Stocks: What They Are, How They Work & How to Invest
Learn what stocks are, how stock ownership works, the different types of stocks, what affects stock prices, how dividends work, how to read a stock quote, and what to understand before buying shares.
A stock represents an ownership interest in a company. When you buy shares of stock, you become a shareholder and may benefit if the stock increases in value or if the company pays dividends. Stock prices can also decline, and investors can lose money.
What Are Stocks?
Stocks, also called equities, represent ownership in a corporation. When a company issues shares of stock, investors can purchase those shares and become shareholders.
A shareholder's ownership percentage depends on the number of shares owned relative to the company's total shares. Some stocks also provide voting rights on certain company matters.
Companies can issue stock to raise capital for purposes such as expanding operations, developing products, entering new markets, or managing their finances.
How Do Stocks Work?
When you purchase a publicly traded stock through a brokerage account, you are buying shares that trade in a market. The price changes as buyers and sellers transact and as expectations about the company and market change.
Investors may seek returns through two primary sources: an increase in the stock's price or dividends paid by the company. Neither is guaranteed.
If you buy 10 shares at $50 per share, the initial purchase value is $500 before applicable costs. If the stock later trades at $60, the shares have a market value of $600. If the stock instead falls to $40, the shares have a market value of $400.
Why Do Companies Issue Stock?
Selling stock can provide a company with capital without creating a traditional debt obligation. Companies may use the money raised for business expansion, research and development, acquisitions, facilities, or other corporate purposes.
A company can initially sell shares to the public through an initial public offering, commonly called an IPO. After shares begin trading publicly, investors generally buy and sell those shares from one another through the secondary market.
Types of Stocks
Common Stock
Common stock is the type of stock most individual investors encounter. Common shareholders generally have voting rights and may receive dividends if the company declares them.
Preferred Stock
Preferred stock generally has different rights from common stock. Preferred shareholders commonly receive dividends before common shareholders and have a higher claim than common shareholders on company assets if the company is liquidated.
Preferred shares generally have different voting characteristics from common shares, and their structure varies by issue.
Common Stock Categories
Investors and financial publications often categorize stocks according to characteristics such as company size, valuation, growth expectations, or dividend payments.
| Category | General Meaning |
|---|---|
| Growth stocks | Companies whose earnings or growth expectations are relatively high compared with broader market measures. |
| Value stocks | Stocks that may appear relatively inexpensive according to measures such as price-to-earnings or other valuation metrics. |
| Income stocks | Stocks associated with dividend payments that may be an important part of their expected return. |
| Blue-chip stocks | Shares of large, established companies with widely recognized businesses and substantial market presence. |
| Small-cap stocks | Stocks of companies with relatively small market capitalizations. |
| Large-cap stocks | Stocks of companies with relatively large market capitalizations. |
What Is Market Capitalization?
Market capitalization, often called market cap, is the total market value of a company's outstanding shares.
A simplified calculation is:
For example, if a company has 100 million shares outstanding and the stock trades at $20, its market capitalization would be approximately $2 billion.
Market-cap categories such as small-cap, mid-cap, and large-cap are useful ways to describe company size, but definitions and thresholds can vary between index providers and financial institutions.
What Makes Stock Prices Go Up or Down?
Stock prices are determined by market trading. Many factors can influence how investors value a company and how much buyers and sellers are willing to pay.
- Company earnings and revenue
- Expectations for future growth
- Interest rates
- Economic conditions
- Industry trends
- Company announcements
- Changes in competition
- Investor sentiment
- Political or geopolitical events
- Broader market conditions
A company's stock price does not necessarily move in exactly the same direction as its current financial results. Expectations about future performance can also affect the market price.
What Are Stock Dividends?
A dividend is a distribution a company makes to shareholders. Companies may pay dividends in cash or, depending on the arrangement, through other forms of distribution.
