- A stock is an investment that represents a unit of ownership in a company.
- There are two ways shareholders can earn returns on their investments: capital gains and dividends.
- Investors can build diversified stock portfolios by investing in ETFs or mutual funds.
What is stock?
A stock is an ownership stake in a company. By investing in a company's stock, your money buys you a slice of that company. Depending on how the company manages its stock, that could mean you're entitled to a share of profits by way of dividends, and/or the stock price could appreciate if the company's valuation grows based on factors like increased revenue, profit, or sometimes simply demand for the company's stock.
Both private and public companies can issue stock, which is often done to raise money to fund operations, invest in new projects, and/or reward existing shareholders such as early employees and investors. Typically, however, stock investing refers to publicly traded companies, which means the stock is open for trading to the general public.
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Let's take a closer look at how stocks work, different stock types, and the potential risks and rewards of investing in stock.
How stocks work
Some of the details of how stocks work can vary depending on factors like whether the company is public or private, where the stock trades, and how the company manages its stock. In general, though, the main points to understand include the following:
Issuance of shares
To create stock, companies first need to divide ownership into shares. Each share of the company's stock represents an ownership stake. For example, if a company issues 100 shares priced at $1 each, then each share would equal a 1% equity stake in the company. Typically, though, each share represents a much smaller fraction of the company's ownership, especially as the company grows.
For private companies, initial shares are usually issued to founders, early investors, and sometimes early employees. In most cases, this private company stock is only open to accredited investors, meaning those who meet certain financial or professional qualifications.
As private companies grow, many eventually go public, which means issuing stock for sale to the general public on a stock exchange like the New York Stock Exchange or Nasdaq, rather than just selling to accredited investors.
A common way to go public is to have an initial public offering (IPO), which involves issuing new shares that investment banks (i.e., underwriters) help sell to other investors, including a pool of shares that gets released on a stock exchange for the general public to buy. Once a company's stock starts trading publicly and after some restrictions like lock-up periods are met, early investors and employees can also typically start trading shares in the public market.
Ownership and rights
Owning stock means owning a slice of a company, and that usually comes with certain rights. For one, shareholders generally have a claim to the company's assets, though others like bondholders might have priority if the company goes bankrupt and sells off assets to pay back creditors and investors.
But assuming all goes well, shareholders have a right to the company's earnings, such as if the company decides to issue dividends that pay out a given amount for each share owned. And if the company is deemed to become more valuable, generally because of growing revenue and profit, then its stock price generally goes up too, so shareholders may be able to sell the stock for more than what they bought it for.
Owning stock can also come with voting rights, such as for electing the board of directors and making decisions on issues like executive pay. However, stock can be divided into different share classes, such as with some stockholders buying shares that do not have voting rights.
Dividends vs. capital gains
There are two primary ways that shareholders can earn returns on their investments: capital gains and dividends.
Capital gains are the profits from when you sell a stock. This happens when you sell it for more than you paid for it.
For example, let's say you bought 100 shares of ABC company at $50 per share for a $5,000 investment. Ten years later, ABC shares are trading at $100. If you sold your shares at that moment, you'd receive $10,000. Aside from possible commissions or fees, you'd profit $5,000 for an annualized return of 7.18%.
As mentioned, stock prices can change based on factors like growing revenue and profit. However, stock prices generally do not exist in a vacuum. Broader economic conditions, market trends, and investor sentiment can also affect stock prices.
A company might have strong financials, for example, but if the economy falls into a recession and investors start panicking, they might sell stock, including in a company that has a good balance sheet. So, fundamentals aside, the stock price might still decrease based on supply and demand, with more sellers than buyers causing the price to drop.
Meanwhile, dividends are usually regular payments to shareholders — often from profits, but not necessarily. Each company can set its own dividend schedule and amount, but quarterly payouts are most common.
Suppose you purchase 50 shares of XYZ stock, which pays a quarterly dividend of $1. In this example, you'd receive $50 per quarter and $200 per year in annual dividend payments from the company. If the company raised its quarterly dividend to $1.10, your quarterly payout would increase to $55 ($50 x $1.10 = $55), and your annual dividend income would grow to $220.
Dividends give investors a means of realizing income without having to sell any of their shares — even during years when the stock price declines. Because of this, dividend-paying stocks are often very attractive to investors who are in or near retirement.
Types of stock
In addition to the difference between private and publicly traded stock, there are also different types of stock, such as in terms of ownership rights and the investment category that the stock can be grouped into. Some examples include:
Common stock
As the name suggests, this is the most common type of stock. These are ordinary shares that represent equity stakes in a company, with the potential for dividends and capital gains.
"If you buy 100 shares of Coca-Cola Company stock, you're most likely buying the common stock," says Robert Johnson, a professor of finance at Creighton University. "Common stock, at most companies, accounts for the vast majority of the shares outstanding."
