what are stocks and how does it work
Investing | Investing 101

What Are Stocks (and How Does It Work)?

If terms like “dividends,” “bull market,” and “IPO” confuse you, you aren’t alone. Many people view the stock market as a complex, intricate concept that they believe they could never understand, let alone participate in. 

However, understanding what a stock is and how it works is an easy way to introduce yourself to the stock market as a whole. You may even find that stocks are less complicated than you think and that purchasing some could be well worth the investment. 

Read ahead to learn the basics of what a stock is, the different types of stocks, and how you can make money from investing in them. 

What exactly is a stock?

A stock is a small portion of ownership of a company or corporation. When you purchase a company’s stock, you actually own a fraction of the company, which entitles you to an equivalent portion of its profit. You may have also heard stocks called shares, since stock owners become shareholders in the company. 

Most investors own common stock, the most basic form of shares. Owning a common stock means you have voting rights in the company, and you may be able to receive dividends, or payments from the company correlating to your portion of ownership. 

Stocks are investments, meaning they will not guarantee profits to the shareholder. When you purchase a share, you do so with the hope that its price will increase, allowing you to sell it down the road for more than you paid for it. Stocks fluctuate in price often, and there’s always a chance that you will decide to sell your share before it becomes profitable—or at a loss. 

Further, compared to other sources of income, stocks are slow-going. You may need to hold on to your shares for years, or even decades, to make a significant profit when you sell. 

But though they do not have a quick turn-around, holding on to several stocks could provide you with a decent chunk of change if you sell them at the right time. 

How does a stock function?

Stocks go through a bit of a journey before you purchase them. 

First, let’s talk about why companies sell stocks in the first place. Most companies decide to sell stocks to raise money for their businesses. When shareholders purchase stocks, they contribute a small amount of funding to the company, allowing it to buy supplies, expand its operations, hire new employees, or pay off debt. 

Most businesses do not release stock shares into the public market until they have established a small customer base and have already become profitable. They want to develop a trustworthy reputation before asking investors to purchase shares; otherwise, they risk having no investors taking the bait. 

When a company decides to issue shares into the public market, it first releases an initial public offering, or IPO. Investors purchase IPOs directly from the company and then sell and trade them to other investors. 

IPOs often create a lot of hype and excitement because many investors assume they will lead to steep profits—like Apple and Uber did when they first hit the market. However, IPOs come with a higher risk than common stocks because some increase in value quickly while others plummet. 

When you purchase any stock other than an IPO, you are buying it from another investor rather than from the company itself. Similarly, when you decide to sell your share, you will sell it to another investor—not back to the company. 

The buying, selling, and trading of stocks occur through a stock exchange. The two largest stock exchanges in the United States are the New York Stock Exchange and the NASDAQ. To get involved in these exchanges, you will need to hire a stockbroker to represent you. 

What happens when you buy a stock?

When you buy a stock share or shares, your money goes to the investor from whom you purchased the share. You now own a fraction of the company, and you have a few options of what to do next. 

First, you can track the value of each share and begin considering the right time to sell. Trying to buy low and sell high take place during “trading,” and this approach can produce quick profits if your stock begins to increase in value immediately. 

However, trading also comes with significant risk, as your share may not increase in value as quickly as you would like. Frequent trading can also be costly because you will likely incur broker fees on each trade. 

Next—and usually the smarter option— you can hold on to your stock and forget about it. Sure, you’ll want to occasionally check its value and watch the stock market trends on the whole, but you should accept that you’ll gain the most profit if you hold on to your stock for several years. 

Holding on to your stock is also beneficial in terms of taxes. If you sell a stock after owning it for less than a year, you’ll have to pay taxes on any profits you make at the same rate as your income. Shares that you hold for longer than a year will qualify for a lower tax rate. 

And the third option is for you to buy more stocks. If your share seems to be on a downward trend with no upswing in sight, the smartest move may be to sell it, accept your losses, and invest somewhere else. 

Whatever you decide to do with your shares, make sure you pay attention to news and stock trends that could affect its value.    

What are the types of stocks?

When a company sells stocks to the public, those shares typically fall into two categories: common stock and preferred stock. 

Common stock is the most popular type of stock and is an excellent choice for beginners. Common stock owners have voting rights in the company, own a share of the company’s profits, and may earn dividends. However, dividends on common stock are often variable, so shareholders may earn different amounts depending on the company’s success. 

Common stock is best for investors looking to hold on to their shares for a while, as these stocks are more likely to produce long-term gains. They tend to experience high volatility, meaning their prices increase and decrease frequently. 