Not every company pays dividends. A company may instead retain earnings to fund operations, expansion, research, acquisitions, debt reduction, or other purposes.
A company can change, reduce, suspend, or eliminate a dividend depending on its circumstances and board decisions.
How to Read a Stock Quote
A stock quote provides a snapshot of a stock's market information. Depending on the platform, a quote may include several data points.
| Quote Item | What It Represents |
|---|---|
| Symbol | The ticker symbol used to identify the security. |
| Price | The displayed market price or most recent traded price. |
| Change | The change in price over the displayed comparison period. |
| Change % | The percentage change over the applicable period. |
| Volume | The number of shares traded during the displayed period. |
| Bid | The highest displayed price a buyer is currently willing to pay. |
| Ask | The lowest displayed price a seller is currently willing to accept. |
Quote information can change quickly while markets are open. Different financial websites may also display delayed or real-time information depending on their data arrangements.
How Do You Buy Stocks?
One common way to buy publicly traded stocks is through a brokerage account. A brokerage account allows investors to buy and sell securities such as stocks, bonds, mutual funds, and ETFs.
Before opening an account, review the brokerage firm's services, investment choices, fees, account types, and other terms.
Cash Accounts
In a cash brokerage account, the investor generally pays the full amount for securities purchased and does not borrow from the brokerage to make the purchase.
Margin Accounts
A margin account allows a brokerage to lend money to an investor using securities in the account as collateral. Margin introduces additional risks, including interest charges, margin calls, and losses that can exceed the amount initially invested.
Stock Order Types
When buying or selling stocks through a brokerage, you generally choose an order type. The two common order types are market orders and limit orders.
Market Order
A market order generally prioritizes execution at the next available price. The exact execution price is not guaranteed.
Limit Order
A limit order specifies the maximum price you are willing to pay when buying or the minimum price you are willing to accept when selling. A limit order may not execute if the market does not reach the specified price.
The price displayed when you enter an order may differ from the eventual execution price, especially in rapidly changing markets.
How to Research Stocks
Researching a company can help you understand the business and the risks associated with its stock. No single metric provides a complete picture.
Revenue and Earnings
Review how the company's revenue and earnings have changed over time and consider what has caused those changes.
Profit Margins
Profit margins can help investors understand how much of the company's revenue remains after different expenses.
Debt
Examine the company's debt and its ability to meet interest and other financial obligations.
Cash Flow
Cash flow provides another perspective on the money moving into and out of a business.
Valuation
Investors may use measures such as the price-to-earnings ratio, price-to-sales ratio, price-to-book ratio, and other metrics when evaluating valuation.
These metrics should be interpreted in the context of the company's industry, business model, growth, profitability, and other factors.
Company Financial Reports
Public companies provide financial and business information through regulatory filings. These documents can provide information about revenue, expenses, debt, risks, operations, management discussion, and other matters.
Investors can use the SEC's EDGAR system to access filings from many public companies.
Company filings, financial statements, investor presentations, market data, and independent research can provide different pieces of information.
Risks of Investing in Stocks
Stocks involve investment risk. Their prices can rise or fall, and there is no guarantee that you will recover the amount you invest.
- Market risk: Overall market conditions can cause stock prices to decline.
- Company risk: Problems with a specific company can cause its stock price to fall.
- Industry risk: Changes affecting an entire industry can affect multiple companies.
- Economic risk: Recessions, inflation, interest rates, and other economic conditions can affect stocks.
- Liquidity risk: Some securities may be more difficult to buy or sell quickly at a desired price.
- Concentration risk: Holding too much of one company or sector can increase the effect of a decline in that investment.
Why Diversification Matters
Diversification means spreading investments across different companies, industries, asset classes, or markets.
If one company experiences a major decline, diversification can reduce the effect that company has on the overall portfolio. However, diversification cannot eliminate investment losses.
Investors can diversify through individual stocks, diversified funds, bonds, and other investments depending on their goals and circumstances.