Holders of common stock also "elect the board of directors and vote on corporate issues" explains Anthony Denier, CEO of the trading platform Webull. "The disadvantage is that in bankruptcy proceedings, common shareholders are last in line for the company's assets."
Preferred stock
Preferred stocks generally offer "stable dividends" and the yields are often "higher than the same company's common stock dividends," says Denier. However, their share prices generally don't appreciate as much as common shares do.
Preferred stock tends to act somewhere between bonds and common stock. Denier adds that if a company is running short on cash, "preferred shareholders receive their dividends before common shareholders."
However, preferred stock usually doesn't come with voting rights.
Class A vs. Class B shares
In some cases, companies may sell separate classes of shares, such as Class A and Class B. The major difference between the two often has to do with voting rights, with the details depending on the specific stock.
For example, Coca-Cola common stock shareholders receive one vote per share, while Class B shareholders receive 20 votes per share. Typically, companies create share classes in this way because they want the voting power to remain with a certain group, such as founders, meaning some share classes might not be for sale to the general public.
Other stock categories and classifications
Let's say you're an average retail investor who only has access to common stock. You can filter your stock search in a variety of ways such as by size, industry, style, or location.
One option is to look at the company's market capitalization — in other words, its size. Some investors may only want to focus on well-established, large-cap companies. Others may want to include small-cap and mid-cap companies which, while often more volatile, could also offer outsized returns.
Companies can also be grouped by industry. Tech, industrials, financials, and consumer staples are just a few industry examples. Investing in stocks from a variety of industries helps to improve your portfolio's diversity.
With style-driven investing, you look for stocks that fit in with a particular investing strategy such as growth, value, or dividend investing.
The growth stocks category usually refers to companies with high revenue and earnings growth potential. So, the stock might trade at a high price-to-earnings ratio now, as investors are projecting significant future growth. Because these stocks are in growth mode, they often do not pay dividends (or very low amounts) because the emphasis is on reinvesting cash back into the company, not paying out dividends to shareholders.
Value stocks generally represent companies that are considered to be trading at an undervalued price based on the fundamentals of the company. For example, a highly profitable bank might not attract investor attention as much as a hot tech startup, so the bank's stock price might trade for lower than what its profit would suggest.
Many value stocks also pay dividends, but dividend stocks are generally considered to be those that pay above-average dividend rates. In many cases, gains from dividend stocks are primarily expected to come from dividends, rather than price appreciation.
Don't get overly caught up by the names, though. A growth stock doesn't necessarily grow in share price faster than a value stock, nor does a value stock necessarily end up correcting to what's considered a fair price by more investors. Instead, these are general categorizations that might fit certain investors' preferred styles and different economic climates.
Another way to classify stocks is by geography. For example, U.S investors may want to broaden their exposure by investing in international stocks, such as a global fund that excludes the U.S., or a regional fund such as one focused on companies based in the Asia-Pacific region.
What are blue-chip stocks?
Large-cap stocks overlap with — but are not exactly the same as — another category of stocks known as blue chips. Large-cap strictly refers to the market capitalization dollar value the company has — usually $10 billion or more. Meanwhile, blue-chip stocks have no official designation but generally are mature, consistent companies that investors feel comfortable with.
That's not to say that blue-chip stocks are risk-free — you should always do your due diligence — but these are often household names that investors feel secure about, like the FAANG group of stocks (Facebook, Amazon, Apple, Netflix, and Nvidia). Many blue-chip stock investors assume that the company will continue to stick around as a successful business for decades to come. Blue-chip stocks often pay dividends and have slow, steady growth, rather than being high risk/high reward.
What is treasury stock?
Treasury stock — also called treasury shares — is stock that a company has bought back from public investors. When a company does a stock buyback, it puts the repurchased shares back under its own control and reduces the supply of shares available in the market. That often boosts the price.
After the buyback, the company can cancel the treasury shares or reserve them for future uses, such as granting stock options to employees.
The amount of treasury stock a company has can be found in its balance sheet. The balance sheet includes the company's assets, liabilities, and shareholders' equity. Typically, the amount of treasury stock a company has is included in a line item at the bottom of the equity section, but it can be included anywhere within the equity section with a debit balance.
While treasury stock isn't something that typically has a significant direct impact on individual investors, it can be worth considering as part of an investment analysis, as companies can use it to protect themselves financially, plan for future mergers or acquisitions, fend off unwanted buyouts, reward employees, or plan for future capital-raising needs, among other reasons.
Why do people invest in stocks?
Investing in stocks can provide several possible advantages, such as the following:
Potential for high returns
While nothing is guaranteed with investing, stocks have historically outperformed other asset classes like bonds, gold, and real estate over the long term — though it depends on exactly what you're comparing. To give you some sense of return potential, though, consider that the S&P 500 has historically averaged over 10% annual returns.
Ownership in companies
Having an ownership stake in a company can mean participating in potential growth, and therefore gaining returns. But some investors also want an ownership stake such as to support companies they believe in or have voting rights in companies they want to reform.
