What Is A Stock?

On Stocks

A stock is a unit of partial ownership of a company.

In other words, if you buy the stock of a company, then you are an owner, at least in part, of the company that issued it.

Stocks are also sometimes referred to as securities, because you are securing partial ownership in a company.

They can also be referred to as equities as you are buying ownership, in other words equity, in a firm.

You may even see the term shares used because you are, in fact, sharing the ownership with others.

Why Sell Shares?

Companies sell shares for a variety of reasons, including to raise money to create new or improve existing products, hire new employees, or build new offices or factories.

The advantages of issuing stock for a company is that the firm can raise cash without going into debt and there is lower risk than when taking out a loan.

Ownership

On a basic level, the amount of your ownership of the company depends on the number of shares that you own when compared to the total number of shares the company issued.

For example, if a company issued 100 shares of stock, and you own 1 share, then you own 1% of the company.

Likewise, if the company issued 100 shares of stock and you own 10 shares, then you own 10% of the company.

Price Of Stocks

As there is no fixed price for a stock and so the term market price is also sometime used.

The price of a share is based on supply and demand.

In other words, a stock goes up or down based on how many people are buying or selling shares.

The more people who buy, the share price goes up. Likewise, if more people sell, then the share price goes down.

Stocks where the price rises and falls more than other stocks are usually said to be more volatile.

Their share price moves more violently than other stocks.

Why Buy Stocks?

In general, the prices of goods in stores and services by companies rise overtime. This is known as inflation.

Keeping money in a savings account is ineffective.

In a savings account, money earns only a small amount of interest and will ultimately lose value over time because it is not able to keep up with inflation.

However, shares rise over time, giving investors an opportunity not only to outpace inflation but to grow their money.

This is one important advantage that stocks have over savings accounts.

When held for the long term, stocks have outperformed cash and bonds, even after taking into consideration world-changing events such as world wars and depressions.

Rather that starting your own company, which may require you to invest a large amount of your own money in a single business, buying shares gives you the advantage of investing in many of the best-run companies there are and spreading out your risk.

Risk

Now, buying stocks is certainly not risk-free. Here are some of the potential risks you may face.

Volatility

In the short term, there is volatility as the price of a stock is always in fluctuation. However, some stocks are more volatile than others.

Some hyper-growth technology stocks and small biopharmaceutical stocks can take an investor on a stomach-churning roller coaster ride, at times even gaining or losing more than half their value in a single day on surprising news.

Still, that being said, volatility isn’t a real risk unless as long as the investor has the stomach and patience to ride it out.

The greatest risk is that the investor panics and sells their shares during a temporary drop in the stock price.

Dividends

A company may also decide to stop handing out a portion of their profits to shareholders as dividends.

This may cause many dividend investors to sell their shares causing the price of the stock to also decrease.

If a company starts to experience financial difficulties then the dividend may be cut or eliminated entirely.

A stock can also drop in price to the point where a shareholder loses most, or even all of their money, and the stock never rises to such heights again. This is often referred to as a permanent loss of capital.

Leverage

Buying stocks on margin, or by using leverage, both of which refer to the practice of borrowing money to purchase shares, is very dangerous.

If the stock price suddenly drops, you could even lose more money than you invested (!!), putting you in debt to the brokerage that loaned you the money.

This above reasons are why it is important to never put all of your money into a single stock and instead purchase the stock of 10 to 15 companies in different sectors (industrial, technology, etc.) to help lower the overall risk and for most investors, avoid using margin altogether.

Return

Now despite the previous mentioned risks of owning shares, the advantages outweigh the disadvantages.

Although the price of a stock could indeed fall to zero, there is no upper limit to how high the price of a stock can climb.

Capital Gains

Many shares are bought with the hopes of selling them later at higher price, this is what is known as a capital gain.

Generally speaking, shares held for more than one year are taxed at a much lower rate than those held for less than one year.

This is why it is better to hold stocks for longer periods rather than shorter periods of time.