Individual Stocks vs. Stock Funds
| Feature | Individual Stocks | Stock Funds |
|---|---|---|
| Ownership | Shares of specific companies | Shares of a fund holding multiple investments |
| Diversification | Depends on the stocks you own | Can provide diversification within the fund |
| Research | Investors research individual companies | Investors research the fund and its investment strategy |
| Company-specific risk | Direct exposure to selected companies | Usually spread across multiple holdings |
Stocks and Long-Term Investing
Stocks are often used as part of long-term investment strategies because companies can grow their businesses over time. However, stock markets can experience substantial declines and periods of volatility.
The appropriate amount of stock exposure depends on factors such as investment goals, time horizon, risk tolerance, financial situation, and the rest of the portfolio.
Historical returns are not guarantees of future results.
Taxes on Stock Investments
Stock investments held in taxable accounts can have tax consequences. Selling shares for more than their adjusted tax basis can create a capital gain, while selling for less can create a capital loss.
The tax treatment of a gain can depend on how long the investment was held and your individual tax situation. Dividends may also have tax consequences.
Tax-advantaged accounts such as retirement accounts have different tax rules. Consider current IRS guidance or a qualified tax professional for questions about your circumstances.
Stock Investing Fees
The cost of investing can include more than a brokerage's advertised trading commission.
Depending on the account and transaction, investors may encounter account fees, transaction-related costs, advisory fees, regulatory fees, fund expenses, or other charges.
Review the current fee schedule and account disclosures before investing.
How to Start Investing in Stocks
- Set a financial goal. Decide what you are investing for and when you may need the money.
- Review your financial foundation. Consider emergency savings, debt, income, and regular expenses.
- Choose an account. Determine whether a taxable brokerage account, retirement account, or another account fits your situation.
- Research your investment. Understand the company, industry, financials, valuation, and risks.
- Decide how much to invest. Use an amount that fits your overall financial plan.
- Place an order. Understand the order type before submitting a trade.
- Diversify. Avoid relying excessively on one company or investment.
- Review periodically. Check whether your investments still fit your goals and risk tolerance.
Common Stock Investing Mistakes
- Buying a stock without researching the company.
- Putting too much money into one stock.
- Confusing a stock's price with its overall valuation.
- Making decisions solely from social-media posts.
- Ignoring fees and taxes.
- Using margin without understanding the risks.
- Assuming past performance guarantees future returns.
- Reacting emotionally to short-term price movements.
- Investing money needed for near-term expenses.
Stock Investing Checklist
- Define your investment goal.
- Determine your time horizon.
- Understand your risk tolerance.
- Choose an appropriate account.
- Research the company.
- Review financial statements and filings.
- Understand the stock's valuation.
- Review dividends if applicable.
- Understand trading and account costs.
- Consider diversification.
- Understand the tax consequences.
Frequently Asked Questions
What is a stock?
A stock represents an ownership interest in a company. Stockholders may have certain rights, including voting rights for many common shares, and may receive dividends if declared.
How do stocks make money?
Investors may receive a return from an increase in the stock's price or from dividends paid by the company. Neither outcome is guaranteed.
Can you lose money investing in stocks?
Yes. Stock prices can decline, and investors can lose some or all of the money invested in an individual stock.
What is the difference between common and preferred stock?
Common and preferred stocks have different rights and characteristics. Common stock generally provides voting rights, while preferred stock generally has priority over common stock for dividends and claims on assets in liquidation.
How do I buy stocks?
One common method is through a brokerage account. Investors can also encounter direct stock plans, dividend reinvestment plans, and stock funds.
What is market capitalization?
Market capitalization is the market value of a company's outstanding shares. A simplified calculation is share price multiplied by shares outstanding.
Are stock dividends guaranteed?
No. Companies can change, reduce, suspend, or eliminate dividends depending on their circumstances and decisions.
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