What Are Stocks?

Stocks are a fundamental part of any investor’s portfolio, whether they are purchased directly or indirectly through funds, and are one of the most basic financial assets an investor can purchase. A stock represents a small piece of ownership in a public company and allows investors to reap financial gains from owning a part of that company.

Stocks and Dividends

Stocks are a share of a company that can be purchased or traded by investors. When you purchase a stock, you become a shareholder in a public company. This means that you have a small piece of ownership or equity in that company and can reap the financial gains from this ownership. Based on the company’s performance or other factors, the value of its stock may rise or fall, meaning that its shareholders either gain or lose money.

For example, if you purchased one stock of Facebook for $100 and Facebook’s stock price rose 10%, your stock would now be worth $110. Companies issue stocks to raise money. This money could be used for launching new products, paying off debt or purchasing capital to expand the company, such as machines or buildings.

Depending on the type of stock purchased, a shareholder is also entitled to one vote per one stock on company management issues decided at the company’s annual shareholder meeting. This includes electing the board of directors, who oversee the management team of the company. If a shareholder cannot attend the annual meeting to vote, he or she can vote by proxy by allowing another individual to vote in his or her name.

The company’s management team usually votes as proxy for a large number of shareholders, because most shareholders, especially if they only own a few shares, do not attend the annual meeting. This means that shareholders do not have to be involved in the daily affairs of running the company.

Dividends

Some companies issue dividends to their shareholders, which are a part of the company’s earnings that are paid on a regular basis. These payments are on top of any rise or decline in the value of the stock. Dividends are typically paid to shareholders quarterly (four times per year), but companies may issue them annually, semi-annually or monthly. Dividends may be issued as cash or additional stocks and may be fixed or variable.

Investors receiving fixed dividends receive the same percentage or dollar amount each time dividends are issued, regardless of the company’s performance. Variable dividends are tied to a company’s performance, meaning that dividend payments will be higher when a company has done well and lower when it hasn’t. Companies can change their dividend policies at any time, even stopping dividends permanently or temporarily.

Stocks form an important part of any investor’s portfolio. While stocks are riskier than bonds or cash investments, they have much higher returns over the long run and many issue dividends on top of this. The Standard and Poor’s 500, an American stock market index that tracks the stocks of 500 large companies, averaged an annual return of 7% over the last 50 years.

For comparison, savings accounts have had interest rates at or below 1% over the last few years. Stocks are much more volatile than bonds or other cash investments, as you’ve likely seen when the stock market has massive swings. A company could perform poorly or go bankrupt, causing its stock price to fall, or a larger economic issue, such as the housing crisis, could cause massive increases or decreases in the value of many stocks. 

Classes of Stock

Companies can issue a variety of stocks based on the ownership rights a shareholder has. The two most frequent types are called common stocks and preferred stocks. Most stocks issued are common stocks. When an individual purchases a common stock of a company, he receives one vote per stock to elect board members or decide on major decisions for the company.

This is different from preferred stocks, where the shareholder does not receive voting rights. Preferred stock also comes with a fixed dividend payment. Common shareholders may or may not receive a dividend and if they do, it is normally a variable dividend. Preferred shareholders must also be paid in full for any dividends before common shareholders can receive theirs, and they also will be paid before common shareholders if a company declares bankruptcy and liquidates its assets.

Variable and fixed dividends perform better in specific situations. Let’s say both Jane and Tom have $100 of stocks in Starbucks, but Jane has preferred stock and Tom has common stock. The fixed dividend on Jane’s stock is 5%. Tom’s dividend depends on what Starbucks’ board of directors decide for a given quarter. One quarter, Starbucks does extremely well and decides that variable dividends will be 10%. Tom will receive $10 on his $100 in stocks, but Jane will only receive $5. Another quarter, Starbucks does very poorly and decides to issue smaller variable dividends at 2%. Tom will only receive $2, but Jane will continue to receive $5. 

TypeBenefitsDisadvantages
Common Shareholders receive voting rights and if they receive variable dividends, potentially higher dividends based on the company's performance. This also means share prices are higher and may appreciate more. Dividends are usually variable, if they are present at all. Common shareholders also have lower priority for payback than preferred shareholders.
Preferred Preferred shareholders have higher priority than common shareholders and receive fixed dividends. Preferred shareholders have no voting rights. Preferred stock typically has a lower price and may appreciate less due to fixed dividends and lack of voting rights.

Beyond common and preferred stocks, companies may also choose to issue other types of stocks based on ownership rights of shareholders. For example, Google issues Class A, Class B and Class C shares. Class A shareholders receive one vote per share, Class B shareholders receive 10 votes per share and Class C shareholders receive no voting rights. This type of structure is used to control the voting power of the company. In Google’s case, the Class B shares are not available on the public markets, but are instead owned by management within the company.

Stock Market Indexes

Stock market indexes track the value of a large number of stocks. One of the best known indexes is the Dow Jones Industrial Average. The Dow Jones measures the value of 30 stocks from large, reputable companies, sometimes referred to as blue chip stocks. Another well-known index is the Standard and Poor’s 500 (S&P 500), which follows stocks from 500 large companies. 

Stock market indexes can serve as a benchmark for the performance of specific investments, meaning an investor who purchases stock in a company could monitor its performance compared to the S&P 500 to see if it has performed well historically. They can also be used to describe how the overall market is performing: you’ll often hear how the Dow Jones or S&P gained a certain number of points in a day or how the markets are recovering from a loss.

How to Buy Stocks

Stocks can be purchased in a variety of ways, including through a broker, as part of a mutual fund or exchange-traded fund (ETF), as part of a dividend reinvestment plan or directly from the company issuing the stocks. Most commonly, investors will purchase stocks through a brokerage either by buying the stock itself or buying a mutual fund or ETF that includes the stock. When purchasing stocks from a brokerage or fund company directly, there are typically commissions and transaction fees on the purchase. Mutual funds and ETFs that include stocks may focus on a particular type of stocks, such as blue chip stocks, or may include other securities, such as bonds.

Investors can sometimes purchase stocks directly from the company that is issuing them, in what is known as a direct stock purchase plan. Not all companies do this, and some may only allow direct stock purchase for employees of the company. Finally, investors may also purchase shares of a company through a dividend reinvestment plan. This plan allows investors to reinvest any dividends they receive on stocks they own into buying more stocks from the company that issued the dividends.

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