Dividends

A few stocks return profits to shareholders in the form of dividends.

These are payments, often paid quarterly to shareholders, although sometimes they are paid annually, or even occasionally as a special dividend.

Dividend stocks are especially popular with people needing income, like retirees.

However, dividends also have the disadvantage of being taxed as regular income, which is a higher rate than capital gains.

Rights Of A Stockholder

As the owner of a company’s stocks, you also have some basic rights, which vary a bit depending on the type of stock purchased.

For common stock, you have the right to share in the profits of the company, vote for proposals by directors or other shareholders on how the company should be managed, and even vote for or against the candidates that have been nominated to the company’s board of directors.

Types Of Stock

There are three different kinds of shares, namely common, preferred, and unlisted, although most shareholders purchase common shares.

It is important to be aware of the differences and carefully considered the pros and cons of each before purchasing a company’s stock on one of the exchanges.

Common Shares

Common shares, also known as ordinary shares, give the shareholder partial right to earnings growth, profits in the form of dividends, and voting rights. This is the most common form stock held by retail investors.

Unfortunately, when are the downsides of common stock is that if the company goes bankrupt or is liquidated, then the common stock shareholders are some of the last to be paid.

Types of Common Stock

Also, there are even different forms of common stock, as some companies issue Class A and Class B shares.

Generally, Class A shares may have voting rights while class B shares might not.

These differentiators may also represent a different amount of stock in the company. For example, a Class B share may represent just 1/5 of the ownership of the Class A share.

There are reasons for different shares of common stock.

For example, when a private company decides to go public, It will often give it’s founders, executives, and other early investors, stock which has voting rights that has more voting rights, often ten times that of the other holders of common stock.

However, some companies may even go so far as the try and disguise that disadvantage by instead giving their Class B shares voting rights while not giving their Class A any voting rights.

Confusing, I know… The companies intentionally intended it to be that way.

This is why it is important to carefully check the company’s bylaws and charter where a detailed description of the different classes stock can be found.

Preferred Shares

Preferred shares are different than common shares in that they do not have voting rights.

The owners of preferred shares receive their dividends before common shareholders and they also have priority if the company is liquidated or goes bankrupt.

Similar to bondholders, preferred share owners are able to receive fixed dividend payments.

In that way, preferred stock is often used as a form of debt by a company. Depending on how the stock was issued, preferred shares may also be convertible to common shares at a later date.

Generally speaking, there is less risk for preferred shareholders than for common stockholders, but based on past performance, greater returns are usually experienced by common stockholders.

Unlisted Shares

Unlisted shares, may be common or preferred, but they are not listed on any major stock exchange.

These kinds of shares are often issued by smaller companies in the U.S. or even by foreign companies which are unable, or perhaps just choose not to meet, the listing requirements of the official exchanges.

Unlisted shares are instead purchased directly from the company or on a unofficial exchange, such as the over-the-counter (OTC) market.

Official exchanges, such as the New York Stock Exchange or NASDAQ, have strict listing requirements which often include a minimum number of shares outstanding, a lower limit for the company’s stock price, a minimum company size as determined either by annual income or market capitalization, etc.

There is also a large listing fee with the official exchanges.

Unlisted shares usually traded directly by brokers or dealers by phone or over computer networks and they tend to have larger bid-ask spreads because they trade less frequently.

How To Buy Stocks?

Stocks trade on exchanges such as the New York Stock Exchange (NYSE) and NASDAQ or even on a unofficial exchange like the over-the-counter market.

Stocks can be purchased through a broker or at times even directly from the company itself.

In the past, paper stock certificates would’ve been issued, but nowadays, due to advances in technology, most shares are issued electronically.

Key Takeaways

Although not without risk, stocks are a great way to outpace inflation and grow your income.

Know what you are buying. Carefully check a company’s bylaws and charter before purchasing so you know exactly what you are purchasing in order not to make a mistake.

Stocks generally rise over time and there are also clear tax advantages to holding for the long term.

What Is A Stock?
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