Portfolio diversification
Stocks can be part of a well-diversified investment portfolio, with the weighting varying based on your investment objectives and risk tolerance. For example, a retiree might want more conservative, stable investments like bonds, but having at least some allocation to stocks could potentially help their investments grow enough to provide sufficient retirement income for the rest of their life. Remember, though, nothing is guaranteed with investing.
Liquidity
Public market stocks are typically easy and quick to buy and sell, meaning they're highly liquid. For example, you could sell stock today and possibly get your money in your bank account in a day or two, depending on factors like the broker you use. In contrast, selling assets like real estate might take weeks or months before the money reaches your bank account, meaning they offer less liquidity.
Risks of investing in stocks
While there are many possible rewards for investing in stocks, there are risks to consider too, such as:
Loss of principal
With stock investing, you can lose money. You might invest in a company that ends up losing out to competitors, or an economic downturn might cause a market selloff that causes your investment to lose value. If you sell when you're down, you could end up with less money than when you started.
Volatility
Stock prices can be volatile. Some days the market is up, some days it's down. If this volatility stresses you out and causes you to make rash decisions, like liquidating your stocks at inopportune times, that could hurt your finances.
Economic risk
As mentioned, what's happening in the broader economy can affect stock returns, but even if you don't lose money, economic conditions can affect your net returns, especially compared to other investments. For example, high inflation could offset some of the investment returns you might earn, whereas some other investments, like I-bonds, could potentially be better hedges against inflation.
Cash flow
If a stock doesn't pay dividends, there's a risk that your cash flow could suffer. You might try to keep your money invested in stocks long-term, which is generally considered to be a best practice for optimizing gains, but that could mean that you have to figure out an alternative way to get cash if your money is tied up in stocks.
How to invest in stocks
Investors can start investing in stocks by opening an account with a stockbroker. Nowadays, that often means opening an online account with a brokerage or investing app. Then, you can research different stocks or stock funds, along with investment strategies, to see what you want to do with your money.
In many cases, starting small with low-cost, diversified funds is the best way to begin investing. By investing in mutual funds or ETFs that invest in a basket of underlying stocks, you can quickly gain access to a diversified range of stocks. Some funds are actively managed, while others track benchmark market indexes, such as the S&P 500.
"Stock picking can be a time-consuming activity if done correctly. Therefore, I always advise [investors] to buy an index [fund] or ETF such as one [that tracks] the S&P 500, like VOO, or on any other sector of interest," says Shanka Jayasinha, CIO of S&J Private Equity.
Quick tip: ETFs and mutual funds charge an annual management fee, referred to as the fund's expense ratio. It's important to know what you're paying in fund fees as high expense ratios will eat into your overall returns.
Many brokers now don't charge commissions for stock trades — including for funds like ETFs — and allow clients to buy fractional shares, so you can start small. As you get more comfortable, you can invest more.
Also, it's usually helpful to be patient and invest for the long term, rather than trying to outsmart other investors and perfectly time the market with the perfect stock picks. Remember, you're going up against professionals who generally have more information and resources than you, and even they tend to struggle to outpace indexes like the S&P 500. So in many cases, the best strategy is to pick an investment style you can stick to for the long run.
When investors are able to take advantage of compounding returns over many years, their profits can increase exponentially. That's why time in the market, rather than perfect timing, is likely to be most important to your success.
"Time is the greatest ally of the investor because of the 'magic' of compound interest," Johnson says.
With this in mind, Johnson recommends that investors "begin investing in a low-fee, diversified equity index fund and continue to invest consistently whether the market is up, down, or sideways."
According to the Schwab Center for Financial Research, the market suffered intra-year setbacks of 10%+ in 10 out of 20 years in the 21st century, demonstrating the relatively high short-term risk of stock investing. Yet, it finished in positive territory in all but three of those years, demonstrating the power of patience with stock investing.
Is it worth investing in stocks?
A stock gives an investor a small ownership share of a company, and the stock's returns are generally based on the company's performance. Investing in stocks is a common way for investors to build wealth over the long run.
However, there are no guarantees. Whenever a public company falters, its stock investors are likely to suffer as well. But the more stocks you own, the lower your risk of taking a big portfolio hit due to one wrong stock pick.
Thankfully, you don't need a huge account balance to build a diversified stock portfolio with your broker. Through the use of ETFs, mutual funds, or fractional shares, it's easy to invest in dozens or hundreds of stocks with minimal capital.
FAQs about stocks
How do I buy and sell stocks?
What is a stock index?
A stock index is a collection of stocks grouped together based on a shared characteristic, such as size or geography. An index is often used as a benchmark by investment funds, either by matching the underlying components of the index or trying to outperform, such as by making some adjustments to the companies included.
What is a stock dividend?
A stock dividend is a cash payout to shareholders. Dividends are often paid on a quarterly basis as a way to pay out some profits to shareholders, but companies can pay dividends at any time, for any reason.
