What are stocks and how do they work?
A stock represents a piece of ownership in a corporation. Stocks are also known as equities, which signifies that anyone who owns them has a stake in the company’s performance.
The stock market’s movements are always in the headlines, which can scare some people away from investing in stocks. According to a 2022 Bankrate survey, 26 percent of Americans believe stocks are the best long-term investment, while 17 percent prefer cash. While cash investments are less volatile than stocks, cash is nearly certain to lose value over time as inflation erodes its value.
People buy stocks to earn a return on their investment, which allows them to grow their wealth and achieve financial goals like retirement. Here’s what else you need to know.
What does it mean to own a stock?
Owning a stock is a little different than if you owned 100 percent of a private business. Owning a share of stock gives you a partial ownership stake in the underlying business. Stock prices are quoted throughout the trading day, which means the company’s market value and your stake frequently changes. If you owned a business by yourself or with a small number of partners, you wouldn’t get a quote on the business every day or maybe not even each year.
Another big difference between owning a stock and owning your own business is decision-making control at the company.
When you own a stock, the company’s management team and all its employees work on behalf of shareholders to build value. The company’s board of directors are there to represent the shareholders’ interests and can make changes to management it deems necessary. You’d be much more involved in the day-to-day decision making of a company you owned on your own or with partners.
While these differences exist, it can be helpful to remember that stocks still represent a stake in an actual business. Sometimes people are captivated by the changing prices on a screen and think they need to be buying and selling stocks frequently, but they’d never behave that way if they owned the entire business.
How stocks work
When a corporation is looking to grow, it needs money to help pay for expenses such as designing new products, hiring more people and expanding into new markets. They issue new shares of stock to help raise that capital. Anyone who buys those stocks is poised to profit if that growth becomes a reality.
How do you make money from stocks?
There are generally two ways:
- Price appreciation. A company’s stock price will typically rise as the earnings and future prospects of the company’s business improve. Over the long-term, earnings growth is a major driver of stock prices so it’s important to identify companies whose businesses are likely to do well.
- Dividends. Some companies also pay dividends, which are a way for them to share a portion of their profits with shareholders. These regular payments are typically made quarterly and can account for a large portion of investors’ returns over time. If a company pays an 18 cent dividend each quarter and you own 10 shares, you’ll receive $1.80 with each payment. Though rare, there can also be stock dividends, which reward shareholders with additional shares.
It’s important to note that dividends are not guaranteed. Companies can slash their dividends. Not all companies pay them, either. Younger, rapidly expanding companies often don’t pay dividends. Instead, they reinvest all profits back into the company with the hopes of growing further and generating more profits that will ultimately lead to a higher stock price.
What are the downsides of stocks?
While stocks offer the potential for growing your money, the appeal of those returns comes with some sizable risks. If the company falls on hard times, posts losses or misses their earnings expectations, the stock price could drop. Wherever the stock goes, your money follows.
There’s a chance you could lose all your money, too. For example, if a business that you invested in closes its doors, your investment is likely gone for good. Stock investors are last in line when it comes to claims on the assets. Employees, vendors and bondholders are all in line to get paid before the stockholders.
How can you invest in stocks?
The stock market is accessible to everyone, and there are two ways to own stocks.
Direct ownership
You can buy stock in individual companies through a brokerage account. As competition has increased in recent years, most online brokerages no longer charge commission fees. So, rather than paying to invest, you’ll be able to put all of your money into your investment. Some companies such as Walmart, Coca-Cola and Home Depot also offer direct investment plans, which allow you to buy shares from them — bypassing the need to open a brokerage account altogether.
While direct investing can put you in the driver’s seat, it also creates a massive workload. Studies have shown that building a properly diversified portfolio of individual stocks requires holding approximately 30 different stocks. (Diversification refers to owning a range of assets vs. holding just one or a small few. This reduces the overall risk in your portfolio.) That’s 30 different companies to monitor, tracking how their business is performing and whether they are on a positive trajectory — a tall order that requires a great deal of time and expertise.
Indirect ownership
Indirect investing is a much easier approach and is a great way for beginners to buy stocks. Rather than reading annual reports, comparing performance data and hand-picking stocks, you can own stocks through a mutual fund or an exchange-traded fund (ETF). These funds invest in hundreds — sometimes even thousands — of stocks. Instead of tying your fortunes to a single company, you can benefit from exposure to a wide range of companies. Think of this as instant diversification from the first dollar you invest.
Do you have to buy one full share?
It’s important to note that owning stocks doesn’t mean you need a mountain of money. Fractional share investing is available via many brokerages, and it allows you to invest a small amount — as little as $5 — in a company. An indirect investment will also spread that money into smaller fractions across companies. For example, buying one share of a fund might make you an investor in Amazon, Alphabet and a number of other high-profile companies.
Bonds vs. stocks: What’s the difference?
In addition to buying stocks, many investors include bonds in their portfolios. To raise capital, corporations can also issue bonds, but buying one does not make you an owner. Instead, you are making a loan to the company, and the bond comes with a maturity date.
The best-case scenario of owning a bond is that you get your money back on that date with some additional interest paid out along the way.
Bonds have a higher priority of repayment in the event of a company’s liquidation, which means they are safer than stocks – though you can still lose some or all of your money. It’s also worth noting that bond prices and interest rates generally move inversely to one another. So as interest rates rise, bond prices typically fall.
Bottom line
Stocks have a great track record of providing shareholders steady returns over time. But past performance doesn’t predict future results, so it’s essential to understand the risks before you start investing. Index funds and ETFs are two ways of purchasing multiple stocks in a single purchase, helping provide instant diversification and reducing risk.
Note: Bankrate’s Brian Baker also contributed to an update of this story.