Preferred stock offers fixed dividends in higher amounts, so preferred stock owners can count on predetermined profits from their shares. They also receive paid dividends before common shareholders do. However, these stocks tend to be less volatile than common ones. While they probably won’t drop in price too drastically, they also will not increase as quickly as common stock. 

Preferred stock owners also do not have voting rights within the company, which may not matter if they are only casual investors. All in all, preferred stock is best for investors looking to make income from their share. 

Aside from preferred and common stock, you can also find several other categories of shares within the stock market. 

Some companies categorize stocks in terms of market capitalization, or the company’s value. Large-cap companies have a market value of at least $10 billion, mid-cap are between $2 billion and $10 billion, and small-cap fall between $300 million and $2 billion. You can calculate market capitalization by multiplying the stock’s price by the company’s total number of shares.

The market also divides stocks into groups by company location and industry. You can purchase shares from U.S.-based businesses as well as companies within the international market. You can also buy stocks from specific sectors, such as technology, energy, or financials. 

Another common stock category is style. The market divides stocks in terms of their projected movement—growth stocks are those growing quickly, while value stocks are underpriced compared to market valuation. 

These categories only break the surface of the many types of stocks on the market. As you dive into the world of stocks, you will begin to learn the distinctions between each class and determine the best category for your financial situation. To start, we recommend purchasing common stock. 

How do I make money in stocks?

You can earn money from stocks in two primary ways:

  1. Selling the stock for a steeper price than what you paid for it
  2. Collecting dividends, or your portion of the company’s profits 

Most investors plan to sell their shares for a profit, which means they want to purchase during a low-price period. Before you buy a stock, keep an eye on market trends and see what direction your targeted share seems to be heading. If its price is actively falling, you may expect it not to increase after you purchase. 

If a stock’s price is on the rise, examine trends to determine if it is experiencing a one-time spike or long-term growth. Look at stock charts from the last five years to see how current trends fit into the company’s history. 

After you purchase, it’s probably best to hold on to your share as long as you feel comfortable. You will begin earning compound interest on long-term holdings, increasing your profits over time. 

You will also make more money by purchasing stocks across several categories, effectively diversifying your portfolio. If investments in one market sector plummet, you can still count on other types to keep you afloat. 

Finally, a reliable way to make money from stocks is to hire a professional to help you make the most informed decisions. If you are new to the idea of stocks and shares, you may not feel confident about the best times to buy and trade. Financial advisors can provide you with personalized guidance to help you make the most money. 

Though your plunge into the stock market may require some trial and error, many investors make sizable profits through their investments each year. With enough experience and informed decision making, you could build wealth the same way.  

FAQs

What is the difference between a stock and a bond? 

We have already discussed how stocks give you partial ownership of a company. Bonds, on the other hand, are loans from a company that generate profit through fixed interest. Bonds are less volatile than stocks. They generally produce lower returns, but they also come with lower risk. 

Do I need a stockbroker to begin buying stocks? 

Some companies require you to purchase through a stockbroker, while others offer direct buying programs. If you’re new to the stock world, you’ll likely benefit from hiring a broker to purchase shares on your behalf. One of the easiest ways to buy through a broker is to set up an online brokerage account. 

What do the terms “bullish” and “bearish” mean in the stock market? 

Investors use the terms “bullish” and “bearish” to describe market trends and other investors’ opinions. “Bullish” means that share prices are rising or that an investor believes a stock will increase. “Bearish” implies the opposite— that stock prices are falling or an investor predicts them to decrease. 

How much do stocks cost? 

Stocks range in price from about one cent to thousands of dollars each. Once a share hits the market, its price will increase or decrease depending on supply and demand. If a stock is in high demand, its price will increase to adjust to the demand of the number of investors looking to purchase it. 

How much profit can you expect to make from a stock? 

If you look at long-term stock trends, you’ll notice that the market tends to produce 7% to 10% annual returns over several decades. In the short term, returns tend to fluctuate widely. Holding on to your stock may eventually result in the most profits, which is why many investors sit tight with their shares for several years. 

Final thoughts

The stock market as a whole and stocks individually are not as complicated as many people make them out to be. Realizing that stocks are just small portions of ownership in a company simplifies tremendously the concept of buying and trading and helps those new to the stock world feel more comfortable diving in. 

One of the best ways to learn more about stocks is to purchase one or more shares for yourself. Find a broker, buy a share in a low price range, and watch how its value fluctuates over time. You’ll be trading in the New York Stock Exchange in no time.