What are stocks and how do they work?

A stock represents a piece of ownership in a corporation and could be a great addition to your investing portfolio. We can help you understand how stock investing works.

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Astock represents a piece of ownership in a corporation. Stocks are also known as equities, which signifies that anyone who owns them has a stake in the company’s performance.

The stock market’s movements are always in the headlines. However, many of the people reading about those ups and downs are standing on the sidelines: According to a 2021 online poll, 39 percent of Americans have no money invested in stocks. Struggling to understand the market — cited by 32 percent of respondents who have been steering clear of the market — is one of the most common reasons for the aversion.

People buy stocks to earn a return on their investment, which allows them to grow their wealth and achieve financial goals like retirement. Here’s what else you need to know.

How stocks work

When a corporation is looking to grow, it needs money to help pay for expenses such as designing new products, hiring more people and expanding into new markets. They issue new shares of stock to help raise that capital. Anyone who buys those stocks is poised to profit if that growth becomes a reality.

How do you make money from stocks?

There are generally two ways:

  1. Price appreciation. A company’s stock price will typically rise as the earnings and future prospects of the company’s business improve. Over the long-term, earnings growth is a major driver of stock prices so it’s important to identify companies whose businesses are likely to do well.
  2. Dividends. Some companies also pay dividends, which are a way for them to share a portion of their profits with shareholders. These regular payments are typically made quarterly and can account for a large portion of investors’ returns over time. If a company pays an 18 cent dividend each quarter and you own 10 shares, you’ll receive $1.80 with each payment. Though rare, there can also be stock dividends, which reward shareholders with additional shares.

It’s important to note that dividends are not guaranteed. Companies can slash their dividends. Not all companies pay them, either. Younger, rapidly expanding companies often don’t pay dividends. Instead, they reinvest all profits back into the company with the hopes of growing further and generating more profits that will ultimately lead to a higher stock price.

What are the downsides of stocks?

While stocks offer the potential for growing your money, the appeal of those returns comes with some sizable risks. If the company falls on hard times, posts losses or misses their earnings expectations, the stock price could drop. Wherever the stock goes, your money follows.

There’s a chance you could lose all your money, too. For example, if a business that you invested in closes its doors, your investment is likely gone for good. Stock investors are last in line when it comes to claims on the assets. Employees, vendors and bondholders are all in line to get paid before the stockholders.

How can you invest in stocks?

The stock market is accessible to everyone, and there are two ways to own stocks.

Direct ownership

You can buy stock in individual companies through a brokerage account. As competition has increased in recent years, most online brokerages no longer charge commission fees. So, rather than paying to invest, you’ll be able to put all of your money into your investment. Some companies such as Walmart, Coca-Cola and Home Depot also offer direct investment plans, which allow you to buy shares from them — bypassing the need to open a brokerage account altogether.

While direct investing can put you in the driver’s seat, it also creates a massive workload. Studies have shown that building a properly diversified portfolio of individual stocks requires holding approximately 30 different stocks.

Diversification refers to owning a range of assets vs. holding just one or a small few. This reduces the overall risk in your portfolio.

That’s 30 different companies to monitor, tracking how their business is performing and whether they are on a positive trajectory — a tall order that requires a great deal of time and expertise.

Indirect ownership

Indirect investing is a much easier approach and is a great way for beginners to buy stocks. Rather than reading annual reports, comparing performance data and hand-picking stocks, you can own stocks through a mutual fund or an exchange-traded fund (ETF).

These funds invest in hundreds — sometimes even thousands — of stocks. Instead of tying your fortunes to a single company, you can benefit from exposure to a wide range of companies. Think of this as instant diversification from the first dollar you invest.

Do you have to buy one full share?

It’s important to note that owning stocks doesn’t mean you need a mountain of money. If you want to invest in Amazon, you don’t have to have more than $2,777 (the current price of one share as of Feb. 3).

Fractional share investing is available via many brokerages, and it allows you to invest a small amount — as little as $5 — in a company. An indirect investment will also spread that money into smaller fractions across companies. For example, buying one share of a fund might make you an investor in Amazon, Google and a number of other high-profile companies.

Bonds vs. stocks: What’s the difference?

In addition to buying stocks, many investors include bonds in their portfolios. To raise capital, corporations can also issue bonds, but buying one does not make you an owner. Instead, you are making a loan to the company, and the bond comes with a maturity date.

The best-case scenario of owning a bond is that you get your money back on that date with some additional interest paid out along the way. Bonds have a higher priority of repayment in the event of a company’s liquidation, which means they are safer than stocks – though you can still lose some or all of your money.

It’s also worth noting that bond prices and interest rates move inversely to one another. So as interest rates rise, bond prices fall.

Last updated on February 13, 2022, and last reviewed by an expert on February 11, 2022.
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