Stocks make a lot of headlines. But what exactly are they?
If you buy stock in a company, that means you officially own part of that company. Yes, it may be a small sliver of ownership, but if the company performs well, makes money and becomes more valuable, your share of the company will also become more valuable. If that happens, you may be able to sell your stock for more than you bought it for. That's how stocks can help you build wealth.
While there are some small differences, the terms "stocks" and "shares" generally mean the same thing — though it's probably more common to say you "own shares of" or "own stock in" a particular company, and you "own stocks" to refer to owning shares of lots of companies.
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How do stocks work?
Stocks work like this: Companies sell shares of their business to investors. Investors buy those shares (called stock), which in turn provides companies with money to expand their businesses through creating new products, hiring more employees or other business initiatives.
Companies typically begin to issue shares of their stock through a process called an initial public offering (IPO). This is called "going public," and it refers to a company's debut on a stock exchange. Once a company’s stock is on the stock market after the IPO, it can be bought and sold among investors. If you decide to buy a stock, you’ll often buy it not from the company itself, but from another investor who wants to sell the stock. Likewise, if you want to sell a stock, you’ll sell to another investor who wants to buy.
These trades are handled through a stock exchange, with a broker representing each investor, who holds stocks and other investments in a brokerage account. The process of opening a brokerage account is similar to opening a bank account — you will need a brokerage account to buy stock.
The way you make money from stocks is by selling them at a higher price than you paid for them. For instance, if you bought a share of Apple stock at $200 and sold it when it reached $300, you would have made $100 (minus any taxes you'd have to pay on the money you made).
What are the benefits of owning stock?
The primary reason that investors own stock is to build long-term wealth by earning a return on their investment. That return generally comes in two possible ways:
- The stock’s price goes up. You can then sell the stock for a profit if you’d like.
- The stock pays dividends. Not all stocks pay dividends, but many do, especially well-established companies. Dividends are payments made to shareholders out of the company’s revenue, and they’re typically paid quarterly. (Interested in dividend income? View our list of high-dividend stocks.)
Over the long term, the average annual stock market return is 10%; that average falls to between 7% and 8% after adjusting for inflation. That means $1,000 invested in stocks 30 years ago could be worth nearly $8,000 today.
It’s important to note that the historical return is an average across all stocks in the S&P 500, a collection of around 500 of the biggest companies in the U.S. It doesn’t mean that every stock posted that kind of return — some posted much less or even failed completely. Others posted much higher returns.
That’s why it’s wise to buy stock not in just one company, but to build a well-rounded portfolio that includes stocks in many companies across various industries and geographies.
Learn more
How to Invest In the S&P 500Key things to know about stocks
Common stocks vs. preferred stocks
There are two main types of stocks: common and preferred. The primary differences between common stock and preferred stock are the dividends and voting rights they offer. Most investors own common stock in a public company. Common stock may pay dividends, but dividends are not guaranteed, and the amount of the dividend is not fixed. Investors of common stock typically have voting rights that are proportional to their ownership level.
Preferred stocks typically pay fixed dividends, so owners can count on a set amount of income from the stock each year. Owners of preferred stock also stand at the front of the line when it comes to the company’s earnings: Excess cash distributed by dividend is paid to preferred shareholders first, and if the company goes bankrupt, preferred-stock owners receive any liquidation of assets before common-stock owners. Owners of preferred stock usually do not have voting rights.
Trading vs. investing
Traders buy and sell stocks to get a short-term profit — they're looking to capitalize on small changes in a stock's share price, and their goal is to time the market. Investors buy and hold stocks, and usually do better over the long term. Investors typically own a diversified portfolio of many stocks and hold on to them through good economic times and bad. They generally don't try to time the market; instead, they often invest small amounts on a regular basis.
Individual stocks vs. funds
Investing in individual stocks takes time. You should research each stock you purchase, which includes a deep dive into the bones of the company and its financials. Many investors opt to save time by investing in stocks through equity mutual funds, index funds and ETFs instead. These allow you to purchase many stocks in a single transaction, offering instant diversification and reducing the amount of legwork it takes to invest.
Am I really part of the company if I own company stock?
Most investors own what’s called common stock, which is what is described above. Common stock comes with voting rights — you'll likely have the chance to cast your vote regarding major changes the company wants to make. However, unless you own a substantial number of shares, your vote doesn't actually carry significant weight.
Again, owning a stock doesn’t mean you carry a lot of weight within the company, or that you get to rub elbows with company bigwigs. It also doesn’t mean that you own a piece of the company’s assets — you aren’t entitled to a parking spot in the company lot or a desk at the company’s headquarters.
What you own, essentially, is a share in the company’s profits — and, it should be said, its losses. The goal, of course, is for the value of the company — and as a result, the value of its stock — to go up while you’re a shareholder.
But while stocks overall have a history of high returns, they also come with risk: It’s entirely possible that a stock you own will go down in value instead, especially in the short term. Stock prices fluctuate for a variety of reasons, from overall market volatility to company-specific events, like a communications crisis or a product recall.
Many long-term investors hold on to stocks for years, without frequent buying or selling, and while they see those stocks fluctuate over time, their overall portfolio goes up in value over the long term.
» Dive deeper: Should you invest in stocks or mutual funds?
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