Two stock exchanges you might’ve heard of are the New York Stock Exchange and the Nasdaq.
- Voting rights: People who own some kinds of stock in a company might have the right to vote on certain aspects of that company’s policies, like choosing the board of directors.
These are just some introductory terms to understand when learning about stocks. It might feel like a lot of financial jargon, but knowing the vocabulary can help you make educated decisions about investing in stock.
What are the different types of stocks?
There are two main types of stock: common stock and preferred stock. Stocks are also sometimes categorized by the size of the company and referred to as large-cap, mid-cap and small-cap stocks.
Any of these types of stocks might also fall into other categories, like growth stock, value stock, income stock and blue-chip stock.
Here’s a breakdown of how these different types of stocks work.
Like the name suggests, common stock is the type of stock that people buy most often. And it might be what first comes to mind when you think about stocks.
Investing in common stock gives the shareholder an ownership stake in the company. It also typically gives a person voting rights at shareholder meetings. Plus, shareholders may be entitled to dividends if the company they invested in is profitable.
Common stock’s value generally comes from how much the stock’s share price grows over time rather than from dividends.
Preferred stock works a little differently than common stock.
For one, preferred stock is issued at “par value.” Par value is the set value of the stock that’s established in a company’s corporate charter. Par value doesn’t change over time with the market like the price of common stocks does.
Par value is the price that a shareholder can redeem preferred stock for by its “call date” or “maturity date.” This is the predetermined date to redeem preferred stock. Dividends are paid to preferred stockholders on a regular schedule based on a percentage of the stock’s par value.
Preferred stockholders take priority over common stockholders for receiving dividends. Another difference is that when investing in preferred stock, investors typically don’t have voting rights.
Preferred stocks might not have as much growth potential as common stocks, so the value comes more from the dividends instead of long-term capital appreciation. But preferred stocks tend to be lower risk than common stocks.
Stocks with earnings that are growing faster than the average market rate qualify as growth stocks.
People might buy growth stocks with the hopes of having high returns from capital appreciation. Investing in high-growth companies can be rewarding, but just like any investment, it comes with risks. For example, growth stocks might be overvalued or the company’s growth might slow down.
It might help to think of value stocks as the opposite of growth stocks. A value stock might be trading at a low cost but still paying out higher dividends. Or the company might have fallen out of favor with investors so the stock price is low, but the earnings or sales of the company are still performing well.
Investors might look to buy value stocks at a low cost with the hope that the price will rise in the future and they’ll have large capital gains.
Income stock—also called dividend stock—are sold by publicly traded companies that regularly pay dividends to investors. Typically, income stock is consistently profitable and low risk. Buying shares of a long-established utility company is one example of investing in income stock.
Blue chip stock
Blue chip stocks are shares in big companies that are well established and have a long history of growth and profitability.
How do stocks work?
Now you know more about the different kinds of stocks. But why do companies issue stocks in the first place?
Companies sell stock to raise money to operate their business. So if a company wants to expand into new markets, create new products, build new facilities or even pay off debt, it might issue stock to help pay for the expenses.
So how do investors make money from stocks? That comes down to capital appreciation and dividends. For a reminder of what those terms mean, revisit the definitions above.
How to buy stocks
There are a number of ways investors might buy—or sell—stocks, according to Investor.gov. Stock might be purchased through a broker, a direct stock plan, a dividend reinvestment plan or stock funds. You can learn more from the Securities and Exchange Commission.
Benefits of investing in stocks
Investing in stocks can have some great potential benefits if managed properly:
- Dividends: Depending on the kind of stock and its market performance, stock dividends can supplement someone’s income.
- Long-term gains: Investing in stocks can give a greater long-term return on investment compared to things like savings accounts. And while there’s no guarantee, stocks have historically given investors annual returns of about 10% per year over the long term.
- Liquidity: Liquidity describes how easy it is to convert a financial asset into cash. Generally, someone can sell their stocks anytime they want to. But depending on the market, they might have to take a loss if they need to sell right away. It might also take some time for the money from a stock sale to show up in an account.
Risks of investing in stocks
Like any investment, stocks can come with risks:
- Market volatility: Stock prices rise and fall over time. Someone might have to sell their stocks for a loss. Or a stock’s price might even go down to zero. So investors run the risk of losing some or all of their investment.
- Higher risk: Investors can’t know for sure that the company they bought stock in will be successful. While they can do their research and make an informed decision, there are many things that can affect a stock’s price. That can include internal things like the company’s management decisions or external factors like natural disasters.
- Uninsured: If someone is thinking of stocks as a way to save for the future, they should know that stocks aren’t federally insured like some savings options are. For example, things like certificates of deposit and individual retirement accounts are insured by the Federal Deposit Insurance Corporation, while stocks are not.
There’s no way to make investing completely risk free. But there are some things investors can do to try to manage the risk.
For example, they might consider investing in different types of things, like a mix of stocks, bonds, real estate and more. They might want to think about diversifying their stock investments, too. That way, their money isn’t tied up in a single company or type of company.
Stocks in a nutshell
It’s important to know how stocks work and the potential benefits and risks of investing in stocks before making any financial decisions. Talking to a financial expert could also be helpful.
Stocks are just one way to invest, and there’s a lot more to know about how to manage your money. And if you’re thinking about how to start saving for retirement, there are even more options to explore.